Key Takeaways

  • Alabama requires pass-through entities (partnerships, LLCs taxed as partnerships, and S corporations) to file composite returns for nonresident members.
  • The Alabama composite tax rate applies at the highest individual rate (currently 5%) to each nonresident’s share of Alabama-sourced income.
  • Since 2021, Alabama allows S corporations and Subchapter K entities to elect entity-level taxation, letting the entity itself pay income tax on behalf of its owners.
  • Electing entity-level taxation may benefit owners by avoiding federal limits on state and local tax (SALT) deductions.
  • Qualified investment partnerships with only passive nonresident investors may be exempt from Alabama composite return requirements.
  • Recent Alabama tax reforms aim to reduce rates and simplify rules, making pass-through entity taxation more competitive.

Alabama pass-through entity tax is applied to any partnership or other entity that is classified as a Subchapter K entity. This does not include estates, trusts (excluding those related to non-resident members), business trusts, or single-member limited liability companies. The pass-through entity must file an annual return with the Alabama Department of Revenue for each taxable year.

A composite income tax return must be filed for any non-resident members, and the pass-through entity must also report and pay the income tax. They must apply the highest income tax rate on each nonresident entity's share.

A pass-through entity must provide a tax return that shows the total amount paid or credited to its nonresident members. A pass-through entity is also required to provide its nonresident members with a record of Alabama income tax remitted to the Alabama Department of Revenue.

Terms Related to Pass-Through Entity Tax

When reviewing the tax code, it is important to fully understand the terms that are used. In the 2013 code of Alabama, a member is defined as one of the following:

  • An individual, estate, trust, or business trust.
  • A corporation.
  • A Subchapter K entity including a limited, general, limited liability, limited liability partnership, or limited liability company.

A nonresident member is:

  • A person who has not been a resident in the state during the tax year.
  • A foreign corporation that has acted commercially but has not been in the state during the tax year.
  • A Subchapter K entity that was not formed in Alabama and has not acted commercially in the state during the tax year.

A pass-through entity is:

  • Classified as Subchapter K and is a partnership or other entity.
  • Does not include estates, trusts, or business trusts.

A qualified investment partnership is a partnership or entity classified as Subchapter K or a business trust that meets these requirements:

  • Qualifying investment securities, office facilities, and tangible personal property needed to carry out the entity's activities in Alabama cannot be lower than 90 percent of the cost of the total assets of the entity.
  • Interest, distributions, dividends, and gains and losses from the exchange or sale of qualifying investment securities and fees for management that are paid by the members must be 90 percent or more of the entity's gross income.
  • An authorized partner, member, officer, or manager of the entity must file a certification showing it meets the criteria in regard to the tax period covered by the certification, at the time and in a form determined by the Department of Revenue.

Qualifying investment securities are described as:

  • Common stock and preferred stock.
  • Debentures, bonds, and additional debt securities.
  • Deposits and other bank or financial institution obligations.
  • Any interests that qualify as an investment partnership.
  • Any additional financial or investment contracts, securities, or instruments.

Composite Return Requirements in Alabama

Alabama requires pass-through entities with nonresident members to file a composite income tax return. This filing aggregates all nonresidents into a single return, applying the Alabama composite tax rate—set at the highest individual income tax rate of 5%—to each nonresident’s share of Alabama-sourced income. The entity must remit the tax directly to the Alabama Department of Revenue and provide each nonresident member with documentation of amounts paid on their behalf.

Composite filing helps ensure that Alabama collects tax from nonresident members who may not otherwise file individual returns in the state. However, members included in the composite filing generally cannot claim individual deductions or credits against this income

Proposed Regulations 810-3-24.2-.01 & 810-3-24.2-.03

Under proposed regulation 810-3-24.2-.01, pass-through entities can choose the option to reduce their composite payment because a nonresident member made the required yearly tax payments and necessary filings.

Qualified investment partnerships that have a nonresident member are usually exempt from paying income tax in Alabama as long as the nonresident member does not act as management within the partnership. A composite return is due for a qualified investment partnership only if it is required to submit a composite payment for at least one of its nonresident members. According to the proposed regulation, the qualified investment partnership must file an Alabama partnership tax return annually with the required K-1 information for each nonresident or resident member who holds an interest at any time during the tax year.

In addition, Proposed Regulation 810-3-24.2-.03 states the nonresident members of a qualified investment partnership that received income from an Alabama source are required to file an Alabama income tax return. Any nonresident member of a qualified investment partnership should file the Alabama income tax return as a way to document and set a record of net operating losses from the qualified investment partnership.

An Alabama income tax return must be completed even if a composite return was filed referencing the same Alabama-sourced income. The only caveat to this rule is if the nonresident member's Alabama source income is only from the qualified investment partnership. In this scenario, the Alabama income tax return is not required.

Electing Entity-Level Taxation in Alabama

In 2021, Alabama enacted legislation allowing S corporations and Subchapter K entities (partnerships and LLCs taxed as partnerships) to elect to pay Alabama income tax at the entity level. This election shifts the tax obligation from the owners to the business itself.

Key points of the election include:

  • Eligibility: Available to S corporations and entities taxed under Subchapter K.
  • Election Timing: Must be made annually, typically with the entity’s tax return.
  • Effect: The entity pays Alabama income tax directly, relieving owners from separate Alabama filing obligations on that income.
  • Federal Benefit: Entity-level tax payments may be deductible for federal purposes, mitigating the impact of the $10,000 SALT deduction cap.

This election can be particularly beneficial for businesses with a mix of resident and nonresident members, as it simplifies compliance and maximizes deductions.

Recent Alabama Tax Reform and Rates

Alabama continues to refine its tax code to encourage business growth and investment. The Alabama composite tax rate remains tied to the state’s top individual income tax rate, but broader reforms are underway. As of 2025, Alabama approved incremental rate reductions to lower the top individual rate, which directly impacts composite return calculations.

For business owners, this means:

  • Lower effective taxes for nonresident members included in composite filings.
  • Potentially improved competitiveness for Alabama-based pass-through entities compared to neighboring states.
  • A need to stay updated on annual rate changes to ensure proper withholding and compliance.

Frequently Asked Questions

  1. What is the Alabama composite tax rate?
    It is the highest individual income tax rate in Alabama, currently 5%, applied to nonresident members’ income from pass-through entities.
  2. Who must file a composite return in Alabama?
    Pass-through entities with nonresident members must file a composite return and remit tax on their behalf.
  3. Can Alabama pass-through entities elect to pay tax at the entity level?
    Yes. Since 2021, S corporations and Subchapter K entities may elect to pay Alabama income tax directly at the entity level.
  4. Do composite return participants lose deductions or credits?
    Yes. Nonresident members included in a composite return generally cannot claim Alabama deductions or credits individually.
  5. How do recent Alabama tax reforms affect pass-through entities?
    Rate reductions in 2025 and beyond will lower the composite tax burden, making Alabama entities more competitive.

If you need help understanding Alabama pass-through entity tax, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.