C. How is tax on an electing flow-through entity calculated?

Flow-through entities that make the election are subject to the flow-through entity tax, which is levied at the same rate levied on individuals for the same tax year under Section 51 of the Income Tax Act (i.e., 4.25% for tax year 2021).⁷ The tax is levied only on the Michigan portion of the positive “business income tax base” attributable to direct members of an electing flow-through entity that are individuals, fiduciaries (i.e., estates or trusts), or other flow-through entities. Any portion of the business income tax base attributable to direct members that are insurance companies, financial institutions, or C corporations is not subject to the flow-through entity tax. Electing flow-through entities must therefore calculate the Michigan portion of the business income tax base before adjusting for the portion that is taxable or nontaxable based on attribution to their members.⁸

Determining the Business Income Tax Base

The starting point for the computation of the “business income tax base” is the flow-through entity’s “business income,” which includes “federal taxable income” and any payments and items of income and expense that are attributable to business activity of the flow-through entity and separately reported to its members.⁹ For most flow-through entities, “federal taxable income” refers to taxable income as defined in IRC 63.¹⁰ However, S Corporations do not have federal taxable income as defined under that section¹¹ and are therefore treated as corporations for the sole purpose of computing the business income tax base under the flow-through entity tax.¹² Thus, the starting point of the flow-through entity tax generally begins with amounts determined and reported by the entity for federal income tax purposes.

Once determined, the “federal taxable income” of a flow-through entity is subject to certain specific statutory adjustments. These adjustments, which must be performed prior to the allocation or apportionment of the business income tax base, generally mirror those adjustments required of individuals in computing taxable income under Section 30 of the Income Tax Act.¹³ These include adjustments for the following items to the extent reflected in federal taxable income of that entity¹⁴:

1. Interest income and dividends derived from obligations or securities of states other than Michigan;
2. Income and losses derived from the sale or exchange of certain obligations of the US government;
3. Charitable contributions;
4. Taxes on or measured by net income, including the Michigan flow-through entity tax;
5. Guaranteed payments for services rendered by a member who is an individual;
6. Tax refunds received under the city income tax and flow-through entity tax; and
7. Income from and expenses of producing oil and gas.

Special additional adjustments may be required when computing the tax base of an entity within a tiered structure (i.e., a structure in which a flow-through entity is owned by one or more other flow-through entities). In a tiered structure, any net positive business income attributable to any flow-through entity that elected to pay the tax for the same tax year must be deducted from the business income tax base.¹⁵ In other words, only positive business income attributable to non-electing flow-through entities will be included in the business income tax base of its members, which, through various return-level adjustments, is added back into the business income tax base of the reporting entity after apportionment and in accordance with that non-electing flow-through entity’s own Michigan business activity.¹⁶ The same adjustments, however, are not required when the business income tax base of an entity in a tiered structure is negative (i.e., less than zero). In these cases, the negative business income tax of a flow-through entity remains includable in the business income tax base of its members, even if the loss-generating flow-through entity elected to pay the flow-through entity tax.¹⁷ Electing flow-through entities in a tiered structure must make the above adjustments to the business income tax base, if applicable, and are not permitted to claim any credit for flow-through entity tax paid by any other flow-through entity.¹⁸

Finally, after making all required adjustments, the flow-through entity tax is levied only on the positive business income tax base of an electing entity. If the business income tax base is less than zero, then no tax is due in that year. While a negative business income tax base is includable in the business income tax base of any members that are flow-through entities, it may not be used to offset the positive business income tax base in any prior or future tax year. That is, the flow-through entity tax does not allow for the carryback or carryforward of losses in a way that is comparable to the business loss provisions of the corporate income tax¹⁹ or the net operating loss provisions of the individual income tax.²⁰

Apportionment of the Business Income Tax Base

After completing the statutory adjustments described in Section I.C.a. of this notice, and before adding back any positive business income allocated or apportioned to Michigan from non-electing flow-through entities, the business income tax base of the flow-through entity is subject to allocation and apportionment. The Michigan portion of the business income tax base is determined using the allocation and apportionment provisions of Chapter 3 of Part 1 of the Income Tax Act.²¹ In this regard, the business income tax base of the flow-through entity is apportioned to Michigan using a sales²² factor that is based on the ratio of sales sourced to Michigan to total sales everywhere.²³ In determining the sales factor, sales of tangible personal property are typically sourced to the state where the property is delivered to the purchaser²⁴ whereas sales other than sales of tangible personal property are sourced based on the location of the relevant income-producing activity.²⁵ Most importantly, the apportionment rules for flow-through entities are the same rules that apply to business income reported by individual members under Part 1 of the Income Tax Act. The information used to apportion the business income tax base under the flow-through entity tax should therefore be the same information reported by many flow-through entities to its individual members to determine business income taxable in Michigan.

⁷MCL 206.51.
⁸Cf. MCL 206.815(5) (allowing the Department to require taxpayers to identify all members).
⁹MCL 206.805(1).
¹⁰The definition of federal taxable income excludes from the computation any deductions described at 703(a)(2), which generally refers to the deduction for a personal exemption, the charitable contribution deduction, the net operating loss deduction, and others. See IRC 703(a)(2).
¹¹TMW Enterprises Inc v Dep’t of Treasury, 297 Mich App 590 (2012).
¹²MCL 206.805(1).
¹³See MCL 206.30.
¹⁴MCL 206.815(2).
¹⁵MCL 206.815(2)(h) and (3).
¹⁶MCL 206.815(4), 206.817(2).
¹⁷MCL 206.815(1).
¹⁸MCL 206.819.
¹⁹MCL 206.623(4).
²⁰MCL 206.30(1)(n).
²¹MCL 206.817(1).
²²“Sales” is defined as “all gross receipts of the taxpayer not allocated under Sections 110 to 114 [of the Income Tax Act].” MCL 206.20(1).
²³MCL 206.121.
²⁴MCL 206.122.
²⁵MCL 206.123