Multistate Partnerships: Navigating Various State Taxation Rules of Corporate Partners

Transcription

1 FOR LIVE PROGRAM ONLY Multistate Partnerships: Navigating Various State Taxation Rules of Corporate Partners THURSDAY, OCTOBER 19, 2017, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at x10 (or x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be ed to registered attendees. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

2 Tips for Optimal Quality FOR LIVE PROGRAM ONLY Sound Quality When listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection. If the sound quality is not satisfactory, please immediately so we can address the problem.

3 Multistate Partnerships Oct. 19, 2017 Dennis Rimkunas, Partner Jones Day, New York Michael J. (Mike) Wynne, Partner Jones Day, Chicago

4 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.

5 Advanced Multistate Taxation of Partnerships and Individual Partners October 19, 2017 Dennis Rimkunas Partner, Jones Day Michael Wynne Partner, Jones Day

6 How We Define Pass-through Entities 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 ) 6

7 State Conformity Overview The issue of federal-state conformity actually raises separate questions: 1. Is it relevant, i.e. what tax is at issue? 2. Is it material for Due Process (Nexus) purposes? 3. Characterization: Does the state s tax law follow the federal characterization of the PTE under the check-the-box rules? 4. Pass-through Treatment: Does the state s tax law follow the federal tax treatment of income of partnerships and disregarded entities? 7

8 #1 Relevance Federal characterization is usually not relevant to: 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 8

9 #2 Material Does the pertinent statute define the terms: partnership corporation person taxpayer If the federal characterization is not expressly followed in the definitions, is there another provision in the statute or a regulation that ties the definitions to the federal regime? Is it necessary to identify the nature of the relevant person for due process analysis under the statute. 9

10 #3 Characterization Most states respect entity characterization under federal check-thebox regulations An LLC that is a disregarded entity for federal tax is a disregarded entity for state tax purposes Separate S Elections (NY, NJ) Some Notable (Income Tax) Exceptions: MA (large S corporations and SMLLCs are taxable as S Corp if owned by S Corp) NH (all PTEs taxed at entity level, even sole proprietorships) RI (corporate-owned SMLLC is taxed as a C Corp) 10

11 #4 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 (CA, IL, NH, ME, MI, OH, OK, TN, TX) Don t forget local jurisdictions (Phili, 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 11

12 Nexus Issues Affecting Partnerships and Partners 12

13 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)) 13

14 General Rule General Rule: The Majority of states consider a person s interest in a partnership that is doing business in the state sufficient to create nexus for the person. General agency principles apply: A partner is an agent for the partnership; A partnership is an agent for its partners. What about control: Does it matter what voting rights a partner has or how diluted the vote is? Does it matter if the partnership interest is limited rather than general? Does it matter if the person is a member rather than a managing member of an LLC? Does the general rule work the other way around: Does a partner pursuing its own business in state create nexus for the partnership? 14

15 How Have the Cases Come Out? 15

16 Ancillary Nexus Issue #1 Nexus Only Key Issue: Some states require (or allow) combined/consolidated returns only for corporate affiliates that have nexus with the state ( nexus-only filings). See Iowa Code Sec (2). Does an outof-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? 16

17 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 only include the corporate member (Partner B) based on its own individual activities? 17

18 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 it has no independent nexus be thrown back if the corporate partner has nexus in the destination state but it does not? 18

19 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? 19

20 Ancillary Nexus Issue #3 PL Key Issue: PL 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 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 (830 CMR (8)(a)) Does PL apply to the income derived from the PTE? Or does PL apply to the corporate partner as the taxpayer under the corporate income tax? 20

21 Ancillary Nexus Issue #3 PL Example: Arizona Dept. of Rev. v. Central Newspapers (11/3/09): Partners = no AZ nexus; Parent has AZ nexus Ponderay = AZ nexus but protected by 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 ? Holding: AZ may include Ponderay s sales in the Partners sales factor numerator because the taxpayer is the Parent and its activities exceeded does not make certain income tax-exempt it prevents a state from exercising taxing jurisdiction over a corporate partner. 21

22 Ancillary Nexus Issue #4 Nexus Based on Receipts New York Example In NY, a corporation is subject to tax if it has receipts of $1 million or more in a tax year from NY activities Generally, there will be nexus: for a general corporate partner, or limited corporate partner that is engaged, directly or indirectly, in the participation in or the domination or control of all or any portion of the business of the partnership if its receipts in NY, if any, when combined with the receipts in NY of the partnership total at least $1 million; for an LLC corporate member that is engaged, directly or indirectly, in the participation in or the domination or control of all or any portion of the business of the LLC if its receipts in NY, if any, when combined with the receipts in NY of the LLC total at least $1 million. (regardless of any limitations in the operating agreement) exception for portfolio investment partnerships 22

23 Ancillary Nexus Issue #4 Nexus Based on Receipts New York Example LLC has $1,250,000 of receipts in NY. Member A has no receipts in NY. A is subject to tax P has two general corporate partners: Partner A owns 60% and Partner B owns 40%. Partnership has $600,000 of receipts in NY. Separately, Partner A has $700,000 of receipts in NY and Partner B has $450,000 of receipts in NY. For purposes of determining nexus only, both corporate partners A and B would be treated as having $600,000 of receipts in NY from P. Combined with their own receipts, both general corporate partners exceed $1 million in receipts in NY ($1,300,000 for Partner A and $1,050,000 for Partner B). Therefore, both general corporate partners are subject to tax. 23

24 Ancillary Nexus Issue #4 Nexus Based on Receipts New York Example LLC has $750,000 of receipts in NY. Separately, Member A has $500,000 of receipts in NY and Member B has $300,000 of receipts in NY. The LLC s operating agreement imposes limitations on both Member A s and Member B s participation in the management of the LLC. Member A is not engaged, directly or indirectly, in the participation in or the domination or control of all or any portion of the business activities or affairs of the LLC. Member B is indirectly engaged in the control of the business activities of the LLC. Member A, but not Member B, would be treated as having $750,000 of receipts in NY from the LLC. Combined with its own receipts, Member A exceeds $1 million in receipts in NY ($1,050,000). Therefore, Member A is subject to tax. 24

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26 Division of the Tax Base Apportionment 26

27 Multistate Taxation: Compliance & Planning Considerations 27

28 Central Tax Base Issue 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 28

29 Flow-Through Entities Apportionment and Corporate Partners Approaches used by states Partnership/Entity Level Approach - Corporate partner includes only its share of the income/loss of pass through entity as apportioned by the entity, but does not include its share of property, payroll and sales. Should any K-1 line items be reflected in factor if business income? Partner/Aggregate Level Approach = Flow-up of factors Corporate partners combine their percentage share of the passthrough entity s apportionment factors with their own apportionment factors 29

30 California Entity vs. Aggregate Calculation of Apportionment Factor 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. 30

31 Illinois: Five Different Apportionment Methods Apportionment Issues Non-Unitary Partnership (No Factor Flow Up) IITA Sec. 305 (a) and (b) Unitary Partnership (Factor Flow Up) 86 Ill. Admin. Code (d) Partnership Complete Member of Unitary Group 86 Ill. Admin. Code (d)(4) Investment Partnership under General Rule IITA Sec. 305(c-5) Investment Partnership Income Treated as Business Income IITA Sec. 305(c-5) 31

32 Illinois Entity vs. Aggregate Calculation of Apportionment Factor A partnership is required to use combined reporting when engaged in a unitary business with one 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, (d). However, this rule does not apply: 1. to shares of income from partnerships whose business activity outside the United States is 80 percent or 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, (c). 32

33 Entity vs. Aggregate Calculation of Apportionment Factor Florida (Fla. Admin. Code Ann. r. 12C-1.015(10)) Partnership factors flow through to the corporate partners Apportionment occurs at the partner level Compliance reporting considerations for tiered partnerships Massachusetts (Mass. Regs. Code tit. 830, ) Partnership factors flow through to corporate partners, if partnership and corporate partners are engaged in related business activities. If they are not engaged in related business activities, corporate partners separately account for partnership income and apportion it using only the partnership s factors. If corporation owns less than 50% of LP, presumed not to be doing business in Massachusetts, and apportionment is at partnership level 33

34 Entity vs. Aggregate Calculation of Apportionment Factor New Jersey (NJ Admin. Code tit.18, 18:7-7.6(g)(3)) Partnership factors flow through to corporate partners, if the partnership and partners are unitary If not unitary, apportion partnership income at the partnership level and report distributive share of apportioned taxable income without regard to the partners separate apportionment factors Note BIS, LP decision Interplay with w/h Oklahoma (Okla. Admin. Code 710: (15)(A)) Partnership factors do not flow through to the corporate partners. Income is apportioned at the partnership level and allocated to the state by the corporate partners. 34

35 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 of the partnership income as post apportionment income or loss. 35

36 Business/Non-Business Income 36

37 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 37

38 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) 38

39 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) 39

40 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 40

41 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 41

42 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 42

43 #3 Business / Nonbusiness Issues 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? 43

44 #3 Business / Nonbusiness Issues At what level is the business income determination madepartner 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? 44

45 Entity vs. Aggregate Business/ Nonbusiness Determination For corporate partners is the business/nonbusiness income determination made at the partnership level or partner level? Majority of states have not addressed Arizona & Illinois Requires partner level determination Arizona Corporation Tax Ruling No 94-2 (4/4/1994) Illinois Admin. Code tit. 86, (a)(3), (b)(1) Alabama Requires partnership level determination. Alabama Supreme Court ruled 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. 45

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47 Withholding and Composite Returns 47

48 Withholding Regimes 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 48

49 Withholding Challenges 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%. 49

50 Withholding Challenges In some states, withholding may not be compulsory May depend on type of owner, i.e. trust, corporation 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. 50

51 Withholding Elections 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 51

52 Withholding Risks 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-corpora tion 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. 52

53 Composite Regimes 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 other sources Agreement that PTE is authorized to resolve any audit/pay deficiency 53

54 Recent Developments Partnership Audit Regulations 54

55 IRS Partnership Audit Rules Default Regime: IRS makes adjustments at partnership level and collects from the partnership Qualifying partnerships (100 or fewer K-1s) may elect out by filing an annual election and providing information about their partners A partnership may elect to amend K-1s and have the partners pay the additional tax (avoids shifting liability between current and former partners) Imputed underpayment is assessed in adjustment year, not the year under review Partnership Representative sole authority to act on behalf of the partnership Effective

56 IRS Partnership Audit Rules State Tax Most states do not tax partnerships and have no mechanisms for reporting changes at the partnership level Audit Rules are procedural and will not be automatically by states that conform to the IRS Multistate apportionment How to apportion additional tax, partnership s or partner s factors? What year s apportionment reviewed or assessed? Nexus Nonresident partners; what if partnership moved or is not in the state? Statute of Limitations Statutory periods vary among states, and may vary from partnerships to partners Representative same as for the IRS or different? Election out same as for the IRS or different? Composite returns? 56

57 IRS Partnership Audit Rules Recent Developments New and Proposed Legislation Arizona (enacted in 2016) If partnership pays, within 90 days of final determination, partnership must pay AZ tax on any increase in income derived from AZ sources at highest individual rate If partners pay, partnership has 90 days to furnish statement to partners, and partners have 60 days to file amended returns Proposed legislation in Montana (similar to AZ (tabled)), Georgia (provided for separate representative (withdrawn)) MTC Model Statute Biggest concern: Lack of Uniformity 57

58 QUESTIONS? Michael J. Wynne Jones Day, 77 West Wacker, Chicago, IL (312) Dennis Rimkunas Jones Day, 250 Vesey Street, New York, NY (212)