Business Issues: State Income Taxes and S-Corporations By Michael Smigocki Federal Strategies Group LLC Earlier this year the U.S. Court of Appeals for the Federal Circuit reversed the decision of U.S. Court of Federal Claims that had ruled disbursements to the shareholders of a Subchapter S Corporation for the payment of state income taxes to be allowable costs. The decision of Information Systems & Network S-Corporation v. United States (Case #04-5151, -5154) places contractors who have open years of indirect rate audits in the confusing position of how to handle these costs for the open years. This article is meant to provide the reader with the history and guidance on these decisions. Income Taxes and S-Corporations A Subchapter S Corporation is a closely held entity (no more than 100 shareholders) that makes a tax election so as to avoid double taxation, once at the corporate level and once at the shareholder level. Instead of paying a corporate tax, all income and losses of the entity are passed through to the shareholders. They pay taxes (both federal and state) from this corporate income on their individual tax returns at the individual rates. Most S-Corporations’ Shareholder Agreements obligate the corporation to reimburse shareholders for the tax liability that arises from income passed on by the corporation. State Income Taxes and the FAR FAR 31.205-41 addresses the allowability of various forms of taxes. State, local and certain federal taxes are generally considered allowable except for those detailed in 31.205-41(b). Since an S-Corporation generally does not pay income taxes (except for those states that do not recognize the S-Corporation status), prior to the original Court of Claims decision, tax payments made by S-Corporations to the shareholders were considered an unallowable cost. In contrast, state income tax payments made by a C corporation are allowable costs. Court of Federal Claims Makes Payments Allowable The Court granted ISN’s motion for summary judgment in November 2000. As a result, state income tax payments made by ISN’s shareholder were deemed to be allowable costs. However, many Subchapter S companies were unaware of this decision and failed to include these payments as reimbursable costs in their incurred cost submissions. In addition, DCAA auditors continued to question their allowability, even when provided with the text of the court ruling. Those that did include the payments in their submissions and provided the proof of allowability to the auditors were able to get recovery of these costs. Appeals Court Decision Reverses This In its decision, the Appeals Court stated that the Federal Claims Court improperly interpreted FAR 31.205-41 in its conclusion that the state income tax payments were allowable. Since the Claims Court was reversed, contractors who have submitted incurred cost submissions with these payments included, and have not been audited by DCAA or other government agency, may have these costs questioned by the auditors. DCAA Audit Guidance In March of this year, DCAA issued audit guidance to its auditors to continue to question claimed cost on individual shareholder income taxes assessed on contractor pass-through income. Thus it appears that DCAA will question any state income tax payments made to shareholders of S-Corporations for all open years, including years after the original Claims Court decision but before the Appeals court decision. The Future of the Issue It has yet to be determined whether the Appeals Court decision will be further appealed. Certain factual inaccuracies were noted in the decision. However, the decision fails to take into consideration the inequity the FAR imposes on Subchapter S Corporations. As a C corporation, state income taxes paid by the corporation are an allowable expense. As an S-Corporation, state income taxes paid by the corporation, to reimburse the shareholder for the liability created by the corporation’s income, are not allowable. If it were not for the income of the corporation, this tax liability would never have existed. So why should the fact that an election by the shareholders to be taxed only once drive allowability? Stay tuned; there may be more in store. (Michael Smigocki, CPA, CVA, ABV, is the senior managing director of Federal Strategies Group LLC. He provides government contract and management consulting, M&A advisory, litigation support and expert testimony to the government contracting industry. He can be reached via email at MikeS@FedStrat.com.)