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1 Advanced Multistate Taxation of Partnerships and Individual Partners Business vs. Nonbusiness Income Characterization, Reconciling Conflicting States Tax Treatments and More WEDNESDAY, JANUARY 27, 2016, 1:00-2:50 pm Eastern IMPORTANT INFORMATION 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 For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the 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.

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3 Advanced Multistate Taxation of Partnerships and Individual Partners January 27, 2016 Ned Leiby Director, Income and Franchise Taxes Ryan Jennifer A. Zimmerman Attorney Horwood Marcus & Berk Chartered

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 STATE TAXATION OF PASS-THROUGH ENTITIES Key Issues and Current Developments Jennifer A. Zimmerman Horwood Marcus & Berk Chartered 5

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 Brief History of PTEs 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 7

8 State-Federal Conformity Issues 8

9 State Conformity Overview 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? 9

10 #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 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 #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, 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 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 12

13 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 Corporate Partner Partner 70% Multistate Business Domiciled in UDITPA State $ Distributive Share = Non-business Income PTE NPH LLC 100% in NH 13

14 Nexus Issues Affecting Partners 14

15 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 correct to tax a nonresident limited partner on its 2% distributive share but not a nonresident shareholder on its 2% stock ownership in a corporation? 15

16 Due Process Clause Constitutional Framework 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)) 16

17 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? 17

18 TAX How Have the Cases Come Out? Non-Resident Limited Partners (NRLP ) NO TAX Borden (IL 2000): NRLP taxable because LP interest is sufficient minimum connection Village SM (NJ 2013): NRLP taxable because LP had in-state presence / connection UTELCOM (LA 2011): NRLP not taxable under state statute Lanzi (AL 2006): NRLP not taxable - under Constitution (akin to stock) BIS (NJ 2011) / Dutton (VA 2007): NRLP with no connections not taxable under Constitution 18

19 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 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 A (nexus) Corp B (no nexus) Corp C (nexus) Corp D (no nexus) PTE (nexus) 19

20 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? 20

21 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) Partner (State A) PTE (State B) State B State A 21

22 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? 22

23 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? 23

24 Ancillary Nexus Issue #3 PL Example: Arizona Dept. of Rev. v. Central Newspapers (11/3/09): Parent Partners = no AZ nexus; Parent has AZ nexus Ponderay = AZ nexus but protected by Parent elected to file as part of consolidated Partners AZ return, including Partners Agreement that Ponderay distributive share 13.5% was business income included in AZ return Issue: whether Ponderay s sales are Ponderay 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. 24

25 Division of the Tax Base - Apportionment 25

26 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: Central Tax Base Issue 1. Partner Level (Unitary) Method 2. Partnership Level (Non-Unitary) Method 3. Business/Nonbusiness Income Classifications 4. Methods for Special Issues 26

27 ADVANCED MULTISTATE TAXATION OF PARTNERSHIPS AND INDIVIDUAL PARTNERS ALLOCATION VS. APPORTIONMENT AGGREGATE VS. ENTITY ISSUES January 27, 2016 Ned Leiby

28 Multistate Taxation: Compliance & Planning Considerations How is FTE income taxed? Resident individual owners Nonresident individual owners Corporate owners Tiered FTE structures What states require filing of FTE tax returns? Individual and corporate owner filing requirements/considerations Availability/Requirements for withholding/composites 28

29 Multistate Taxation: Compliance & Planning Considerations FTE may need to file and information return: With state in which it is organized With state(s) in which it does business With state(s) in which it derives income States in which it derives losses (no income) may not require the filing of a tax return. Passive activity loss (NOL?) considerations: Is there a need to establish losses absent a state filing requirement? Impact on carryovers and composite filings Disposition of assets/interest and any state gain recognition With states in which it has a resident owner Information only: No sourced income(loss) 29

30 Multistate Taxation: Compliance & Planning Considerations Nexus Business/Nonbusiness Determination Unitary vs Nonunitary Sourcing: Apportionment or Allocation Corp. / Individual 30

31 Flow-Through Entities Nexus to Corporate Partners (Qualified) Investment Partnership Exceptions Qualified Investment Securities- defined by state CT: Trading on own behalf exception 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. Application to Partnership nexus? NY Dept. of Taxation FAQs Corporate Partner - California Deemed to be doing business in state and unitary with partnership if general partner Owe $800 minimum tax No consideration given to ownership in 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. The SBE has declared in opinions that it is extremely difficult to overcome the inherent passive investment nature of an limited partner interest. 31

32 Nonresident Income From Investment Partnership Investment Partnership Defined per state law; however, in general: 90% of the cost of the total assets of the investment partnership must consist of investment securities, bank or financial institution deposits, office space and equipment reasonably needed to carry on investment activities. 90% of its gross income must come from interest, dividends and gains from sale or exchange of qualifying investment securities. 32

33 State Non-Conformity with Federal Passive Activity Loss ( PAL ) Rules (IRC 469) Most states piggy-back federal treatment Exceptions California CA Form 3801 Modifies 469 Maryland Definition of Passive Activities (Real Property Trade or Business Professional) Calculation of loss on disposition Limitation amounts Differing basis considerations/tracking PALs are limited, based on ratio of loss calculated on federal Form

34 State Non-Conformity with Federal Passive Activity Loss ( PAL )Rules (IRC 469) Pennsylvania Income grouped into categories; however, net losses from one category cannot offset income from different categories. Carryover of disallowed losses not allowed. Spouses may not offset one another s income/losses New Jersey Income grouped into categories; however, net losses for each group of income is disallowed Carryover of disallowed losses not allowed 34

35 State Taxation of Nonresidents on Sales of Their Partnership Interests Note differences in implications for individual partners versus corporate partners. Individual Income Tax Purposes Most states treat the gain as sale of an intangible thereby sourcing the sale to state of domicile/residency. Some states require a nonresident to allocate nonbusiness gain based on where partnership had activity. Nonresident-Sourced to California if the property has a business situs in California Intangible property do not gain a California situs merely because of the partnership conducts business in California Appeal of Ames, 87-SBE-042 ( SBE 6/17/87); Appeal of Bass, 89- SBE -004 (SBE 1/29/89) 35

36 State Taxation of Nonresidents on Sales of Their Partnership Interests Corporate rules may differ. Implications for a corporate partner largely depend on whether the gain arises from business income or nonbusiness income. If the sale is considered nonbusiness, the gain is typically allocated to the state of commercial domicile. several states, including California, have rules to allocate the nonbusiness gain based on the underlying partnership s property or sales factors. If the sale is considered business income, then the gain is included in the apportioned tax base. Many states have rules that would exclude the proceeds from the sale of a partnership interest from the sales factor. California s new market sourcing regulation includes the sale of partnership interest in the sales factor based on the underlying partnership s factors. 36

37 California Sale of Partnership Interest Nonbusiness Income Corporate Tax Rules Nonbusiness Income CRTC 25125(d) provides for look through treatment on the sale of a partnership interest held as a nonbusiness asset. If more than 50% of the underlying partnership s assets consist of tangible property, gain allocated to California based on the ratio of tangible property in California to tangible property everywhere, determined at the time of sale. If more than 50% of underlying partnership s assets consist of intangibles, gain allocated to California based on the partnership s prior year sales factor. 37

38 California Sale of Partnership Interest Business Income Corporate Tax Rules Business Income Computing California Sales Factor For sales after 1/1/2013, market sourcing rules in CCR provide for look through treatment for sale of partnership and closely held corporations. If more than 50% of the underlying partnership s assets consist of tangible property, then proceeds are assigned to the numerator of the sales factor by averaging the underlying partnership s payroll and property factors. If more than 50% of underlying partnership s assets consist of intangibles, then proceeds are assigned to the numerator of the sales factor based on the underlying partnership s sales factor. 38

39 Special Rules: Sale of PTP Interests Some states have special allocation rules for sale of publicly-traded limited partnership ( PTP ) interests. Implications for IRC 751 ( hot assets ) income Implications for separate activity rules for PTPs Sourcing based on state apportionment factor IA ID OK MT 39

40 Michigan Flow-Through Entities Malpass v. Dept. of Treasury (2013) Multistate business income may be reported by individuals through either the unitary or separate-entity method Earlier case law held that the sole shareholder of an S corp could not combine apportionment factors of unitary S corps 40

41 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) Alabama Illinois Admin. Code tit. 86, (a)(3), (b)(1) 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. 41

42 PARTNER K-1 Line 1, 2, 3 are net income. These amounts usually are not be included in partner s apportionment factor- depending on state and partner s relationship with partnership Business/Nonbusiness Investment Partnership? P&L % may be different than capital % 42

43 Page 2: CA K-1 Differences between CA And federal amounts 43

44 Page 3: CA K-1 Amounts should match amount on Form 592-B. CA K-1 issued whether or not composite return is filed. NOTE: Separate Returns. If estimates paid with composite, then likely no w/h. 44

45 Be Wary of Different Apportionment Rules/Special Industries Be aware of differences in apportionment factor methodology for corporations and partnerships Some states adopt the corporate apportionment rules for determining sourcing of nonresident partnership income States that use individual income sourcing rules have many gaps and the sourcing guidance is out dated. Example : CT, NY, PA Corporation- Single Factor Partnership- Three Factor (Weighted) Attendant Nexus Considerations CT Economic Nexus 45

46 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 pass-through entity s apportionment factors with their own apportionment factors 46

47 Entity vs. Aggregate Calculation of Apportionment Factor 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. 47

48 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) 48

49 Entity vs. Aggregate Calculation of Apportionment Factor Illinois 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). 49

50 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 50

51 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. 51

52 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. 52

53 Non-unitary Partnership Income Reporting IL-1120: Non-unitary Partnership Business Income 53

54 1065 PAGE 1 Gross Revenue = Partner s % of Lines 1,4-7. Net amounts may require further digging for gross revenue. Note potential tiered flowthrough issue for line 4 Line 6 Gross or Net? Line 7 can be many different items (+ & -) 54

55 Make special note of items of foreign income flowing through as this may impact apportionment. 55

56 Entity vs. Aggregate Apportionment-Example EXAMPLE Orange Corp. operates exclusively in State A and generates $2,000,000 of taxable income. It has total revenue of $5,000,000. Orange Corp. is also a general partner in Golden Partnership owning 30% of capital and the same P&L%. Golden generated a taxable loss of ($1,000,000) on total revenue of $ 20,000,000 and operates in States B & C. Orange Corp. (GP) 30% Golden Partnership 56

57 Example: Flow-Through Apportionment Orange Corp. Sales % Sales State Income (Loss) State A $5,000, % $2,000,000 State B $0 0% $0 State C $0 0% $0 Total $5,000, % $2,000,000 Golden Partnership Sales % Sales State Income (Loss) State A $0 0% $0 State B $15,000,000 75% ($ 750,000) State C $ 5,000,000 25% ($ 250,000) Total $20,000, % ($1,000,000) 57

58 Example: Flow-Through Apportionment Orange Corp. Direct Golden Line 28 Federal Taxable Income $2,000,000 ($300,000) $1,700,000 Entity Only Scenario State A $2,000,000 State B ($225,000)* (75% x $300,000) State C ($ 75,000)* (25% x $300,000) Total $1,700,000 * Sourced on State K-1 issued by Golden 58

59 Example: Flow-Through Apportionment Aggregation (Flow-up) Sales Sales % Apportioned Income T.I.= $1,700,000 State A $ 5,000, % $ 772,650 State B $ 4,500,000* 40.91% $ 695,470 State C $ 1,500,000** 13.64% $ 231,880 Aggregate Denominator * 30% x $15,000,000 ** 30% x $ 5,000,000 $11,000, % $1,700,000 Lack of uniformity/mismatch compare the two approaches. If State C is OK? If States A & B are IL and CA? Unitary/Non-unitary? 59

60 Factor Flow-up and Tiered Partnership Direct Factors from OP, LLC use 25% 25% INC. OP, LLC 15% 20% Effective Rate = 20% + (15% * 25%) = 20% % = 23.75% OP, LP 60

61 Factor Flow-up and Tiered Partnership OP, LLC 25% L.P. 15% G.P. INC. OP, LP 20% L.P. Impact of L.P. interest on effective rate calculation? Can a limited partner be unitary? 61

62 Additional Considerations For Preparers of Returns What information to pass through to partners/investors. Does reporting through factor data to partners create confusion for partners absent significant disclosure? Unitary determination must be made at partner level (or jointly with partnership In Practice?) What do tiered partnerships do? Does characterization of receipts of the partnership flow through to the partners? Michigan RAB states that receipts that flow through from the partnership that are not taxed at the entity level (because they are protected by P. L ) 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 62

63 Additional Considerations For Preparers of Returns Individual partner filing requirements by state Need for establishing loss carryovers/state buckets? PTPs treated as separate activities Receiving/passing through relevant data for estimates Asset Managers: Impact of 12/29/15 notice of change to text of proposed marketbased sourcing regulation (CCR ) Trends Expansion of w/h and composite requirements State level impact of new rules adopted by IRS for partnership audit assessments??? Different state basis for partnership or assets? Depreciation non-conforming states Losses allowed/suspended 63

64 Thank You! Ned Leiby Ryan, LLC 64

65 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: #3 Business / Nonbusiness Issues 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? 65

66 At what level is the business income determination madepartner or partnership level: Most states have no guidance. Exceptions: #3 Business / Nonbusiness Issues Partnership Level: AL, CA, IL Partner Level: AZ, PA If non-business income, the question is to which state is the income sourced? 66

67 Business / Nonbusiness Example PTE A 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. $250,000 state tax liability Retail: $150,000 ($200,000 x 75% appt) Dividends: $200,000 ($200,000 x 0%) Liability may vary depending upon domicile rule! 67

68 #4 Special Issues (a) What problems exist with tiered partnerships? Timing Issues / Withholding Regimes / Composite Returns (b) 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 Differences may include whether the sale is treated as a sale of an intangible or sale of tangible assets, and whether gain is source to situs of partnership 68

69 Business/Non-Business Income 69

70 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 70

71 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) 71

72 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) 72

73 73

74 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 74

75 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 75

76 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 76

77 Compliance Headaches/ Withholding Requirements 77

78 Compliance / Administrative Issues 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? 78

79 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 79

80 2014 State & Local Tax Webinar, AGN North America 80 80

81 2014 State & Local Tax Webinar, AGN North America 81 81

82 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 uppertier PTE is a non-resident individual, it may instead withhold at the individual rate, currently 4.25%. 82

83 Withholding Challenges 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.. 83

84 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 84

85 Under-report which results in penalties Based on difference in tax rates between PTE and owner Tiered Entities- special risks Withholding 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 85

86 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 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 86

87 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-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 nonresidents.. 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. 87

88 Typical Conditions: Composite Regimes 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 88

89 2014 State & Local Tax Webinar, AGN North America 89 89

90 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 90

91 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 owner s distributive share of PTE income Be careful do you want to submit to the jurisdiction of the state? Do you have a choice? 91

92 Take-Aways 92

93 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) 93

94 QUESTIONS? THANK YOU! Jennifer A. Zimmerman T: (312) Breen M. Schiller T: (312) Horwood Marcus & Berk Chartered 500 W. Madison Street, Suite 3700 Chicago, IL