State and Local Tax
Action Item: The City of Philadelphia is imposing its School Income Tax on City residents’ Subchapter S Corporation income, whether or not distributed. This is a departure from prior enforcement of this tax. City residents who are shareholders in Subchapter S corporations should consider filing appeals from the City’s assessment of this tax.
The City of Philadelphia Revenue Department (“City”) is assessing the School Income Tax (“SIT”) on the entire share of a resident S Corporation shareholder’s income, whether or not distributed. The assessments reach back to 2007 and are based on a 2007 change in the City’s SIT regulations, which is being challenged in a case pending at the Philadelphia Tax Review Board. Impacted taxpayers should consider taking action to preserve their ability to challenge their assessments.
The SIT is imposed at the rate of approximately 4% on “net income from the ownership, lease, sale or other disposition of real property and tangible and intangible personal property received or credited to the resident.” The SIT has historically been viewed as a tax on passive investment income, and not on business income. In fact, the SIT Ordinance exempts from the tax income from carrying on or exercising for profit any trade, business, profession or enterprise that is subject to the City’s Net Profits Tax or Wage Tax.
Prior to 2007, only S Corporation distributions were subject to the SIT. Starting in 2007, however, the City amended its SIT regulation to tax shareholders of S Corporations on their pro rata share of S Corporation income. That is, the City now applies the SIT to a shareholder’s full Schedule K-1 income, whether or not distributed. The City started enforcing this change aggressively approximately two years ago and is assessing impacted residents for years 2007-2013.
Is the City’s position correct under the law? Does the SIT tax base, that is, “income from the ownership, sale or other disposition of intangible property,” such as S Corporation stock, reach the underlying business income earned by the S Corporation, which may already have been taxed under the City’s Business Income and Receipts Tax (“BIRT”) ordinance, or is the ordinance intended to tax only the passive investment income of an S Corporation shareholder? Is it discriminatory to exempt a partner’s share of partnership net income from the SIT but not an S Corporation shareholder’s share of S Corporation income, especially when most partnerships pay no NPT because of the credit they receive for paying the same BIRT paid by S Corporations? A shareholder of a C corporation pays SIT only on distributed corporate dividends. Should an S Corporation shareholder be treated differently?
These questions are likely to be addressed in the pending Tax Review Board case and, perhaps, by the Pennsylvania courts to which appeals of that case may be taken. Meanwhile, the City appears poised to amend its SIT regulations to go back to the pre-2007 taxation of S Corporation income—on distributions only. However, this amendment is expected to be prospective only, applying to tax years 2014 forward.
What should you do if you are assessed for 2007-2013? If you have already paid the assessed tax, you should consider filing a refund petition with the City. Refund petitions can generally be filed within three years of the tax payment. If you received an assessment that has not been paid, you should consider filing a petition with the Tax Review Board contesting the assessment. You have 60 days from the date of your assessment notice to file this petition. Some audited SIT taxpayers may have waived their refund and appeal rights by signing settlement agreements with the City at the conclusion of their audits, under which the City agreed to waive all penalties (and 25% of the interest for prompt payment) in exchange for waiving their right to pursue refunds and appeals.
