On April 27, 2021, the Multistate Tax Commission (MTC) Uniformity Committee voted to accept its Standing Subcommittee’s recommendation to create a work group to study several key issues relating to multistate taxation of Internal Revenue Code Subchapter K entities classified for income tax purposes as partnerships and their partners (including multimember LLCs and their members).
The work group held its organizational meeting via conference call on June 15, with the indefatigable Helen Hecht, MTC Uniformity Counsel, chairing the meeting. A new website has been established for this project.
Tax practitioners, taxpayers, and state tax administrators will be watching its work with great interest, as many regard partnership taxation as the most complex area of both federal and state taxation. It is widely believed that eventual MTC action on this topic may have a major impact on taxpayers and states alike.
The Standing Subcommittee began its work with a virtual meeting on Nov. 19, 2020, at which it was presented with a brief memo introducing the most salient issues in pass-through entity (PTE) taxation. At its January 2021 virtual meeting, the Standing Subcommittee reviewed a “Working Draft: State Income Taxation of Partners and Partnerships: MTC Staff Memo—Context and Issue Outline” (the “Working Draft”) which, as of its March 15, 2021, iteration, had grown to a 44-page summary.
The Working Draft provides a helpful analysis of the taxation of partnerships—including state substantive law creating and governing partnerships, federal income tax principles, and multistate tax matters. The authors commend it to your reading.
The Working Draft demonstrates many of the challenges involved in taking on an in-depth study of partnership taxation at the state level. Given the complexity of PTE taxation generally, the Working Draft wisely narrowed the Standing Subcommittee’s conversation only to entities taxed as partnerships. Indeed, Maria Sanders, vice chair of the Uniformity Committee and chair of its Standing Subcommittee, later remarked: “The Standing Subcommittee does believe this is a good project for the Uniformity Committee to take up, but this is also a very large project.” During the June 15 organizational meeting, Hecht went further, remarking that there are many complex parts and this is one of the largest projects the MTC has ever attempted.
Some of our longtime readers may recall that the MTC attempted to tackle some of these issues—particularly whether certain PTEs should be subject to an entity-level tax—over a decade ago. However, in May 2013, the MTC Executive Committee voted to discontinue the project and simply issue a project report summarizing the issues and setting forth the history of the project, which MTC Uniformity Counsel Helen Hecht generously furnished to the authors.
There are more issues to address now than when the MTC last ventured into the partnership tax arena. Recent changes in federal tax law and their impact on the states have certainly put PTE tax issues in the limelight. For example, the Bipartisan Budget Act of 2015 established the Centralized Partnership Audit Regime (CPAR), which the MTC recently addressed through its partnership audit/revenue agent report (RAR) project. There are clear indications the IRS has begun these entity-level partnership audits in earnest, and larger PTEs may expect to see audit notices in the not too distant future.
In addition, more than a dozen states (most recently Colorado) so far have responded to the cap on state and local tax deductions in the Tax Cuts and Jobs Act of 2017, Public Law 115-97, by enacting elective (except for Connecticut) entity-level taxes on partnerships and certain other PTEs.
Many tax practitioners also believe the U.S. Supreme Court’s decision in Wayfair, eliminating the physical presence requirement for substantial nexus under the Commerce Clause in the sales and use tax context, has emboldened states to assert nexus over out-of-state taxpayers—including PTEs and their partners—under a variety of other taxes, especially income taxes.
Demographics are also playing a large part in the rising profile of PTE taxation, as retiring baby boomers sell or otherwise transfer their interests in PTEs and generate substantial income events as they transition their businesses, whether to the next generation or to cash-rich investment funds.
These trends have brought PTE taxation before the U.S. Supreme Court in two recent cases: Arizona v. California and Noell Industries Inc. v. Idaho State Tax Commission. Unfortunately, the complaint or cert. petition was denied in both. There have also been several recent high-profile PTE tax decisions by state courts, such as the Noell decision by the Idaho Supreme Court, as well as YAM Special Holdings, Inc. v. Comm’r of Revenue by the Minnesota Supreme Court and Vectren Infrastructure Services Corp. v. Dep’t of Treasury by the Michigan Court of Appeals (vacated on appeal to the Michigan Supreme Court and remanded).
There are concerns from some quarters that in addition to attempting to resolve some of the technical or politically thorny issues courts have eschewed, the MTC may attempt to legislate the outcome of future disputes to be more favorable to state taxing authorities.
The March Recommendation
The Standing Subcommittee’s recommendation, officially submitted to the Uniformity Committee and dated March 18, 2021, represents the culmination of the Subcommittee’s thinking on why the MTC should take up a multi-pronged project on state partnership taxation. The March recommendation concluded that a partnership study project satisfied the formal criteria employed by the Uniformity Committee to evaluate new projects:
- the MTC has sufficient expertise to address the issues;
- the work would build on the MTC’s successful Partnership/RAR project dealing with state adjustments in connection with the federal CPAR; and
- partnership taxation is growing in importance, as evidenced by the increasing share of business income reported by entities classified as partnerships under Subchapter K.
The March recommendation defines the scope of the project by reference to the key issues identified in the Working Draft, which the Uniformity Committee relied on, along with the recommendation to establish the work group to deliberate and present its findings to the Uniformity Committee. The March recommendation further outlines four major issues to address, the first three of which were the focus of the work group’s June 15 organizational meeting:
- partnership operating income, generally (pass-through treatment);
- sale of a partnership interest;
- administrative and other issues; and
- partnership-level taxes, as well as 10 sub-issues. The authors will focus on three of the four major issues here.
Partnership Operating Income
The Working Draft concludes there is a consensus among the states (though not explicit law) around the notion that states have jurisdiction to impose reporting requirements on a partnership based solely on a direct or indirect resident partner in the state. It also opines that a majority of states agree there is nexus to tax a nonresident/nondomiciliary direct partner on the partner’s share of partnership income derived from the state, even if the partner’s only connection to that state is its ownership of and deriving income from the partnership interest, and the partner is neither a general partner nor actively engaged in the partnership’s business.
The Working Draft acknowledges the traditional distinction between limited and general partners, but perhaps treats that distinction as a proxy for active vs. passive involvement in the business. The Working Draft also points out the disagreement over whether a state has nexus to tax an indirect partner on that partner’s share of income from a partnership doing business in the state; though again, the consensus among the states seems to be that they indeed have this power.
The issues of nexus to tax nonresident partners are distinct from the issues surrounding apportionment of a partnership’s income, or of a nonresident partner’s income from the partnership. Complex partnership structures make proper classification as business income or nonbusiness income difficult and the Working Draft recognizes at least four ways states classify business or nonbusiness income in tiered structures. The Working Draft suggests the majority of states retain the character of income as business or nonbusiness income in tiered partnership structures as that income passes through to a partner.
However, it adds that this rule more commonly applies when the income is first classified as nonbusiness income—in which case it seemingly always remains nonbusiness income. Income that begins as business income in the hands of a lower-tier partnership, it appears, can often become nonbusiness income in the hands of an upper-tier partner. The Working Draft also asserts that the majority rule among states that have addressed the question is to combine apportionment factors, causing them to “roll up” to higher-tier partners. However, it conceded application of this rule in tiered structures remains unclear.
Issues Related to Sale of a Partnership Interest
One of the driving forces behind the MTC’s new effort appears to be the disparity in judicial rulings over whether the gain on the sale of a nondomiciliary partner’s interest in a partnership doing business in the taxing state should be apportionable to that state if the seller has no other connection to that state. Although not cited, a recent illustration of that disparity is the difference not only in outcome but the analysis utilized by the Idaho Supreme Court in Noell Industries, Inc. [correctly decided, we believe], as contrasted to that of the New York City Tax Appeals Tribunal in Goldman Sachs Petershill Fund Offshore Holdings (Delaware) Corp. [incorrectly decided, we believe]. In the former, the unitary business principle was applied by the court, while in the latter the parties’ stipulation that the partner and partnership were not unitary was essentially disregarded by the tribunal and a different, non-constitutional test was applied.
The work group likely will attempt to handle this issue in the spirit of uniformity, while the authors predict there may be some push-back from the tax practitioner community if a model statute attempts to circumscribe the Due Process Clause and Commerce Clause and place definitional limits on the unitary business principle in this context.
Partnership-Level Taxes Paid in Lieu of Taxes on Partners
Although the new genre of state PTE taxes is stated as one of the driving forces behind the MTC’s renewed efforts, ironically it was listed last among the four major issues to be addressed by the work group and was not given much time during the organizational meeting. Achieving some level of uniformity among the states that have enacted or are contemplating one version or another of these PTE taxes is a laudable goal on its own. It can truly be said of these new taxes so far that “no two snowflakes are alike.”
In addition to these and a handful of other top-level issues, the work group will also need to address important sub-issues including: state adjustments/federal conformity; taxation of so-called investment partnerships; and transfer pricing among related parties. Although relegated to a back seat in the Working Draft, one of the most oft-mentioned goals of tax practitioners for this project is to address the state tax credit—or lack thereof—for other states’ net income taxes paid, or OSTC, particularly in the context of entity-level taxes imposed on multistate PTEs.
The March recommendation implies that the final product of the project will be model legislation or a summary of existing state laws representing best practices and there was no suggestion of a different direction expressed during the June 15 organizational meeting. As it relates to existing law in states without fully-developed partnership tax rules, the recommendation states: “Some of the changes may or may not require legislation—but given that there appears to be a developing consensus on a number of issues, there [is] no reason to expect concerted political opposition to clarifying those issues.” While MTC member states may find consensus on an issue, taxpayers and their advisers may have a very different view.
Congress enacted Subchapter K to provide maximum flexibility in reflecting the economic substance of agreements among partners. Each partnership structure represents a unique economic arrangement unto itself, and the CPAR is an acknowledgement of the challenges the IRS faces in administering an income tax structure designed to allow such custom-tailoring. The overlay of state constitutional limitations on taxation and federal-state nonconformity adds complexity. However desirable, uniformity in some areas may be unachievable. Perhaps with the broader expertise now available to the MTC, the states’ and taxpayers’ recent turnaround regarding the popularity of PTE taxes, and the input of motivated volunteers from the public, the outcome will be different—and mutually beneficial—this time around.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Kelvin Lawrence is a partner in the Columbus office of Dinsmore & Shohl LLP who helps clients solve Ohio, multistate, and federal tax and unclaimed property problems.
Bruce P. Ely is a partner with the mulitstate law firm of Bradley Arant Boult Cummings LLP in Birmingham, Ala., and founder of its SALT practice group.
Both authors are members of Bloomberg Tax’s State Tax Advisory Board.
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