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State Taxation of Corporate Partners in Multistate Partnerships Mastering Complexities of Business vs. Nonbusiness Income Characterization, Aggregate vs. Entity Determination, and More

THURSDAY, NOVEMBER 19, 2015, 1:00-2:50 pm Eastern

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FOR LIVE EVENT ONLY

November 19, 2015

State Taxation of Corporate Partners in Multistate Partnerships

Ned Leiby

Ryan

ned.leiby@ryan.com

Breen M. Schiller

Horwood Marcus & Berk

bschiller@hmblaw.com

Jennifer A. Zimmerman

Horwood Marcus & Berk

jzimmerman@hmblaw.com

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

Jennifer A. Zimmerman Breen M. Schiller

Horwood Marcus & Berk Chartered

STATE TAXATION OF PASS-THROUGH ENTITIES

Key Issues and Current Developments

6 6

• Partnerships

– General Partnerships

– Limited Partnerships

– Joint Ventures

– Alliances

– Private Equity Funds

– Hedge Funds

• Multi-member LLCs taxed as partnerships

• SMLLCs (“disregarded entities”)

• S corporations

• Specialized Entities: RICs, REITs, REMICs, Cooperatives and

Some Trusts

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

How We Define “Pass-Through Entities”

7 7

• The last 20 years reflect a substantial increase in the

use of PTEs

• The increase was driven by federal tax law and state

entity laws

• Corporate income tax was declining at the same time

government revenue needs were increasing

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

avoidance of double taxation, maximization of losses

and incentives and allowance for flexibility

Brief History of PTEs

8

State-Federal Conformity Issues

9 9

The issue of federal-state conformity actually raises two

separate questions:

#1 - Characterization: Does the state’s tax law follow the

federal characterization of the PTE under the “check-

the-box” rules?

#2 - Pass-through Treatment: Does the state’s tax law

follow the federal tax treatment of income of

“partnerships” and “disregarded entities”?

State Conformity Overview

10 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)

11 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

12 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

13 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

NPH

LLC

70%

Corporate

Partner

Multistate Business

Domiciled in UDITPA

State

$ Distributive Share =

Non-business Income

100% in NH

PTE

Partner

14

Nexus Issues Affecting Partners

15 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?

16 16

Constitutional Framework • Due Process Clause

– Two requirements: (1) Taxpayer must have sufficient “minimum

contacts” with the taxing state and (2) income must have a

“rational relationship” to intrastate values of the enterprise

– Concern is the “fundamental fairness of government activity”

(Quill Corp. (1992))

– A state may not subject to tax a nonresident on its ownership of

stock in a domestic corporation under the DPC (Shaffer v.

Heitner (1977))

• Commerce Clause

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

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

• “Unitary” Principles

– The “lynchpin of apportionability … is the unitary-business

principle” (Mobil Oil (1980))

17 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?

18 18

How Have the Cases Come Out?

Borden

(IL 2000):

NRLP

taxable

because LP

interest is

sufficient

“minimum

connection”

Non-Resident Limited Partners (NRLP”) TAX

NO

TAX

Village SM

(NJ 2013):

NRLP

taxable

because LP

had in-state

presence /

connection

UTELCOM

(LA 2011):

NRLP not

taxable –

under state

statute

BIS (NJ 2011) / Dutton (VA 2007):

NRLP with no connections not

taxable – under Constitution

Lanzi

(AL 2006):

NRLP not

taxable -

under

Constitution

(akin to

stock)

19 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. 422.37(2). Does an out-

of-state partner qualify as a “nexus” member solely on the basis of

the activities of in-state PTE?

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

Corp B

(no nexus)

PTE

(nexus)

Corp D

(no nexus)

Corp C

(nexus)

Corp A

(nexus)

20 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?

21 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)

State A

Partner

(State A)

PTE

(State B)

State B

22 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?

23 23

Ancillary Nexus Issue #3– PL 86-272

• Key Issue:

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

an entity whose activities within the state are limited to solicitation of

sales of TPP and ancillary activities. Should the activities of an in-state

PTE that exceed PL 86-272 subject the out-of-state partner to tax?

• Considerations:

– Similar considerations as throw-back – who is the taxpayer?

– MA: if a foreign corporate partner is unitary with its in-state partnership,

the activities of the partners are deemed to be the activities of the

partner for determining whether the income if the partner is precluded

under 86-272 (830 CMR 63.39.1(8)(a))

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

86-272 apply to the corporate partner as the taxpayer under the

corporate income tax?

24 24

Ancillary Nexus Issue #3– PL 86-272

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

• Holding: AZ may include Ponderay’s sales in the Partners’ sales factor

numerator because the taxpayer is the Parent and its activities exceeded

86-272. 86-272 does not make certain income tax-exempt – it prevents a

state from exercising taxing jurisdiction over a corporate partner.

Partners

Ponderay

• Partners = no AZ nexus; Parent has AZ nexus

• Ponderay = AZ nexus but protected by 86-272

• Parent elected to file as part of consolidated

AZ return, including Partners

• Agreement that Ponderay distributive share

was business income included in AZ return

• Issue: whether Ponderay’s sales are

excluded from the consolidated return sales

factor numerator on the basis of 86-272?

13.5%

Parent

25

Division of the Tax Base -

Apportionment

26 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:

1. Partner Level (Unitary) Method

2. Partnership Level (Non-Unitary) Method

3. Business/Nonbusiness Income Classifications

4. Methods for Special Issues

Central Tax Base Issue

27 27

• The share of partnership income and factors is

combined with the partner’s income and factors in

determining the corporate partner’s state taxable income

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

determination prior to “flow-up”

– IL: 86 Ill. Admin. Code 100.3380(d) – flow-up if unitary

– CA: Cal. Code Regs. Tit. 18, s. 25137-1 – flow-up if unitary

– MA: 830 CMR 63.38.1 - flow-up if engaged in “related business

activities”

• Consider the impact on tax base and apportionment!

#1 – Partner (Unitary) Level Method (“Flow-Up” / “Aggregate” / Combined” / “Unitary”)

28 28

Partner Level (Unitary) Example

Corporation A’s State Tax Return:

1. Business income / unitary (GP + 80% capital)

2. Tax Base ($600,000) is included in Corp A’s

pre-apportioned state tax base

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

combined with its own factors in apportioning

Corp A’s entire income to state

Corporation A

• General partner – active management

• 60% Profits Interest / 80% Capital Interest

• Distributive Share: $600,000

• Same line of business as PTE (retail)

• Retail

PTE

A

29 29

• The partner’s share of partnership income is

apportioned by the partnership’s factors separate from

the partner’s other income and factors.

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

– IITA Sec. 305(a) and (b))

– MA: 830 CMR 63.38.1(4)(d): separate accounting applies if

corporate limited partner owns less than 50% of capital or profits

interest (directly or indirect) of partnership under presumption

that activities of the partnership are “unrelated” (rebuttable by

Commissioner)

#2 – Partnership Level (Non-Unitary) Method (“Separate Accounting” / “Allocation”/ “Non-Unitary”)

30 30

• The partners then allocate this post-apportioned share

of state-sourced income separately

– The allocation rules may differ!

• Compare the impact on tax base and apportionment

with the Partner Level Method! – Whether the result is favorable depends on the facts…

– Under Partnership Level Method, if PTE is in an income position and

has high in-state factors = potential for substantial tax liability to the

partner.

– Under Partner Level Method, high income position and factors from

PTE may be offset against partner losses and/or apportionment dilution

#2 – Partnership Level (Non-Unitary) Method (“Separate Accounting” / “Allocation”/ “Non-Unitary”)

31 31

Partnership Level (Non-Unitary) Example

• Net Income: $1,000,000

• Business: Retail

• Apportionment = 75%

Corporation A

• Limited Partner (no active management)

• 40% Profits Interest / 40% Capital Interest

• Distributive Share: $400,000

• Business line different from PTE

Corporation A’s State Tax Return:

1. Business Income (partner level determination)

2. Non-Unitary (LP/no control + 40% capital)

3. Corp A’s State Tax Liability from PTE = $300,000

$400,000 distributive share

x 75% partnership factors

4. $300,000 is added to A’s other post-apportioned

income

A

PTE

32 32

• Key Issue:

– In some states, if a “business/nonbusiness income” regime

exists, and the distributive share is determined to be

nonbusiness income, such income is allocated to the

appropriate state, instead of apportioned (e.g., to the state of

domicile or other sourcing rules applicable to nonbusiness

income).

• Considerations:

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

example, if dividend income is allocable to domicile, do you look

to the partner’s or the partnership’s commercial domicile?

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

business income?

#3 – Business / Nonbusiness Issues

33 33

• At what level is the business income determination

made- partner or partnership level:

– Most states have no guidance.

– Exceptions:

• Partnership Level: AL, CA, IL

• Partner Level: AZ, PA

• If non-business income, the question is to which

state is the income sourced?

#3 – Business / Nonbusiness Issues

34 34

Business / Nonbusiness Example

• Net Income: $1,000,000

• Dividends: $500,000

• Retail: $500,000

Corporation A

• Limited Partner

• 40% Profits Interest / 40% Capital Interest

• Distributive Share: $400,000

• Business: Investment

Corporation A’s State Tax Return:

1. Assume retail is business income/apportionable

2. Assume dividends are nonbusiness income

allocable outside of state

4. Non-Unitary (LP/no control, 40% capital)

5. $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!

A

PTE

35 35

(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

#4 – Special Issues

36

Business/Non-Business Income

37 37

Business v. Non-Business Income

• Transactional Test

– Income arising from transactions and activity in the

regular course of the taxpayer's trade or business

• Functional Test

– Includes income from tangible and intangible property

if the acquisition, management, and disposition of the

property constitute integral parts of the taxpayer's

regular trade or business operations

38 38

Transactional Test

• Identify transactions and activity occurring in the

regular trade or business

– Generally, all transactions that are dependent upon or

contribute to the operations

• Three standard tests:

– Frequency and regularity of transactions

– Former business practices

– Subsequent use of proceeds (reinvestment or

distribution)

39 39

Functional Test

• Identify whether the transaction is an integral

part of the taxpayer’s trade or business

– Focus on whether property was used in trade or

business

– Frequency is generally irrelevant

– In the case of a disposition of assets, state may look

at whether the disposition itself is an integral part of

the business operations (e.g., IA, AL, TN, NC, IL, PA)

40 40

41 41

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

42 42

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

43 43

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

44

Compliance Headaches/

Withholding Requirements

45 45

• Key Issues:

– The obligation of nonresident partners to file returns

and pay taxes in every state where a partnership

does business creates an administrative nightmare

for both state tax authorities, PTE management and

partners

– Must a nonresident partner file returns in every state

where a PTE does business?

– What method is required/optional – nonresident filing,

withholding regime or composite filing?

Compliance / Administrative Issues

46 46

• 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

47 47

• Some states have threshold based on income or tax

– May be applied to the entity or to a specific owner

– Ex. MI- Requires PTEs with Michigan-sourced business income

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

or corporations

– Other states thresholds very low

• Some rates impose rate differentials that become

complex with tiered structures

– Lower tier may have to look to upper tier

– Ex. MI- requires withholding for both PTE and corporate owners

at the full 6% corporate. If the PTE knows the ultimate owner of

the upper-tier PTE is a non-resident individual, it may instead

withhold at the individual rate, currently 4.25%.

Withholding Challenges

48 48

• In some states, withholding may not be compulsory

– May depend on type of owner, i.e. trust, corproration

– May depend on type of PTE

– May exempt certain type of entities

• Sometimes voluntary at option of PTE and/or owners

• Also it may make sense to withhold

– May eliminate need to disclose taxpayer sensitive information. .

Withholding Challenges

49 49

• 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

50 50

• Under-report which results in penalties

– Based on difference in tax rates between PTE and owner

• Tiered Entities- special risks

– Withholding may be required by all levels and then there are

duplicative payments

• In this situation may want to elect out.

– Run higher risk of under-reporting

– Attributable to differences in apportionment methodologies

between the business and the owner

Withholding Risks

51 51

• Timing issues with estimated tax payments

– Often quarterly payments but seasonal business.

• Under-report which results in penalties

– Based on difference in tax rates between PTE and owner

• Tiered Entities- special risks

– Withholding may be required by all levels and then there are

duplicative payments

• In this situation may want to elect out.

– Run higher risk of under-reporting

– Attributable to differences in apportionment methodologies

between the business and the owner

Withholding Risks

52 52

• Conflict between state reporting requirements and legal

requirements for the PTE

– Ex. S corporations

– Distributions made to owners must be made on a basis

proportionate to ownership, otherwise the S-corporation runs the

risk of inadvertent termination of its S-election under 2

scenarios:

• Owners are residents of multiple states and participation in

withholding is limited to non-residents.. Disproportionate

distributions can result in termination of the S-corporation

election.

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

different withholding regime.

Withholding Risks

53 53

• Typical Conditions:

– Requirement of an election/consent to participate is common

(some require consent to be submitted, some require it to be

executed and available but not filed, some require an annual

filing)

– Limitation of composite returns to individual partners (no

corporate or PTE partners but some allow trust members to

participate)

– Preclusion of composite returns if the partner has in-state

income from other sources

– Agreement that PTE is authorized to resolve any audit/pay

deficiency

Composite Regimes

54 54

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

55 55

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?

56

Take-Aways

57 57

• 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)

SALT Department Tools

58

QUESTIONS?

THANK YOU!

Breen M. Schiller T: (312) 606-3220

bschiller@saltlawyers.com

Horwood Marcus & Berk Chartered 500 W. Madison Street, Suite 3700

Chicago, IL 60661 www.saltlawyers.com

Jennifer A. Zimmerman T: (312) 606-3247

jzimmerman@saltlawyers.com

STATE TAXATION OF CORPORATE PARTNERS IN MULTISTATE PARTNERSHIPS

AGGREGATE VS. ENTITY ISSUES

Ned Leiby

ned.leiby@ryan.com

• Compliance & Planning Considerations

60

Entity vs. Aggregate

Nexus Business/Nonbusiness

Determination Unitary vs Non-

unitary Apportionment

61

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

P&L % may be

different than

capital %

PARTNER K-1

Non-unitary Partnership Income Reporting

62

IL-1120:

Non-unitary

Partnership

Business

Income

Flow-Through Entities – Nexus to Corporate Partners

• (Qualified) Investment Partnership Exceptions

― Qualified Investment Securities- defined by state

• Corporate partners must combine share NY receipts from partnership with their own

NY receipts to determine if they meet $1 million gross receipts nexus threshold.

New law effective 1/1/15- Aggregation requirement.

• Corporate Partner - California

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

general partner

• 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.

63

Entity vs. Aggregate

Business/ Nonbusiness Determination

• For corporate partners is the business/nonbusiness income determination

made at the partnership level or partner level?

― Majority of states have not addressed

• Arizona & Illinois

― Requires partner level determination

― Arizona Corporation Tax Ruling No 94-2 (4/4/1994)

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

• Alabama

― Requires partnership level determination. Alabama Supreme Court ruled

gain from the sale of partnership assets was not business income to the

corporate partners because such sales were not in the regular course of

the partnership’s trade or business.

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Gross Revenue = Partner’s

% of Lines 1,4-7. Net

amounts may require further

digging for gross revenue.

Note potential tiered flow-

through issue for line 4

Line 6 – Gross or Net?

Line 7 can be many different

items (+ & -)

1065 – PAGE 1

66

Make special note of items of

foreign income flowing through

as this may impact

apportionment.

SCHEDULE K

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

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• 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.

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Entity vs. Aggregate Calculation of Apportionment Factor

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, § 100.3380(d). However, this rule does not apply:

― 1. to shares of income from partnerships whose business activity outside the United States is 80

percent 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, § 100.3380(c).

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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.

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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, § 63.38.1)

• 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

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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 §710:50-17- 51(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.

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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.

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Golden Partnership

Orange Corp. (GP)

30%

Example: Flow-Through Apportionment

Orange Corp. Sales % Sales State Income (Loss)

State A $5,000,000 100% $2,000,000

State B $0 0% $0

State C $0 0% $0

Total $5,000,000 100% $2,000,000

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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 $20,000,000 100% ($1,000,000)

Example: Flow-Through Apportionment

Orange Corp. Direct Golden Line 28

Federal Taxable Income

$2,000,000 ($300,000) $1,700,000

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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

Example: Flow-Through Apportionment

Aggregation (Flow-up) Sales Sales % Apportioned Income

T.I.= $1,700,000

State A $ 5,000,000 45.45% $ 772,650

State B $ 4,500,000* 40.91% $ 695,470

State C $ 1,500,000** 13.64% $ 231,880

Aggregate Denominator

$11,000,000 100.00% $1,700,000

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* 30% x $15,000,000

** 30% x $ 5,000,000

Lack of uniformity/mismatch –compare

the two approaches.

• If State C is OK?

• If States A & B are IL and CA?

• Unitary/Non-unitary?

Factor Flow-up and Tiered Partnership

Direct Factors from

OP, LLC use 25%

25%

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20%

15%

Effective Rate = 20% + (15% * 25%)

= 20% + 3.75%

= 23.75%

OP, LP

OP, LLC

INC.

Factor Flow-up and Tiered Partnership

Impact of L.P. interest

on effective rate

calculation?

Can a limited

partner be unitary?

78

20%

L.P.

15%

G.P.

OP, LP

OP, LLC

INC. 25%

L.P.

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 2015-5 states that receipts that flow through from the partnership that

are not “taxed” at the entity level (because they are protected by P. L. 86-272) are not

protected at the corporate partner level – Flow through receipts are from an investment,

and not from the sale of tangible property

• What percentages to use for performance fee allocations to G.P.s?

• Any impact of proposed regs. under IRC §707(a)(2)(A) (7/23/15)

• Treats certain partnership distributions as disguised payments for services

• Significant entrepreneurial risk requirement

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Thank You!

Ned Leiby

Ryan, LLC

ned.leiby@ryan.com

www.ryan.com