Recent Developments In State Taxation Of Pass-Through Entities

By Bruce P. Ely and William T. Thistle, II*,

State and local taxation of pass-through entities1continues to present complex issues for the owners of those entities, especially when the pass-through entities are conducting business in multiple states. Compared with resident owners over which a state has jurisdiction because of their physical presence in the state, non resident owners of pass through entities are presented with more difficult issues. As a way to collect additional revenue and potentially avoid difficult constitutional questions involving how to tax non residents, many states have enacted entity-level taxes or withholding or composite return requirements.

Applying these entity-level taxes and withholding/composite return requirements, however, presents states with a variety of issues. States may look to federal income tax law when imposing net-income based taxes on pass-through entities. However, for multiple reasons, applying federal rules at the state and local level often presents more questions than it answers. First, the federal rules do not address jurisdictional issues in a domestic context. Second, domestic entities must only comply with one federal taxing regime, while multistate pass-through entities must comply with the taxing systems of each state in which they have nexus.

In addition, owners of multistate pass-through entities must answer the often troublesome questions of where they must file returns and what income must be included on the return for each state in which they are required to file. Jurisdictional questions, apportionment issues, and reporting requirements for owners of pass-through entities residing in a state other than where the entity does business are just a few of the areas in which there have been numerous recent developments. Many states continue to assert that an ownership interest in a pass-through entity alone is sufficient to give the state jurisdiction over the nonresident owners doing business in that state. States taking this position may often ignore or fail to give adequate weight to federal constitutional issues that arise when taxing nonresident owners.

What follows is a summary of some of the major developments occurring within the past 18 months surrounding these issues:

Nexus Issues for Pass-Through Entities and Their Owners

Jurisdictional issues continue to arise from an ownership interest in a pass-through entity by a nonresident individual. The question of whether a partnership interest, especially a limited partnership interest, is sufficient to create nexus for a nonresident individual or non-domiciliary corporation has been argued and discussed for many years. A recent Louisiana Court of Appeal decision highlighted the length a state department of revenue will go to assert that an owner of a limited partnership interest had nexus with the state, even absent any contacts with the state other than an ownership interest. As discussed more fully below, the Louisiana Court of Appeal upheld the taxpayer's challenge that its contacts with the state were insufficient to establish nexus under the Due Process Clause of the U.S. Constitution.

In addition to Louisiana, other states are continuing to push the edges of what constitutes nexus as a way to generate additional revenue from out-of-state businesses. In addition to aggressively asserting nexus on audit, some states are enacting questionable statutory and regulatory provisions laying out what kind of presence is required to establish income tax nexus. These new nexus tests presumably rest on the premise that Quill Corp. v. North Dakota2 only applies to sales and use taxes, not other types of taxes. California, Connecticut, and Michigan are the most recent states to jump onto the factor-presence nexus bandwagon. While physical presence in a state is generally sufficient to create nexus, a state arguably should not be able to assert that a business is subject to a state s taxing jurisdiction solely based on the fact that the business makes sales into the state.

The jurisdictional issues pass-through entities and their owners face are not confined to the area of federal constitutional nexus. Questions still arise regarding the applicability of Public Law 86-272 to pass-through entities. For example, Michigan s new factor-presence nexus test might very well conflict with Public Law 86-272. Discussed below are several recent state developments addressing various aspects of the jurisdictional issues faced by pass-through entities and their nonresident owners.

California

Effective for taxable years beginning on or after January 1, 2011, California adopted a new doing business standard that affects out-of-state corporations and pass-through entities and their owners that have property, payroll, or sales sourced to the state.3 Beginning in 2011, a taxpayer is considered to be doing business in California if it meets any of the following thresholds: (1) the taxpayer is organized or commercially domiciled in California; (2) the taxpayer has sales in California in excess of the lesser of $500,000 or 25% of its total sales; (3) the taxpayer s real and tangible personal property in California exceed the lesser of $50,000 or 25% of the taxpayer's total real and tangible personal property; (4) the amount paid in California by the taxpayer for compensation, exceeds the lesser of $50,000 or 25% of the total compensation paid by the taxpayer; (5) for the conditions above, the sales, property, and payroll of the taxpayer include the taxpayer's pro rata or distributive share of the pass-through entity s (partnerships, S corporations, LLCs treated as partnership) factors.

In January 2011, the California Franchise Tax Board (the FTB ) issued guidance asserting that the activities of a disregarded entity doing business in California will be attributed to the owner of the entity for state income/franchise tax purposes.4 Thus, the in-state activities of a SMLLC or Q-Sub that elects to be treated as a disregarded entity for federal and state income tax purposes will be treated as the activities of a branch or division of its corporate owner. Accordingly, if the entity s California activities are sufficient to create nexus with the state, then its corporate owner will automatically be deemed to be doing business in California.

In a news release issued in March 2011, the FTB admitted that California s expanded definition of doing business may create new franchise tax filers.5 The release indicated that the expanded definition may cause corporate limited partners previously subject to the corporate income tax to now be subject to the corporate franchise tax, including the minimum tax.

Connecticut

The Connecticut Department of Revenue issued guidance regarding economic nexus legislation for purposes of its corporation business tax and personal income tax.6 The legislation,7 enacted on September 5, 2010, became effective for all tax years beginning on or after January 1, 2011. The new legislation provides that any corporation or pass-through entity that derives income from Connecticut or has substantial economic presence within the state will be subject to tax in Connecticut. Economic presence is defined as the purposeful direction of business activities toward Connecticut and will be evaluated based on the frequency, quantity, and systematic nature of the business s economic contacts with the state. The guidance also sets forth a new bright-line test for economic nexus, stating that any corporation or pass-through entity not otherwise subject to income taxation or a filing requirement is subject to taxation in Connecticut if the entity has yearly receipts of $500,000 or more attributable to sources within the state. However, Public Law 86-272 will continue to provide protection against Connecticut income tax for sales of tangible personal property by businesses that have economic nexus with the state.

The new guidance also stated that the ownership and use of intangible property within Connecticut would subject an entity to tax on income when: (1) the intangible property generated gross receipts within the state, including through a franchise or license; (2) the activity through which the corporation obtained the gross receipts from the intangible property was purposeful; and (3) the corporation s presence within the state satisfied the bright-line test. The Department clarified, however, that income arising from passive investment activities within Connecticut will not be considered a basis for a finding of economic nexus.

Louisiana

In an important decision for limited partners, the Louisiana Court of Appeal unanimously held that the mere ownership of a limited partnership interest in a limited partnership that conducted business within the state was not sufficient to subject a nonresident corporate limited partner to the Louisiana corporate franchise tax.8 Petitioners, UTELCOM, Inc. and UCOM, Inc., were foreign corporations maintaining their commercial domicile exclusively outside of Louisiana. Neither corporation was registered or qualified to do business in Louisiana during the relevant periods and neither engaged in any business activities or had any physical or other presence in the state. The court also found that the petitioners did not: (1) render any services to or for any affiliate company, or to or for any other party in Louisiana; (2) have any employees, independent contractors, agents, or other representatives in Louisiana; (3) buy, sell, or procure services or property in Louisiana; or (4) maintain a bank account in Louisiana.

The court held that these contacts were insufficient to subject the petitioners to Louisiana s franchise tax. The court also held that the Louisiana Department of Revenue s regulation ignored the clear wording of the [franchise tax] statutes and the interpretation of the Supreme Court and seeks to expand the scope of the specific incidents of taxation at issue. The Court...