NEW YORK STATE BAR ASSOCIATION TAX SECTION. Annual Meeting. State and Local Tax Implications of Federal Tax Reform.

NEW YORK STATE BAR ASSOCIATION TAX SECTION Annual Meeting State and Local Tax Implications of Federal Tax Reform January 23, 2018 Chair: Irwin M. Slomka, Morrison & Foerster LLP, New York City Joshua E. Gewolb, Harter Secrest & Emery LLP, Rochester Alysse McLoughlin, McDermott Will & Emery, New York City Helen Hecht, General Counsel, Multistate Tax Commission, Washington, DC I. Introduction A. The Federal Tax Cuts and Jobs Act of 2017 ( H.R.1 ) has state tax implications for individuals, corporations and pass-through entities. To a large extent, the impact results from state conformity with federal taxable income, which is often the starting point in computing state taxable income. Federal conformity generally simplifies both taxpayer compliance and state tax administration. B. Some of the federal changes, such as the corporate tax rate reduction, do not have direct state implications. Others, such as business interest deduction limitations, could apply in some states unless state legislation is enacted to decouple from the federal treatment. C. Our panel will address some of the state and local tax implications of the federal legislation. II. Individual Tax A. Rate Reduction. Retains seven tax brackets, but top bracket is reduced to 37%. Other brackets will be 10%, 12%, 22%, 24%, 32% and 35%. 1

B. Deductions 1. SALT Deduction. Limits the itemized deduction for state and local taxes to $10,000, which applies to the aggregate of both state and local property taxes and state and local income taxes. 2. Mortgage Deduction. Limits the deduction for home mortgage interest to mortgages of up to $750,000 for newly purchased homes. The deduction for interest on home equity loans is suspended. 3. Standard Deduction. Nearly doubled to $12,000 (single)/$24,000 (married filing jointly). C. Individual AMT. Preserves the individual alternative minimum tax, but raises the threshold amount for its application. D. 20% Deduction for Qualified Business Income (discussed below). E. Duration of Changes. All individual tax provisions sunset on 1/1/2026. F. State Considerations 1. General. Reduction in federal tax rate does not impact SALT liabilities, but changes to deductions could affect the income tax base in states that start with federal taxable income as the base for calculating an individual s state taxable income. 2. SALT Deduction. Some states are considering ways to mitigate the impact of the $10,000 SALT deduction cap (without lowering state taxes). Reportedly, these potential strategies include: a. Charitable contributions. Proposed California legislation to allow residents to make charitable contributions to the California Excellence Fund, claim a federal charitable 2

deduction and claim a dollar-for-dollar credit against their state income tax liability. California S.B. 227. b. Payroll tax. Creation of an employer payroll tax with a corresponding state tax credit for the employee. c. Allowing Prepayment of Taxes: While the federal legislation precluded the deduction in 2017 for pre-paid state income taxes, there is no explicit prohibition for prepaying property taxes. However, per IRS guidance, deductions will only be allowed in 2017 for the pre-payment of property taxes assessed by states and municipalities before 2018. III. Business Tax A. Interest Deduction 1. General Description of Change a. Section 13301 of the Act modifies IRC 163(j) to add a limitation on deductibility of business interest. b. Generally, the deduction for net business interest is limited to 30% of the taxpayer s adjusted taxable income for the year. IRC 163(j)(1)(B). The amount of any business interest not allowed as a deduction is carried forward to future years. IRC 163(j)(2). c. The 30% limitation generally does not apply to taxpayers with average annual gross receipts of $25 million over a three year period. IRC 163(j)(3). d. Special rules apply to pass-through entities. Generally, the limitation applies at the entity level. IRC 163(j)(4). 3

2. State Implications a. New York State (ii) (iii) Entire net income is defined in Tax Law 208.9 as federal taxable income (i.e., Line 28 on Form 1120) subject to certain adjustments. There is no adjustment for interest. As New York conforms to the federal treatment of interest, the federal interest limitation will apply, and will increase the New York tax base. Because the carryforward under IRC 163(j)(2) simply increases the federal interest expense for future years, it will automatically carryforward on the federal income to be apportioned to New York in future years. However, the apportionment percentage in the year in which the deduction is realized may be different from that in the year in which the interest was incurred. Application to New York State combined groups will need to be considered. b. Multistate (ii) The same issues identified with respect to New York above will apply on a multistate basis. Depending on state law, the limitation may or may not be incorporated. The interaction of this provision with state provisions regarding addback of interest paid to related parties will need to be reviewed. The fact that the overall 4

federal interest deduction is now limited could potentially affect the mechanics of these provisions. B. Net Operating Losses 1. General Description of Change a. Section 13302 of the Act modifies IRC 172 with respect to deductions for net operating losses. b. The deduction for net operating losses is now limited to 80% of taxable income. IRC 172(a)(2). c. The net operating loss carryback is eliminated. IRC 172(b)(1)(A). d. Indefinite carryforward is now permitted. Id. 2. State Implications a. New York State (ii) (iii) Tax Law 210.1(a)(ix) establishes a net operating loss deduction in New York. The New York State net operating loss is the amount of a business loss multiplied by the apportionment factor in the year that the loss is incurred (i.e., it is determined on a post-apportionment basis). Tax Law 210.1(a)(ix). Tax Law 210.1(a)(ix)(1) explicitly states that the net operating loss deduction is not limited to the amount allowed under IRC 172. 5

(iv) (v) Although federal law now has an indefinite carryforward period, the three year carryback and 20 year carryforward are hard-coded into the New York statute and are not affected by the federal law change. Tax Law 210.1(a)(ix)(4). The modification of IRC 172 should not affect the prior net operating loss conversion subtraction under Tax Law 210.1(a)(viii)(B). b. Multistate (ii) Overall, as state NOL rules differ in many regards from federal NOL rules (and from one another), states will need to determine how to respond legislatively to the federal change. The revenue impact of the change will depend on the current state rules, but as described below because state NOL rules are often decoupled from the federal rules, for many states the impact will be limited. State taxable income generally begins with federal income before subtraction of NOLs (i.e., Form 1120, Line 28) or federal NOLs are added back. Accordingly, the computation of state taxable income may be unaffected by the limitation of the deduction for NOLs to 80% of taxable income. However, the mechanics of states differ and the result in each will depend on the specific statutory mechanics, as well as other state-specific rules. 6

(iii) The majority of states specify the number of years in which losses can be carried forward or carried back (or already disallow carryback entirely) and therefore will not be affected by the federal change. A minority of states follow the federal law in this regard and accordingly the carryforward/carryback rules will follow the federal change. C. Immediate Expensing 1. General Description of Change a. Section 13201 of the Act amends the bonus depreciation provisions of IRC 168(k) to provide for immediate expensing of certain business assets. b. Bonus depreciation of 100% is permitted for property placed in service between September 27, 2017 (the date of release of the House framework) and January 1, 2023. (This period is extended to January 1, 2024 for certain property with a longer production period.) Thereafter, the special bonus depreciation provision begins to phase out. c. Section 13101 of the Act expands the deduction under IRC 179 for small businesses. 2. State Implications a. New York Tax Law 208(9)(b)(17) generally requires an addition to federal taxable income of the amount of the deduction under 168(k). Accordingly, the expansion 7

b. Multistate of IRC 168(k) should generally not affect the computation of New York taxable income. (ii) Most states already decouple from federal provisions regarding bonus depreciation. See, e.g., Pennsylvania Corporation Tax Bulletin 2017-02 (clarifying that Pennsylvania law requires add back of 100% bonus depreciation). Those states that do not will need to determine whether to conform to the federal changes, with the corresponding impact on the fisc. For states whose statutes do not automatically decouple from this change, expedited action would be required due to the retroactive effect of the bonus depreciation provision. D. Contributions to Capital 1. General Description of Change a. Section 13312 amends IRC 118 with respect to contributions to capital. b. The general rule remains that gross income does not include contributions to capital. However, a new exception is now added, which states that a contribution to capital does not include any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such). IRC 118(b). There is an exception for contributions made pursuant to a master development plan approved prior to enactment. Section 13312(b)(2). 8

c. The Conference Report provides two examples of the application of this provision. In the first example, a municipality makes a contribution of municipal land. This is deemed to be taxable. In the second example, a municipality offers a tax abatement for locating in the municipality. This is deemed not to be taxable. d. No corresponding change is made to IRC 721 with respect to contributions to partnerships. 2. State Implications a. New York (ii) This provision will decrease the value of New York State and local incentives structured as grants to corporations. As State tax abatements do not constitute contributions to capital, this would create an economic reason to consider replacing cash grant payments with tax abatements. New York does not have a specific provision excluding its own grant payments from income (as such a provision was not necessary under prior law). Accordingly, in absence of legislative change such payments would flow through with federal income and be subject to New York tax. b. Multistate The issues identified for New York above are also likely to apply on a multistate basis. 9

E. Repeal of Corporate Alternative Minimum Tax 1. General Description of Change a. Section 12001 of the Act repeals the alternative minimum tax for corporations (Section 23456). 2. State Implications a. New York New York does not have an equivalent to the federal alternative minimum tax for corporations. b. Multistate A small minority of states impose a corporate alternative minimum tax. These states may need to address the implications of the federal elimination of alternative minimum tax for corporations. IV. International Tax A. General Description of Change: 1. The new regime includes a shift from a system of worldwide taxation with deferral to a hybrid territorial system, featuring a participation exemption regime with current taxation of certain foreign income, a minimum tax on low-taxed foreign earnings, and new measures to deter base erosion and promote U.S. production. B. DRD for Foreign-Source Dividends: 1. Domestic corporate C shareholders of 10% owned corporations will be able to take a 100% DRD for the foreign-source portion of dividends received. IRC 245A. 10

a. Not available for dividends received by REITs or RICs. b. Not available for dividends received from PFICs. c. Not available for hybrid dividends an amount received from a CFC for which the CFC received a tax benefit related to taxes imposed by a foreign country. d. No foreign tax credit or deduction will be allowed for any foreign taxes paid (or deemed paid) with respect to a dividend for which the 100% DRD is allowed under IRC 245A. e. Gain from the sale or exchange of stock of a foreign corporation that is treated as a deemed dividend to a domestic corporate shareholder will be eligible for the 100% DRD. 2. State Implications a. Multistate (ii) To the extent a state taxes foreign dividends because foreign dividends are included in the federal income tax base, such dividends will likely now be exempt pursuant to the federal DRD. To the extent a state specifically provides that it taxes foreign dividends, the foreign dividends could still be taxable. C. Repatriation Transition Provisions: Due to the shift from a worldwide tax regime through enactment of the 100% dividend-received deduction for foreign-source income received from foreign corporations, a provision has been enacted to ensure that income that has been earned previously by 11

CFCs but that has not yet been subject to tax pursuant to the Subpart F inclusion provisions, will not escape taxation. Thus, the repatriation transition provisions (the RT ) impose a one-time tax on foreign earnings that have not been previously taxed, albeit at a lower rate than the corporate tax rate. Following are the mechanics of the RT provisions: 1. The taxpayer increases the amount of its taxable income included under IRC 951(a) to reflect the deferred foreign E&P of its CFCs (the RT Addition ). 2. The taxpayer takes a deduction titled a participation exemption under IRC 965 equal to an amount that would result in the taxpayer being subject to tax at a rate of 8% on the amount by which its RT Addition exceeds its aggregate foreign cash position, plus an amount that would result in the taxpayer being subject to a tax rate of 15.5% on the amount of the taxpayer s aggregate foreign cash position that does not exceed the taxpayer s RT Addition (collectively, the RT Deduction ). 3. The taxpayer can elect to defer payment of the RT tax liability by paying the liability in eight installments, each of which is computed based on a percentage of the RT tax liability. 4. State Implications a. Multistate The RT Addition will be included in the starting point of a state s taxable income if the state uses federal taxable income or gross income as the starting point. 12

(a) (b) If the RT Addition is included, it is necessary to determine if there is a state modification such as a DRD or a Subpart F exclusion that will exclude the RT Addition. In determining whether the inclusion applies, it is necessary to examine the state tax modification carefully to see whether it will apply to the RT Addition because the RT Addition is not included in the definition of Subpart F income under IRC 952 and it may or may not be classified as a dividend for state tax purposes. (ii) (iii) The RT Deduction will be included in the starting point of a state s taxable income if the state uses federal taxable income as the starting point. It should not matter if the state starting point is taxable income before special deductions; the RT Deduction should not be considered a special deduction pursuant to IRC 241 because IRC 965 is not in Part VIII of the IRC. (a) It should be irrelevant if the RT Deduction is deducted on line 29 of the federal 1120 return as a special deduction, because it is not a special deduction and placement on a federal return should not trump the language in the IRC. 13

(b) If the RT Deduction is included in determining the starting point of the state tax base, it is necessary to determine if there is a state modification such as a DRD or a Subpart F modification that will add back the RT Deduction. b. New York (ii) (iii) (iv) New York should include the RT Addition and the RT Deduction in the starting point for determining the tax base because the RT Addition and the RT Deduction are both included in federal taxable income. New York should exempt the RT Addition as other exempt income that is excluded from the tax base The amount of the RT Addition exclusion will be decreased for interest attributed to the RT Addition whether through direct and indirect attribution or by means of the 40% attribution election. There should be no modification for the RT Deduction unless it is considered a DRD. D. New Provisions in Determining the Federal Tax Base: 1. Global Intangible Low-Taxed Income ( GILTI ): H.R.1 provides for taxation of GILTI at a reduced effective rate of 10.5 percent (13.125 percent beginning in 2026) in an effort to tax a portion of the active (non-subpart F) income of CFCs that portion of the CFCs income that is equal to the excess of an implied 10 percent 14

rate of return on the CFCs adjusted bases in tangible depreciable property used to generate active income. The GILTI is implemented through the following components: a. The taxpayer includes its share of the GILTI of its CFCs in its taxable income under newly added IRC 951A (not 951(a)) (the GILTI Addition ). b. The taxpayer takes a deduction under new IRC 250 equal to, at most, 50% of the GILTI Addition plus any corresponding section 78 gross-up (combined, these two components comprise the GILTI Deduction ). 2. State Implications a. Multistate Similarly to the RT Addition, the GILTI Addition will be included in the starting point of a state s taxable income if the state uses taxable income (or gross income) as the starting point. (a) (b) If the GILTI Addition is included, it is necessary to determine if there is a state modification such as a DRD or a Subpart F exclusion that will exclude the GILTI Addition. In determining whether any potential exclusion applies, it is necessary to examine the state tax modification carefully to see whether it will apply to the GILTI Addition because the GILTI 15

Addition is not included in the definition of Subpart F income under IRC 952, the GILTI Addition is not added to gross income pursuant to IRC 951(a) (which adds Subpart F income to gross income), and the GILTI Addition is less likely to be classified as a dividend for state tax purposes than Subpart F income and the RT Addition. (ii) The GILTI Deduction will be included in the starting point of a state s taxable income if the state uses taxable income after special deductions as the starting point. (a) (b) (c) The GILTI Deduction is a special deduction because it is in Part VIII of the IRC. 1 As a special deduction, the GILTI Deduction will not be included in the starting point of the state tax base in those states that link to the IRC before special deductions. Many states take the position on their returns that they link to the IRC before special deductions, but a review of their statutes may indicate that they link to federal taxable income, thus necessarily including special deductions. 1 Technically, the GILTI Deduction is provided for in Subtitle A, Chapter 1, Subchapter B, Part VIII of the IRC, but for purposes of this outline we will refer to this section as Part VIII. 16

(d) If the GILTI Deduction is included in determining the starting point of the state tax base, it is necessary to determine if there is a state modification such as a DRD or a Subpart F modification that will add back the GILTI Deduction. b. New York (ii) (iii) The GILTI Addition will not be excluded from the business income tax base as other exempt income as it is not added to federal gross income pursuant to IRC 951(a). The GILTI Addition may be excluded from the business income tax base as dividends from unitary corporations not included in the combined return if the GILTI Addition is considered to be a dividend. The GILTI Deduction may be added back if the GILTI Addition is considered to be a dividend and the GILTI Deduction is considered to be a DRD. 3. Foreign-Derived Intangible Income ( FDII ) a. A deduction is allowed for income earned by corporate U.S. taxpayers from selling property or providing services outside the U.S. b. The taxpayer takes a deduction under new IRC 250 equal to, at most, 37.5% of the taxpayer s foreign-derived intangible income (the FDII Deduction ). 17

c. State Tax Implications Multistate (a) (b) The FDII Deduction will be included in the starting point of a state s taxable income if the state uses taxable income after special deductions as the starting point. The FDII Deduction is a special deduction because it is in Part VIII of the IRC. (1) As a special deduction, the FDII Deduction will not be included in the starting point of the state tax base in those states that link to the IRC before special deductions. Many states take the position on their returns that they link to the IRC before special deductions, but a review of their statutes may indicate that they link to federal taxable income, thus necessarily including special deductions. (2) Under current law, it is likely that no state modification will exist to add back the FDII Deduction because it does not seem to be a DRD and it is not in Subpart F. 18

(ii) New York (a) (b) The FDII Deduction should be included in the starting point for the taxable base. The FDII Deduction may be added back if it is considered to be a dividend-received deduction, however this does not seem likely. E. Expanded Transfer Pricing Rules: 1. The transfer pricing rules are broadened by expanding the definition of intangible property and by expanding the IRS s authority to challenge transfer pricing methods used by taxpayers. a. The definition of intangible property for transfer pricing purposes now includes any item of potential value that is not attributable to tangible property or the services of an individual including goodwill, going concern value, and workforce in place. b. The IRS is given the authority to value transfers of intangible property on an aggregate basis with the transfer of other property or services that have been transferred if determined to be the most reliable means of valuing such property. c. The new rules sanction the ability of the IRS to use aggregation and realistic alternative theories 2. State Implications a. States have been increasingly applying federal transfer pricing principles. It is assumed that the states will quickly 19

start applying the expanded transfer pricing rules, even potentially for audits for tax years before 2018. F. Base Erosion and Anti-Abuse Tax ( BEAT ) 1. Intended to address base erosion resulting from companies serving the U.S. market through foreign affiliates located in low- or no-tax jurisdictions. 2. A new Section 59A was created that imposes an alternative minimum tax designed to reduce excessive earnings stripping accomplished through payments to foreign affiliates. 3. Applicability of BEAT a. Applies to groups with at least $500 million in annual gross receipts. b. The BEAT applies if 3% (2% for banks and securities dealers) of a company s total allowable deductions are associated with foreign activity. c. The BEAT does not apply to REITs, RICs, or S corps. 4. The BEAT is equal to the amount that a company s taxable income, computed without regard to base eroding payments to related corporations and taxed at a 10% rate, exceeds the company s regular corporate tax liability minus certain tax credits. The BEAT will be phased in, starting with the imposition of a 5% rate for taxable years starting in 2018. 20

5. Base erosion payments are deductible cross-border payments to related parties a. Includes payments to related parties that are deductible; payments to related parties for the purchase of depreciable or amortizable property; and reinsurance payments made to related parties. b. Base erosion payments do not include payments subject to 30% US withholding or cross-border purchases of inventory included in cost of goods sold. 6. Business tax credits, like the investment tax credit and production tax credit, can offset up to 80% of the BEAT tax. 7. State Tax Implications a. Without any state legislation, it is likely this provision will have no impact on a corporation s tax liability in any state because this is a tax liability that is essentially imposed on an alternative tax basis. It doesn t change a taxpayer s federal gross income or taxable income. V. Treatment of Pass-Through Entities and Their Income A. Qualified Business Income Deduction for Individuals 1. Federal Change (sunsets on 1/1/2026). a. General. Provides for a 20% deduction for noncorporate owners for qualified business income from a partnership, limited liability company that elects to be treated as a partnership, S corporation, or sole proprietorship. The 21

deduction is allowed against federal taxable income, and is not allowed as a deduction in computing federal adjusted gross income. The deduction has the effect of reducing the maximum tax rate on pass-through income from 37% to 29.6%. b. Qualified business income. Qualified business income is generally defined as the net amount of qualified items of income, gain, deduction, and loss relating to any qualified trade or business of the taxpayer. IRC 199A(c)(1). Qualified business income does not include: (a) (b) (c) (d) Guaranteed payments to partners for services. IRC 199A(c)(4). Payments to a taxpayer for services rendered with respect to the qualified business. IRC 199A(c)(4). Most investment related income, including capital gains or losses, dividends, and interest income (unless the interest income is properly allocated to the business). IRC 199A(c)(3)(B). Items of income, gain, deduction and loss that are not effectively connected with a U.S. trade or business. IRC 199A(c)(3)(A). 2. Limitation on Amount of Deduction. The deduction is limited based generally on a percentage of the W-2 wages of the pass-through 22

entity paid with respect to the qualified trade or business, and/or on a percentage of the unadjusted basis of all qualified property of the entity. 3. Limitation: Income from Certain Service Businesses. The 20% deduction is not available for income received from a trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. See IRC 199A(d), 1202(e)(3)(A). B. State Tax Implications. 1. For states that start with federal taxable income, unless a state opts out of the 20% deduction, noncorporate owners will be entitled to the 20% deduction. a. For federal purposes, limiting the 20% deduction to individual owners, but not corporate owners, provides individuals with a lowered effective tax rate comparable to the rate reduction afforded to corporations. In some states, however it may result in corporate owners being taxed on their pro rata share of income at a higher effective state tax rate than individual owners are taxed, because the corporate owners will not receive the 20% deduction nor will they necessarily receive the benefit of a reduced state corporate tax rate. 23

b. New York. New York State starts with federal gross adjusted income not federal taxable income, and therefore the 20% deduction should have no impact on an individual s New York State taxable income. However, under the wording of New York s itemized deductions statute (Tax Law 615), the 20% deduction may nonetheless be allowed for certain individuals unless New York State enacts remedial legislation. Specifically, 615 allows resident individuals who itemize their federal deductions to take a New York itemized deduction which is defined as the total amount of his deductions from federal adjusted gross income... as provided in the laws of the United States. Tax Law 615(a). Although the 20% deduction is not an itemized deduction for federal purposes, under the language of 615(a), it may be treated as one for New York purposes. c. Multistate. States that start with federal taxable income (e.g., Colorado and Minnesota) will need to decouple from federal law if they do not want to allow the 20% deduction. States that start with federal adjusted gross income or gross income must determine whether they need to adjust their laws to avoid adopting the 20% deduction. It is also worth noting that in some states individuals and corporations are taxed at equivalent tax rates (for example, in New York the tax rate is 7.1% for corporations and between 4% and 8.82% for individuals). Those states that allow the 20% deduction for individuals will need to determine whether there is a tax policy rationale for allowing the deduction for individual owners but not allowing it to corporate owners. 24

C. Carried interests. The Act provides that a promoter s carried interest in a partnership ( applicable partnership interest ) in an applicable trade or business will constitute short term capital gains unless the property sold by the partnership was held for at least three years. 1. An applicable partnership interest is any interest in a partnership that, directly or indirectly, is transferred to (or held by) the taxpayer in connection with performance of services in any applicable trade or business. IRC 1061(c). 2. An applicable trade or business is any activity that consists in whole or in part of the following: (1) raising or returning capital, and either (2) investing in (or disposing of) specified assets (or identifying specified assets for investing or disposition), or (3) developing specified assets. IRC 1061(c)(2). 3. The Act does not, however, treat the carried interest as compensation for services. 4. Potential impact in states that provide special treatment for capital gains. a. New York State. New York State does not afford special tax treatment to resident individuals for long term vs. short term capital gains, and does not tax nonresident individuals on income earned from the purchase and sale of property for one s own account. Tax Law 631(d). b. Multistate. In contrast, for example, Massachusetts taxes long-term and short-term capital gains at different rates. Other states, like Arkansas and South Carolina provide partial or full exclusions for certain long-term capital gains. Such 25

states will need to consider whether to conform to the new federal rule. c. The state impact would have been more significant if the carried interests were treated as compensation for services. D. Repeal of the Partnership Technical Termination Rule in IRC 708 a. Under prior law, a partnership was treated as terminated if: (a) no part of any business, financial operation or venture of the partnership continues to be carried on by any of its partners in a partnership (IRC 708(b)(1)(A)); or (b) within any 12-month period, there was a sale or exchange of 50% or more of the total interest in partnership capital and profits. IRC 708(b)(1)(B). b. The Act repealed the rule in IRC 708(b)(1)(B) providing for technical terminations of partnerships in cases where there is a sale or exchange of 50% or more of the total interest in the partnership. 2. State implications. Depending on which version of the Internal Revenue Code a state conforms to, the repeal of the technical termination rule could result in a partnership being terminated for state tax purposes, but not for federal tax purposes. a. New York State. Has rolling conformity with the Internal Revenue Code, so this should not be an issue. b. Multistate. Approximately 21 states conform to the IRC as of a fixed date. For example, Florida currently conforms to the IRC as of January 1, 2017, so at this time it may be 26

possible to have a partnership termination for Florida tax purposes, but no termination for federal tax purposes. VI. New Federal Partnership Audit Regime A. Effective Date. The new audit regime was enacted into law on November 2, 2015 under the Bipartisan Budget Act of 2015 ( BBA ). It applies to partnership tax years beginning after December 31, 2017. IRC 6221 et seq. 1. As a practical matter, these audit rules will not be applied until after 2018, after partnerships file their 2018 partnership tax returns. 2. However, partnerships may elect to apply these rules to tax years beginning after November 2, 2015. B. Proposed and Final Regulations Issued to Date. 1. Proposed regulations implementing the new audit regime were released on June 14, 2017 (REG-136118-15). 2. Additional proposed regulations addressing multi-tiered partnerships and other items not covered in the June 14, 2017 regulations were released on December 15, 2017. (REG-120232-17, REG-120233-17). 3. Final regulations for electing out of the new partnership audit regime were released on December 29, 2017 (T.D. 9829). 4. Proposed regulations addressing international provisions under the partnership audit regime were released on November 30, 2017. (REG-119337-17). 27

C. Authority to Collect Tax at the Entity Level. The 2015 legislation creating the new federal partnership audit regime authorizes the IRS to require partnerships to pay an imputed underpayment in the case of an adjustment by the IRS to any item of income, gain, loss, deduction, or credit of a partnership, or any partner s distributive share thereof. IRC 6225(a). 1. The authority to assess and collect tax directly at the partnership entity level is a significant departure from prior policy, which only permitted assessment and collection at the partner level. 2. Underpayment Calculated at Highest Marginal Tax Rate. In general, the imputed underpayment with respect to any partnership adjustment is determined by netting all adjustments of items of income, gain, loss, or deduction and multiplying such net amount by the highest rate of tax in effect for the reviewed year under IRC 1 or 11. IRC 6225(b)(1)(A). 3. Current Partners May Be Responsible for Prior Partners Underpayments. Any resulting audit deficiency is assessed directly against the partnership. Therefore, for example, an underpayment relating to the 2018 tax year ( reviewed year ) may be borne by the partners in the year the underpayment is assessed, e.g., by the partners in 2021, unless it is pushed out to the partners in the reviewed year, who may be different than the partners in the year the underpayment is assessed. D. Ability to Push-Out the Liability. A partnership can elect, within 45 days of an IRS notice of final partnership adjustment, to push out the underpayment adjustment directly to the partners in the reviewed year. IRC 6226(a). 28

1. Multi-Tier Push-Outs. The proposed regulations permit partnerships to elect to push out adjustments through tiers of partnerships to the ultimate taxpayer owner. Under those regulations, each passthrough partner in the ownership chain may either pay the tax or push out the adjustment to its partners, until either a pass-through partner or non-pass-through partner takes the adjustments into account. 2. Relief from Liability. A partner/partnership electing to push-out an adjustment to its partners is relieved from liability if it makes the election properly and fully complies with the prescribed requirements. 3. Information Collected at Each Tier. Under the proposed regulations, the partnership making the initial push-out election is not required to collect all of the relevant information regarding each partnership and its partners, or as to whom the ultimate owners are. Instead, each partnership making an election to push out needs to provide information about its partners. 4. Enforcement and Compliance. A partner/partnership that does not push out an adjustment to its direct partners is required to pay the adjustment itself. E. Ability to Opt Out. A partnership may opt out of the federal audit regime for any tax year if the partnership has 100 or fewer partners in that year, and all of the partners are eligible partners. IRC 6221(b). 1. 100 or Fewer Partners. The final regulations provide that a partnership has 100 or fewer eligible partners if it is required to furnish 100 or fewer information statements under section 6031(b). 29

2. Eligible Partners. Eligible partners are defined as individuals, C corporations, S corporations, any foreign entity that would be treated as a C corporation if it were a domestic corporation, and the estates of deceased partners. IRC 6221(b)(1)(C). a. Not included. Eligible partners do not include partnerships, trusts, disregarded entities, persons that hold an interest on behalf of another person, and estates other than the estate of a deceased partner. 3. Election. An annual election must be made on a timely filed return for the tax year. The partnership must disclose the name and taxpayer identification number of each partner of the partnership. IRC 6221(b)(1)(D). a. Revocation. Once made, the election may only be revoked with the permission of the IRS. 4. Tax Matters Representative. Requires the partnership to select one person that has sole authority to deal with the IRS (does not have to be a partner). IRC 6223. F. State Considerations 1. Conformity. Will states conform to these rules by enacting legislation? Most states conform to the Internal Revenue Code for the determination of taxable income, but not for its administrative procedures. 2. Nexus. 30

a. Does a state have sufficient nexus over a nonresident limited partner of a partnership that does business in the state? If not, it can be addressed through partnership withholding rules. b. For push-out liability to partners in a reviewed year, does a state have sufficient nexus over a former partner that is no longer in the state? c. Does a state have sufficient nexus over an out-of-state partnership, allowing it to require tax payment by that partnership, merely because a partner resides in the state? Can the state require reporting by a partnership that conducts no in-state activity? 3. Apportionment. a. A partnership may opt to pay the state tax where it is located in a lower tax jurisdiction than its partners, resulting in a strategic shifting of the tax to a low tax state. b. For a partnership that engages in investment activities, nonresident partners may not be required to apportion to the state where the partnership is located their share of the partnership s investment income. c. A partnership may not know how its partners apportion their income in states where the partner s taxable income from the partnership is based on the partner s own apportionment factors. This could make it difficult for states to ensure that the full amount of the partnership s state tax liabilities are being collected from the partners. 31

4. Combined Partnership Reporting. It could result in a need for state combined partnership reporting if partnerships are permitted to pay the tax at the entity level. This is because related partnerships can engage in intercompany transactions that serve to reduce the tax of the partnership located in a high tax state. 5. Reporting Partnership Level Adjustments. Can states require that partnerships report partnership level tax adjustments made under the federal regime, and if so, how would that be effectuated? 6. Application of Election to Opt Out. Will the states adopt the same requirements for eligibility to opt out or establish their own criteria? Will the partnership s federal election to opt out also bind the state, or will it need to make a separate state election (if available)? G. State Responses to New Audit Regime 1. Arizona. To date, Arizona is the only state to have enacted legislation partially conforming to the federal audit regime. AZ Senate Bill 1288 (May 11, 2016). 2. MTC Working Group. The MTC has prepared a draft Model Uniform Statute and Regulation for Reporting Adjustments to Federal Taxable Income and Federal Partnership Audit Adjustments with the purpose of providing uniformity to taxpayers across states. The draft was last updated on December 20, 2017. It can be found at: http://www.mtc.gov/getattachment/uniformity/project- Teams/Partnership-Informational-Project/Proposed-Model-RAR- Statute-Interested-Parties-Version-of-MTC-Draft-12-20- 17.pdf.aspx?lang=en-US ny-1310682 32