SEPTEMBER 2011: What You Need To Know About - South Carolina Incomes Taxes, Part 2
Author: Lew Wessel | Photographer: Photography by Anne
Who knew? After two years of writing articles on big subjects like Investing, Insurance, Federal Taxes, etc., I focused my last missive on the limited subject of South Carolina income taxes and got the greatest response yet from CH2 readers. Okay… I can take a hint. Now, here are some more things I think you need to know about South Carolina taxes and state income taxes in general.
Most South Carolinians are only required to file a Federal 1040 and a South Carolina SC1040. These are the taxpayers who live and work within the state borders and have no investments in other states. For these “lucky” people, reading and deciphering South Carolina income tax laws, including its 50+ tax credits, is all the knowledge required with regard to state income taxes.
On the other hand, there are those who perform substantial personal services in another state, have a business or rental property in another state, or have sold a piece of real property such as a second home or raw land located in another state. Members of this group will most likely be required to file both a South Carolina return as well as an income tax return in the other state(s) in which they are doing business or investing.
Working on a tax engagement with multiple state returns is a pain, even for the most seasoned tax professional. As I mentioned in the previous article, tax practitioners are very comfortable with their own state income tax laws, but other state’s tax laws (and each state is unique) can be a challenge to master. Perhaps it’s no surprise that many tax filers simply ignore the obligation to file “foreign” state returns and let 100 percent of the income flow from their federal return into their home state return. This is a big mistake for multiple reasons, not the least of which is that there is a legal requirement that is being ignored that may result in significant interest and penalties. In addition, it can lead to some “unfair” and costly consequences.
Let’s say you own a rental property in North Carolina. You dutifully report the income or loss each year on your federal return, but instead of reporting the gain or loss on a North Carolina return (D-400 and non-resident worksheets), you simply let it flow through to your South Carolina SC1040. You eventually sell the rental property for $1,000,000, which results in a tax gain of $500,000. Two hundred thousand dollars of the gain is attributable to depreciation deductions taken over the years. Again, you report the gain on your federal and South Carolina returns.
Here’s the problem: North Carolina receives the informational form required at real estate closing (Form NC-1099NRS), reporting that you have received $1,000,000. Since they’ve never seen anything related to your property before, the state sends you a tax bill based on the full $1,000,000. In a panic, you call up a tax pro to try to straighten out the mess—not an easy task. First, since you never filed a tax return in North Carolina, the three-year statute of limitations never started; thus, every year is fair game in North Carolina, and they’ll want not only the tax on the actual capital gain, but also the back taxes, penalty and interest from the very first year you started renting the property. Meantime, the tax pro will be able to file amended tax returns in South Carolina, but for only three years, due to our statute of limitations. If you had rental income prior to that, you will have paid twice on the same income. Finally, if this all takes too long, you may end up paying capital gain on the sale to both North Carolina and South Carolina.
Bottom line: File that “foreign” state return! If it’s too much of a hassle, hire someone to do it.
WHAT’S FAIR IS FAIR
Everyone can agree that getting taxed on the same income twice is unfair. The good news is that South Carolina tax law, as well as the income tax laws of every state of which I am aware, includes rules and procedures to mitigate or totally fix this potential problem for multi-state taxpayers.
Credit for taxes paid to another state. As a citizen of South Carolina, you are required to pay taxes on your personal service income, even if it is earned in another state that is taxing those same earnings. To fix this, South Carolina provides a credit for taxes paid to the other state(s). This credit is calculated on Form SC1040TC and eliminates most, if not all, of the double taxation. Caveat: Your tax software can handle this if you enter the information from your W-2 or 1099 properly, but it can be tricky. Just make sure you know what result you are looking for on the final return so that you can be sure the computation is correct.
Gain or loss on out of state earnings. Unlike personal service income, South Carolina does not tax the income or loss from out-of-state rental properties, businesses, and real property. This type of income and the eventual capital gain or loss from the sale of the property or business is taxed in the state in which it is earned. Not a problem except for the fact that since South Carolina is a “conformity state”; i.e. all South Carolina tax information begins with federal taxable income which, of course, includes income and gains from every state.
The fix for this is to add back or deduct the non-South Carolina income from federal taxable income in order to arrive at South Carolina taxable income. The amounts added back or deducted will match those found on the “foreign state” returns, so that double taxation is once again avoided. One pretty cool thing about the way this is handled by South Carolina is that if the non-South Carolina income or capital gain is earned in one of the seven states without an income tax, there will be zero state taxes on that income. (Note: This is not true for the credit on personal services income, because if there is no tax on that in the other state, there is no credit…sorry.)
There is a further twist to the adjustment for capital gains or losses on the sale of property or a business in another state. If there are additional capital gains or losses on the return, such as from the sale of publicly traded stock, the 44 percent deduction SC allows for capital gains must be adjusted for the amount of gain or loss you are taking out of South Carolina income. Again, your tax software can handle this, but don’t count on it—check and recheck!
Active trade or business income deduction. I didn’t mention this in my last article, but it’s a nice tax break for South Carolina taxpayers that is often missed. This deduction is a good-faith effort on the part of South Carolina lawmakers to put all business income on an equal footing, regardless of the legal form in which the business is transacted. Thus, since corporate profits in South Carolina are taxed at a maximum rate of 5 percent, 2 percent less than the maximum individual rate of 7 percent, this deduction allows a business owner operating as a sole proprietor, partnership or Subchapter S to identify the business profits included in his income and separate them out to be taxed at a maximum of 5 percent instead of 7 percent. This can be a substantial savings, e.g. $2,000 for every $100,000 of profit. Note: This break pertains only to profit from the business itself, not from the amount you earn from personal services performed in that business. The calculation of these two amounts is, at best, an art, not a science. Fortunately, the law allows a “safe harbor” assumption of a 50/50 split; just make sure you check that box!
The deduction is on Line “l” of the SC1040 and also requires filing a special form: I-335.
Two wage earner credit. This is a credit of up to $210 for couples filing jointly where both spouses have earned income. It’s a small credit aimed at fixing the “marriage penalty” caused by two incomes moving a couple into a higher bracket. Go ahead and claim it on your return, and use the credit for a well-earned tax-return-completion dinner at your favorite restaurant.
Our border states. To illustrate how unique each state’s tax laws are, take note that Georgia taxes its residents on all income, including gains and losses from businesses or rental property located in another state. It does allow a tax credit for taxes paid on those earnings in another state. Georgia has neither a special deduction for capital gains nor a reduced rate on business income.
North Carolina has an exclusion similar to South Carolina’s for gains and losses in another state, but again, has no special deductions for capital gains nor a reduced rate on business income. If you do have a gain on property sold in North Carolina, pay special attention to its capital gain computation scheme as a large federal capital loss carry forward may effectively render the gain tax-free, even on a non-resident return.
Florida, of course, has no income taxes.
A FINAL WORD
Everyone, even the most seasoned tax pro, uses tax software to prepare tax returns. The difference between the tax pro and the civilian is that the tax pro knows what he/she wants to see when he reviews the return that comes chugging out of the printer. Hopefully, after reading these two articles on South Carolina taxes, you too will know what credits and deductions you are entitled to, and you will leave less money on the table for the tax authorities.
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