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Multistate Partnerships: Mastering State Taxation of Corporate Partners

WEDNESDAY, OCTOBER 26, 2016, 1:00-2:50 pm Eastern

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FOR LIVE PROGRAM ONLY

Multistate Partnerships: Mastering State Taxation of Corporate Partners

October 26, 2016

Ned Leiby KPMG LLP nleiby@kpmg.com Jennifer A. Zimmerman Horwood Marcus & Berk jzimmerman@hmblaw.com Dátus Tomasovich KPMG LLP dtomasovich@kpmg.com JoAnna Simek BKD, LLP jsimek@bkd.com

Notice

The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual

• r entity. Although we endeavor to provide accurate and timely

information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

4

Dated Material

THE MATERIAL CONTAINED IN THESE COURSE MATERIALS IS CURRENT AS OF THE DATE PRODUCED. THE MATERIALS HAVE NOT BEEN AND WILL NOT BE UPDATED TO INCORPORATE ANY TECHNICAL CHANGES TO THE CONTENT OR T0 REFLECT ANY MODIFICATIONS TO A TAX SERVICE OFFERED SINCE THE PRODUCTION DATE. YOU ARE RESPONSIBLE FOR VERIFYING WHETHER OR NOT THERE HAVE BEEN ANY TECHNICAL CHANGES SINCE THE PRODUCTION DATE AND WHETHER OR NOT THE FIRM STILL APPROVES ANY TAX SERVICES OFFERED FOR PRESENTATION TO

• CLIENTS. YOU SHOULD CONSULT WITH WASHINGTON NATIONAL TAX

AND RISK MANAGEMENT

• TAX AS PART OF YOUR DUE DILIGENCE.

5

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. 6

STATE TAXATION OF PASS-THROUGH ENTITIES Key Issues and Current Developments

7

 Partnerships

 General Partnerships  Limited Partnerships  Joint

Ventures

 Alliances  Private Equity Funds  Hedge Funds

 Multi-member LLCs taxed as partnerships  SMLLCs (“disregarded entities”)  S corporations  Specialized Entities: RICs, REITs, REMICs, Cooperatives and Some Trusts

(Note: we will reference “PTEs” and “partners”)

How We Define “Pass-Through Entities”

8

Entity vs. Aggregate Example of Structure & Various Chains of Ownership

(The “Fund”)

Limited Partnership (“LP”)

LLC

OP,LP (Operations) Limited Partners Shareholders (Foreign & Tax-Exempt) Blocker Corp LLC/LP General Partner CORP 9

 The last 20 years reflect a substantial increase in the use of

PTEs

 The increase was driven by federal tax law and state entity

laws

 Corporate income tax was declining at the same time

government revenue needs were increasing

 Pass-through planning was led by federal tax benefits:

avoidance of double taxation, maximization of losses and incentives and allowance for flexibility

Brief History of PTEs

10

 Income tax generally not imposed at the entity level  Composite return distinction  Partnership may be required to file a return in states where partner lives

even if entity has no other connection with the state

 Generally reporting on a separate entity basis (i.e., no combined reporting)  Partnership tax law generally articulated under individual tax law, not

corporate tax law



Watch for differences in apportionment/allocation, depending on partner type.

 Multi-tiered structures present additional complexities, pitfalls, and

• pportunities

Corporation vs. Partnership –State Taxation Differences

11

State-Federal Conformity Issues

12

The issue of federal-state conformity actually raises two separate questions: #1 - Characterization: Does the state’s tax law follow the federal characterization of the PTE under the “check-the- box” rules? #2 - Pass-through Treatment: Does the state’s tax law follow the federal tax treatment of income of “partnerships” and “disregarded entities”?

State Conformity Overview

13

#1 – Characterization

 Most states respect entity characterization under federal

“check-the-box” regulations

 An LLC that is a disregarded entity for federal tax is a

disregarded entity for state tax purposes

 Some Notable (Income Tax) Exceptions:

 MA (large S corporations and SMLLCs are taxable as S Corp if

• wned by S Corp)

 NH (all PTEs taxed at entity level, even sole proprietorships)  RI (corporate-owned SMLLC is taxed as a C Corp)

14

#2 – Pass-Through Treatment

 Most States Also Follow Federal Pass-through Treatment

 No tax on the PTE, but tax on the partners

 Some Notable Exceptions and Variations:

 Entity-level taxes (IL, NH, ME, OH, OK, TN, TX)  Don’t forget local jurisdictions (Philly, DC, NYC)  Entity-level capital stock and fees (NY, PA, others)  Withholding/estimated tax/partner consent rules (many)  Composite filing rules (many)

 Some States Also Provide Exemption for Investment

Partnerships and Their Partners

15

Reminder of “Other” Filings

 Remember that PTEs are generally not disregarded

for non-income taxes, including:

 State registrations and filing fees  Non-Income Taxes:

 Most Sales and Use Taxes  Some Franchise / Privilege Taxes  Excise Taxes (“sin taxes” – tobacco, alcohol, etc.)  Property Taxes  Real Estate Transfer Taxes  Employment Taxes

16

Corporation vs. Partnership –State Taxation Differences

 Different nexus rules may apply

 Factor presence/economic nexus may apply only to corporations (NY)

 Tax base

 Depreciation  COD income IRC § 108(i) conformity  Step-ups/downs (IRC § 754)  Different apportionment factor weighting and sourcing

 Examples

 NY-Partnership equally weighted 3 factor and cost of performance for sourcing  NY-Corp single sales factor, market based sourcing  CT

• 2015 different, aligned 2016

 PA-differences 17

Conformity Conflicts

“Jurisdictional Mismatches” may occur. Example:

– PTE operates solely in NH; 70% corporate partner domiciled in UDITPA state, conducts business in many states; PTE distributive share is “non-business” income – NH: Applies entity-level tax on PTE (BPT & BET) using water’s edge combination apportionment factors (no business/non-business distinction) – Domicile state: taxes entire 70% share of “nonbusiness” income to the Partner in state of commercial domicile

NPH LLC

70%

Corporate Partner

Multistate Business Domiciled in UDITPA State $ Distributive Share = Non-business Income 100% in NH

PTE Partner

18

Entity vs. Aggregate

 Compliance, Reporting and Planning Considerations

Nexus Business/Nonbusiness Determination Unitary vs Non-unitary

Apportionment

19

Nexus Issues Affecting Partners

20

Central Nexus Issue

 Key Nexus Question:

 May a state in which the PTE is doing business subject a

nonresident corporate partner to the state’s corporate income (or franchise tax) on its distributive share of partnership income, even if the corporate partner has no independent activity in the state?

 Key Policy Question:

 Is it appropriate to tax a nonresident limited partner on its 2%

distributive share but not a nonresident shareholder on its 2% stock ownership in a corporation?

21

Constitutional Framework

 Due Process Clause

 Two requirements: (1) Taxpayer must have sufficient “minimum contacts” with

the taxing state and (2) income must have a “rational relationship” to intrastate values of the enterprise

 Concern is the “fundamental fairness of government activity” (Quill Corp.

(1992))

 A state may not subject to tax a nonresident on its ownership of stock in a

domestic corporation under the DPC (Shaffer v. Heitner (1977))

 Commerce Clause

 Four Part Test: (1) Substantial Nexus, (2) Fairly Apportioned, (3)

Nondiscrimination, (4) Fairly Related (Complete Auto (1977))

 “Unitary” Principles

 The “lynchpin of apportionability … is the unitary-business principle” (Mobil

Oil (1980))

22

General Rule

 General Rule: The vast majority of states consider a

corporation’s ownership of an interest in a partnership doing business in the state to be sufficient to create nexus for the corporation, even if the corporate partner has no other contact with the state.

 Issues:

 What theories support this conclusion?  What constitutional principles prohibit taxation?  Does the same rule apply to members of LLCs?  Does the same rule apply to limited partners?

23

How Have the Cases Come Out?

Borden (IL 2000): NRLP taxable because LP interest is sufficient “minimum connection”

Non-Resident Limited Partners (NRLP”) TAX NO TAX

Village SM (NJ 2013): NRLP taxable because LP had in-state presence / connection UTELCOM (LA 2011): NRLP not taxable – under state statute

BIS (NJ 2011) / Dutton (VA 2007): NRLP with no connections not taxable – under Constitution

Lanzi (AL 2006): NRLP not taxable - under Constitution (akin to stock)

24

Entity vs. Aggregate

Flow-Through Entities – Nexus to Corporate Partners



(Qualified) Investment Partnership Exceptions



Qualified Investment Securities- Defined by state. Generally an asset and income test.

• Corporate partners must combine share NY receipts from partnership with

their own NY receipts to determine if they meet $1 million gross receipts nexus threshold. New law effective 1/1/15- Aggregation requirement.



Corporate Partner - California



Deemed to be doing business in state and unitary with partnership if general partner



$800 minimum tax



No consideration given to % ownership of partnership with respect to unitary determination



If unitary, % of apportionment factors will flow through and be combined with factors of corporation



Unitary status unlikely if corporation is a limited partner. California SBE has declared in opinions that it is extremely difficult to overcome the inherent passive investment nature of a limited partner interest.



Oregon: Is the partner an “excise tax” or “income tax” payer?

25

Ancillary Nexus Issue #1 – “Nexus Only”

 Key Issue: Some states require (or allow) combined/consolidated returns

• nly for corporate affiliates that have nexus with the state (“nexus-only”

filings). See Iowa Code Sec. 422.37(2). Does an out-of-state partner qualify as a “nexus” member solely on the basis of the activities of in-state PTE?

 Example: A and C are eligible, but is B by virtue of PTE?

Corp B (no nexus) PTE (nexus) Corp D (no nexus) Corp C (nexus) Corp A (nexus) 26

Ancillary Nexus Issue #1 – “Nexus Only”

 Considerations:

 Yes, but only if the Partner B is taxable in the state by virtue of the PTE’s

activities? So, does this mean that a 2% GP may be an eligible member but a 2% LP may not? What impact could this have on the return?

 No, if Partner B is only a passive limited partner because a corporate

shareholder would not be taxable by virtue of its subsidiary’s nexus?

 No, if the state consolidated return statute can be strictly construed to

• nly include the corporate member (Partner B) based on its own

individual activities?

27

Ancillary Nexus Issue #2 – Throw-Back, Throw-Out, Joyce/Finnegan

 Situation 1: Should a corporate

partner’s sales to a destination state where it has no independent nexus be thrown back if the PTE has nexus in the state but it does not?

 Situation 2: Should a PTE’s sales to

a destination state where is has no independent nexus be thrown back if the corporate partner has nexus in the destination state but it does not?

Partner (State A) PTE (State B)

State A

Partner (State A) PTE (State B)

State B

28

Ancillary Nexus Issue #2 – Throw-Back, Throw-Out, Joyce/Finnegan

 Considerations:

 No throwback in either case in states that attribute the activities of the PTE to

the partner (e.g., the partner has nexus in the state)?

 No throwback only in Situation 1 because a partner can have nexus in the state

by virtue of the PTE but a PTE cannot have nexus in a state by virtue of a partner?

 Does it matter if the state adopts Joyce or Finnegan?



In Joyce states, a PTE’s sales (Situation 2) may be subject to throwback despite the fact that the partner has nexus because each entity’s factors are calculated independent of the others.



Does it matter if the PTE can be an eligible “member” of a unitary group as opposed to just corporations being eligible members?  What is the right answer from a policy perspective?  Should you evaluate a “nexus” position to prevent throwback? 29

Ancillary Nexus Issue #3– PL 86-272

 Key Issue:

 PL 86-272 generally precludes a state from imposing an income tax on an entity

whose activities within the state are limited to solicitation of sales of TPP and ancillary activities. Should the activities of an in-state PTE that exceed PL 86-272 subject the out-of-state partner to tax?

 Considerations:

 Similar considerations as throw-back – who is the taxpayer?  MA: if a foreign corporate partner is unitary with its in-state partnership, the

activities of the partners are deemed to be the activities of the partner for determining whether the income if the partner is precluded under 86-272 (830 CMR 63.39.1(8)(a))

 Does PL 86-272 apply to the income derived from the PTE? Or does PL 86-272

apply to the corporate partner as the taxpayer under the corporate income tax?

30

Ancillary Nexus Issue #3– PL 86-272

Example: Arizona Dept. of Rev. v. Central Newspapers (11/3/09):

Holding: AZ may include Ponderay’s sales in the Partners’ sales factor numerator because the taxpayer is the Parent and its activities exceeded 86-272. 86-272 does not make certain income tax-exempt – it prevents a state from exercising taxing jurisdiction over a corporate partner. Partners

Ponderay

• Partners = no AZ nexus; Parent has AZ nexus
• Ponderay = AZ nexus but protected by 86-272
• Parent elected to file as part of consolidated

AZ return, including Partners

• Agreement that Ponderay distributive share

was business income included in AZ return

• Issue: whether Ponderay’s sales are

excluded from the consolidated return sales factor numerator on the basis of 86-272?

13.5%

Parent

31

Division of the Tax Base - Apportionment

32

 Key Question:

 Once the partner is taxable and the amount and character of the PTE’s

tax base has been determined, what method is used to “divide” the partner’s tax base among the states to accomplish fair apportionment?

 Different Approaches:

1.

Partner Level (Unitary) Method

2.

Partnership Level (Non-Unitary) Method

3.

Business/Nonbusiness Income Classifications

4.

Methods for Special Issues

Central Tax Base Issue

Note: Reporting apportioned income and apportionment percentage does not satisfy requirement (or partner need) to report the partner’s share of apportionment factor(s).

33

 The share of partnership income and factors is combined with

the partner’s income and factors in determining the corporate partner’s state taxable income

 Some states require a “unitary” or “business income”

determination prior to “flow-up”

 IL: 86 Ill. Admin. Code 100.3380(d) – flow-up if unitary  CA: Cal. Code Regs. Tit. 18, s. 25137-1 – flow-up if unitary  MA: 830 CMR 63.38.1 - flow-up if engaged in “related business

activities”

 Others (e.g., FL) do not. Constitutionally suspect?

 Consider the impact on tax base and apportionment!

#1 – Partner (Unitary) Level Method

(“Flow-Up” / “Aggregate” / Combined” / “Unitary”)

34

Partner Level (Unitary) Example

Corporation A’s State Tax Return:

• 1. Business income / unitary (GP + 80% capital)
• 2. Tax Base ($600,000) is included in Corp A’s

pre-apportioned state tax base

• 3. Corp A’s 80% “share” of PTE’s factors is

combined with its own factors in apportioning Corp A’s entire income to state Corporation A

• General partner – active management
• 60% Profits Interest / 80% Capital Interest
• Distributive Share: $600,000
• Same line of business as PTE (retail)
• Retail

PTE A

35

 California



If partners are unitary with partnership, then partnership’s factors flow-up to the unitary partner(s).



If partner(s) are not unitary, then no flow-up



If partner(s) and partnership are not unitary, but the income is considered business income, then partners must apportion partnership income separately from their other business income.



California's regulation regarding the treatment of partnership income does not distinguish between a limited and general partnership interest. Because partnership law prohibits a limited partner from exercising a management role with respect to a limited partnership, absent a unitary relationship between the general and limited partner, unity between the limited partnership and its limited partners on the basis of strong centralized management is

• unlikely. However, combination may be a consideration if the partnership and the limited

partner share operational ties.

Entity vs. Aggregate

Calculation of Apportionment Factor

36

Entity vs. Aggregate California-Sample Reporting of Apportionment Data to Partner

37

Entity vs. Aggregate

Calculation of Apportionment Factor

 Illinois



A partnership is required to use combined reporting when engaged in a unitary business with

• ne of its partners. If unitary, the partner's distributive share of the business income and

apportionment factors of the partnership must be included in that partner's business income and apportionment factors. If the partner had no other activities in Illinois, the partner would apportion the sum of it income plus its share of the partnership income to Illinois using the partnership Illinois sales factors and the partnership everywhere sales factors. In determining the business income of the partnership, transactions between the unitary partner, or members of its unitary business group, and the partnership are not eliminated. However, all transactions between the unitary business group and the partnership are eliminated for purposes of computing the apportionment factors of the partner and of any other member of the unitary business group. Ill. Admin. Code tit. 86, § 100.3380(d). However, this rule does not apply:



• 1. to shares of income from partnerships whose business activity outside the United States is 80 percent
• r more of its total business activity;



• 2. where the partnership has a different apportionment method than the corporate partner; or



• 3. where the partnership is not in the same general line of business or a step in a vertically structured

enterprise with the corporate partner. Ill. Admin. Code tit. 86, § 100.3380(c). 38

Entity vs. Aggregate Illinois – Tiered Partnership Structure



If a partnership and a partner are engaged in a unitary business and the partnership is a partner in a second partnership, the partner's share of the first partnership's share of the base income apportioned to Illinois by the second partnership must be included in the partner's Illinois net income. This treatment applies if the partner is not engaged in a unitary business with the second partnership. However, if the partner is engaged in a unitary business with the second partnership, the partner's share of the first partnership's share of the business income and apportionment factors of the second partnership must be included in the partner's business income and apportionment factors.



If the partnership is a partner in a second partnership and one of its partners is engaged in a unitary business with the second partnership, that partner must include in its business income and apportionment factors its share of the partnership's share of the second partnership's business income and apportionment factors. (See Example later in this deck)



Generally, when a corporation's activities and its partnership's activities are not considered to be in a unitary group, the partnership allocates its nonbusiness income and apportions its business income which is then added to the corporation's other business income apportioned to Illinois and nonbusiness income allocated to the state. The Illinois income is calculated at the partnership level and merely reflects the partner's share

• f the partnership income as post–apportionment income or loss.

39

Entity vs. Aggregate Data Gathering

Line 1, 2, 3 are net income. For factor-flow- up purposes, these numbers are irrelevant. Note: P&L % may be different than capital %

40

Entity vs. Aggregate Data Gathering

Gross Revenue = Partner’s % of Lines 1,4-

• 7. Net amounts may require further digging

for gross revenue. Note potential tiered flow-through issue for line 4 Line 6 – Gross or Net? Line 7 can be many different items (+ & -)

41

Make special note of items of foreign income flowing through as this may impact apportionment. Entity vs. Aggregate Data Gathering

Foreign Gross Income (Line 16f) should be noted Make special note of items of foreign income flowing through as this may impact

apportionment.

42

 The partner’s share of partnership income is apportioned by

the partnership’s factors separate from the partner’s other income and factors.

 Often applies if “non-unitary” relationship is found.

 IITA Sec. 305(a) and (b))  MA: 830 CMR 63.38.1(4)(d): separate accounting applies if corporate

limited partner owns less than 50% of capital or profits interest (directly

• r indirect) of partnership under presumption that activities of the

partnership are “unrelated” (rebuttable by Commissioner)

 Some states (e.g., OK) require that allocation and apportionment occur at

the partnership level, regardless of unitary relationship.

#2 – Partnership Level (Non-Unitary) Method

(“Separate Accounting” / “Allocation”/ “Non-Unitary”)

43

 The partners then allocate this post-apportioned share of

state-sourced income separately

 The allocation rules may differ!

 Compare the impact on tax base and apportionment with the

Partner Level Method!

 Whether the result is favorable depends on the facts…  Under Partnership Level Method, if PTE is in an income position and has high in-

state factors = potential for substantial tax liability to the partner.

 Under Partner Level Method, high income position and factors from PTE may be

• ffset against partner losses and/or apportionment dilution

#2 – Partnership Level (Non-Unitary) Method

(“Separate Accounting” / “Allocation”/ “Non-Unitary”)

44

Non-unitary Partnership Income Reporting

Non-unitary partnership income (loss) is directly allocated to the state based on amount(s) reported on State K-1, K-1 equivalent

• r footnotes

Factors are not flowed-up/Apportionment is not recalculated Amount of non-unitary income (loss), including separately stated items, is separated and removed from the tax base and reported separately from the amount of base income subject to apportionment.

45

Partnership Level (Non-Unitary) Example

• Net Income: $1,000,000
• Business: Retail
• Apportionment = 75%

Corporation A

• Limited Partner (no active management)
• 40% Profits Interest / 40% Capital Interest
• Distributive Share: $400,000
• Business line different from PTE

Corporation A’s State Tax Return: 1. Business Income (partner level determination) 2. Non-Unitary (LP/no control + 40% capital) 3. Corp A’s State Taxable Income from PTE = $300,000 $400,000 distributive share x 75% partnership factors 4. $300,000 is added to A’s other post-apportioned income

A PTE

46

Non-unitary Partnership Income Reporting California Example

Non-unitary Partnership Income Removed from base income subject to apportionment. Non-unitary partnership income removed from tax base and not subject to apportionment by corporate partner on Line 10.

47

Non-unitary Partnership Income Reporting California Example

Allocate CA sourced amount directly on line 28 (after apportionment)

48

Non-unitary Partnership Income Reporting Illinois Example

IL-1120: Non-unitary Partnership Business Income

IL-1120: Non-unitary partnership business Income removed from business/apportionable income (line 25). K-1 amount sourced to IL reported on line 33 (after apportionment of business income)

49

 Key Issue:

 In some states, if a “business/nonbusiness income” regime exists, and the

distributive share is determined to be nonbusiness income, such income is allocated to the appropriate state, instead of apportioned (e.g., to the state of domicile or other sourcing rules applicable to nonbusiness income).

 Considerations:

 Do the allocation rules look to the partner or partnership? For

example, if dividend income is allocable to domicile, do you look to the partner’s or the partnership’s commercial domicile?

 What is the impact if it is non-business income as opposed to business

income?

#3 – Business / Nonbusiness Issues

50

Business v. Non-Business Income

 Transactional Test

 Income arising from transactions and activity in the

regular course of the taxpayer's trade or business

 Functional Test

 Includes income from tangible and intangible property if

the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations

51

Transactional Test

 Identify transactions and activity occurring in the

regular trade or business

 Generally, all transactions that are dependent upon or

contribute to the operations

 Three standard tests:

 Frequency and regularity of transactions  Former business practices  Subsequent use of proceeds (reinvestment or

distribution)

52

Functional Test

 Identify whether the transaction is an integral part of

the taxpayer’s trade or business

 Focus on whether property was used in trade or business  Frequency is generally irrelevant  In the case of a disposition of assets, state may look at

whether the disposition itself is an integral part of the business operations (e.g., IA, AL, TN, NC, IL, PA)

53

54

Business v. Non-Business Income

 Minnesota

 Firstar Corp v. Commr. Rev.  Capital gain from sale of office building was nonbusiness

income

 Applied transactional test

 Infrequent:

Taxpayer had not previously sold commercial property

 Subsequent use of proceeds: Not reinvested in the ongoing

business operations – treated as dividend to shareholders

55

Business v. Non-Business Income

 California

 Jim Beam Brands Co v. FTB

 Gain from the sale of a unitary subsidiary is business income  Applied functional test  Gain was business income because the property while owned

by taxpayer was used to produce business income

 Court rejected argument that disposition of property is not an

integral part of the business

56

Business v. Non-Business Income

 Is business/non-business income determination made

at:

 The partnership level?  The partner level?

 Not much guidance; only a handful of states have

addressed in public guidance

57

 At what level is the business income determination

made- partner or partnership level:

 Most states have no guidance.  Exceptions:

 Partnership Level: AL, CA, IL  Partner Level: AZ, PA

 If non-business income, the question is to which state

is the income sourced?

#3 – Business / Nonbusiness Issues

58

Entity vs. Aggregate Business/Nonbusiness Determination

• Majority of states have not addressed

For corporate partners is the business/nonbusiness income determination made at the partnership level or partner level?

• Requires partner level determination
• Arizona Corporation

Tax Ruling No 94-2 (4/4/1994)

• Illinois Admin. Code tit. 86, §§ 100.3500(a)(3), 100.3500(b)(1)

Arizona & Illinois

• Requires partnership level determination. In Alabama, gain

from the sale of partnership assets was not business income to the corporate partners because such sales were not in the regular course of the partnership’s trade or business. Lanzi v. Ala. Dep’t of Rev. (Ala. Civ. App. 2006)

Alabama

59

Business / Nonbusiness Example

• Net Income: $1,000,000
• Dividends: $500,000
• Retail: $500,000

Corporation A

• Limited Partner
• 40% Profits Interest / 40% Capital Interest
• Distributive Share: $400,000
• Business: Investment

Corporation A’s State Tax Return:

• 1. Assume retail is business income/apportionable
• 2. Assume dividends are nonbusiness income

allocable outside of state

• 4. Non-Unitary (LP/no control, 40% capital)
• 5. $150,000 state sourced income
• Retail: $150,000 ($200,000 x 75% appt)
• Dividends: $0 ($200,000 x 0%)

Sourcing may vary depending upon domicile rule! A PTE

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#4 – Special Issues

 What problems exist with tiered partnerships?

 Timing Issues / Withholding Regimes / Composite Returns

 Do the same sourcing rules apply if the partnership has

individual partners instead of corporate?

 Some states adopt the corporate apportionment rules for determining

sourcing of nonresident partnership income (e.g., MA)

 For those states that still apply individual income sourcing rules, many of

the sourcing guidance remains vague and archaic (e.g., NYS)

 Differences may include whether the sale is treated as a sale of an

intangible or sale of tangible assets, and whether gain is sourced to situs

• f partnership

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Sale of Partnership Interest

 Corporate seller

 If business income, generally treated as an intangible source as sale other than

sale of TPP (i.e., costs of performance, possible “throw-out,” etc.)

 Some exceptions (such as based on location of the payor)

 If non-business income, generally source to commercial domicile  Individual seller  Generally source to resident state

 Emerging trend: sourcing based on location of the underlying

PTE’s assets (in theory, only should apply if nonbusiness income)

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Sale of Partnership Interest

 Gain or loss on the sale of a partnership interest is allocable to this state in the

ratio of the original cost of partnership tangible property in the state to the

• riginal cost of partnership tangible property everywhere, determined at the

time of the sale.

 In the event that more than 50 percent of the value of partnership’s assets

consist of intangibles, gain or loss from the sale of the partnership interest is allocated to this state in accordance with the sales factor of the partnership for its first full tax period immediately preceding the tax period of the partnership during which the partnership interest was sold.

• California (Cal. Revenue and Tax Code § 25125)
• Hawaii (Hi. Rev. Stat. § 235-6)
• Maine (Me. Rev. Stat. Title 36, Part 8, Chapter 807 §5142)
• Minnesota (Minn. Stat. §290.17)
• North Dakota (N.D. Cen. Code §57-38.1-17.1)
• Oregon (Ore. Rev. Stat. § 314.635)
• Oklahoma (OK Stat. Title 68, Section 2358)-Publicly-traded partnerships only (and other modifications)

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Sale of Partnership Interest

 Use of current year apportionment factor to allocate

gain

 Idaho (Id. Stat. Title 63, §3026A)  Montana (Mt. Code Ann. §15-30-2101) – PTP only

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Compliance Headaches/ Withholding Requirements

65

 Key Issues:

 The obligation of nonresident partners to file returns and pay

taxes in every state where a partnership does business creates an administrative nightmare for both state tax authorities, PTE management and partners

 Must a nonresident partner file returns in every state where a

PTE does business?

 What method is required/optional – nonresident filing,

withholding regime or composite filing?

Compliance / Administrative Issues

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Data/Record-Keeping Items

• Partner Data
• Demographics, Partnership Agreements
• State Apportionment
• State Modifications
• State-specific data (credits,
• State Footnotes
• Exemptions/Waivers
• State K-1 by partner and summary
• State WH by Partner and summary
• Supplemental Info.

Data Points Requiring Documentation/Workpapers

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 Understanding required items and partners’ needs - Good and appropriate

communication is critical!

 What are general and different limited partners (PTEs, Corps, individuals)

information needs?

 UBTI footnotes for tax-exempt entities.  Too much information with incomplete explanation can cause confusion and lots

• f phone calls/e-mails seeking clarification.

 Should provide partners with all information necessary for them to complete

their tax returns accurately

 State K-1s, disclosures, and apportionment schedules  Some states may impose a filing requirement if the PTE has a partner that’s

a resident of a certain state (e.g., NY resident partner filing requirement)

 Substantial time commitment

Recordkeeping and Data Management State Disclosures Attached to Federal K-1

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 California Cal. Rev & Tax. Cd. §§ 18633-18633.5

 Similar to federal reporting requirements (IRC Regulation § 1.6031(c)-1T)  Any person who holds an LLC/partnership interest as a nominee for

another person shall do both of the following:

 Furnish to the LLC/partnership, in the manner prescribed by the Franchise Tax Board, the

name, address, and taxpayer identification number of that person, and any other information for that taxable year as the Franchise Tax Board may prescribe by forms and instructions.

 Furnish to that other person, in the manner prescribed by the Franchise Tax Board, the

information provided (K-1 information) by that entity under subdivision (b).

 The provisions of Section 6031(d) of the Internal Revenue Code, relating to the separate

statement of items of unrelated business taxable income, shall apply.

Recordkeeping and Data Management Nominee Reporting – State Requirements

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Recordkeeping and Data Management Nominee Reporting - State Requirements

 Potential Penalties for Noncompliance – California

 Failure to File: 5% per month (capped at 25%) of tax due  Failure to Provide Information: 5% per month (capped at 25%)

• f unpaid tax

 Failure to Comply with Filing Requirement-Per Partner

Penalties

 Aiding and Abetting Understatement of Tax Liability: $10,000 if

liability relates to a corporation

 Other??-Was withholding required? Preparer?

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Considerations For Preparers of Returns

 What information to pass through to partners/investors?



Reporting of factor data to partners has the potential to create confusion unless accompanied by an explanation

 Unitary determination must be made at partner level (or jointly with partnership –

In Practice?)

 What do tiered partnerships do in practice?  Does characterization of receipts of the partnership flow through to the partners?



Michigan – RAB 2015-5 states that receipts that flow through from the partnership that are not “taxed” at the entity level (because they are protected by P . L. 86-272) are not protected at the corporate partner level – Flow through receipts are from an investment, and not from the sale of tangible property

 What percentages to use for performance fee allocations to G.P.s?  Any impact of proposed regs. under IRC §707(a)(2)(A) (7/23/15) ?



Treats certain partnership distributions as disguised payments for services



Significant entrepreneurial risk requirement

71

Considerations for Preparers of Returns

 Market based sourcing rules for intangibles and services



Lack of uniformity



California

 Attach lower tier state K-1s to state partnership return when reporting

lower tier modifications or withholding (e.g. Illinois).

 New

York City Unincorporated Business Tax (“UBT”)



4% on unincorporated businesses (e.g. partnerships)



Disallowed deduction for payments to partners including amounts paid to partners

• f pass-through partner who are employees of a different corporate partner.

 Pennsylvania



Required apportionment data depending on partner type:



Single factor for corporations



Three factor (equally weighted) for others



Corporate partner uses reported factors from LLCs to compute income tax but not capital stock/foreign franchise tax

72

 General Rule: withholding at the source is generally required

for PTEs with nonresident partners.

 Typically pay at the highest individual or corporate tax rate (multiplied

by the owner’s distributive share of income attributable to the state)

 Typical Exemptions:

 Partner provides an exemption certificate certifying it will file/pay tax

individually

 Partner is tax-exempt  Partner files as part of a composite return  PTE is a specialized entity (e.g., investment partnership)  Partner is not a nonresident

Withholding Regimes

73

 Some states have threshold based on income or tax

 May be applied to the entity or to a specific owner  Ex. MI- Requires PTEs with Michigan-sourced business income of over

$200,000 to withhold on behalf of owners that are PTEs or corporations

 Other states thresholds very low

 Some rates impose rate differentials that become complex

with tiered structures

 Lower tier may have to look to upper tier  Ex. MI- requires withholding for both PTE and corporate owners at the

full 6% corporate. If the PTE knows the ultimate owner of the upper-tier PTE is a non-resident individual, it may instead withhold at the individual rate, currently 4.25%.

Withholding Challenges

74

 In some states, withholding may not be compulsory

 May depend on type of owner, i.e. trust, corproration  May depend on type of PTE  May exempt certain type of entities

 Sometimes voluntary at option of PTE and/or owners  Also it may make sense to withhold

 May eliminate need to disclose taxpayer sensitive information.

.

Withholding Challenges

75

 Some states allow owners to explicitly elect out of

withholding.

 Waiver usually required  May be perpetual or required to be renewed  Keep part of books and records  May need to provide to state

 Why elect not to withhold?

 Owner has losses in state and no tax will be due  Owner already making estimated tax payments  Prefer to file composite return

Withholding Elections

76

 Under-report which results in penalties

 Based on difference in tax rates between PTE and owner

 Tiered Entities- special risks

 Withholding may be required by all levels and then there are duplicative

payments

 In this situation may want to elect out.

 Run higher risk of under-reporting  Attributable to differences in apportionment methodologies between

the business and the owner

Withholding Risks

77

 Timing issues with estimated tax payments

 Often quarterly payments but seasonal business.

 Under-report which results in penalties

 Based on difference in tax rates between PTE and owner

 Tiered Entities- special risks

 Withholding may be required by all levels and then there are duplicative

payments

 In this situation may want to elect out.

 Run higher risk of under-reporting  Attributable to differences in apportionment methodologies between

the business and the owner

Withholding Risks

78

 Conflict between state reporting requirements and legal

requirements for the PTE

 Ex. S corporations  Distributions made to owners must be made on a basis proportionate

to ownership, otherwise the S-corporation runs the risk of inadvertent termination of its S-election under 2 scenarios:

 Owners are residents of multiple states and participation in

withholding is limited to non-residents.. Disproportionate distributions can result in termination of the S-corporation election.

 When the PTE is owned by different types of entities under different

withholding regime.

Withholding Risks

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 Typical Conditions:

 Requirement of an election/consent to participate is common (some

require consent to be submitted, some require it to be executed and available but not filed, some require an annual filing)

 Limitation of composite returns to individual partners (no corporate or

PTE partners but some allow trust members to participate)

 Preclusion of composite returns if the partner has in-state income from

• ther sources

 Agreement that PTE is authorized to resolve any audit/pay deficiency

Composite Regimes

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Why Is It a Nightmare?

 Lack of uniformity among withholding/composite regimes.

Variations include:



Composite return wherein nonresident consents to taxation



Nonresident withholding required



Estimated tax payments are required



Withholding done but PTE remains contingently liable

 Thresholds of minimum distributions vary  Lack of clear guidance and forms within each state  Compliance software is often outdated  Communication/documentation to/from partners not always timely  Difficulties exist in how to account/report refunds and audit issues to

partners

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Why Is It a Nightmare?

 Complexities with multi-tiered structures as outlined herein  PTE funding issues should be established for partner liabilities  Transferee liability/management after PTE ceases operations  Partners not subject to withholding or composite return must typically

agree to submit to the jurisdiction of the state and agree to pay tax on the

• wner’s distributive share of PTE income



Be careful – do you want to submit to the jurisdiction of the state? Do you have a choice?

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Take-Aways

83

SALT Department Tools

 Develop a “due diligence” checklist for all PTEs  Establish multistate matrix addressing:

 Significant jurisdictional/nexus rules  State method of dividing the tax base  Specialized issues (credits, throwback, etc.)  Required forms (withholding, etc.)  Specialized entity exemptions

 Confer with business development / legal teams on

proper terms to include in entity agreements (reporting requirements, deadlines, information management, audit management)

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