(Co-author: Kelvin Lawrence)
On April 27, 2021, the Multistate Tax Commission's (MTC) Unity Committee voted to adopt its Standing Subcommittee's recommendation to form a working group to address several key issues related to corporate taxation of the Internal Revenue Code, Subchapter K, for income tax purposes Classified as partnerships, investigate their partners (including multi-member LLCs and their members).
The working group held its organizational meeting on June 15 via conference call, with the tireless Helen Hecht, MTC Uniformity Counsel, chairing the meeting. A new website has been set up for this project.
Tax professionals, taxpayers, and government tax administrations will watch his work with great interest because partnership taxation is, for many, the most complex area of both federal and state taxes. It is widely believed that any MTC action on this issue could have a major impact on taxpayers and states.
The Standing Subcommittee began its work with a virtual meeting on November 19, 2020, during which it was presented with a short memo presenting the main issues related to the taxation of transit companies (PTE). At its virtual meeting in January 2021, the Standing Subcommittee examined a “Working Draft: State Income Taxation of Partners and Partnerships: MTC Employee Note – Context and Sketch of the Facts” (the “Working Draft”), which as of March 15, 2021 iteration of a 44- page summary has grown.
The working draft provides helpful analysis of partnership taxation – including the substantive law governing partnership formation and regulation, federal income tax principles, and state tax matters. The authors recommend it to your reading.
The working draft highlights many of the challenges of an in-depth study of partnership taxation at the country level. Given the complexity of PTE taxation in general, the Working Draft has wisely limited the Standing Subcommittee's discussion to companies taxed as partnerships. In fact, Maria Sanders, Vice Chair of the Uniformity Committee and Chair of its Standing Subcommittee, later remarked, "The Standing Subcommittee believes this is a good project for the Uniformity Committee, but this is also a very large project." June, Hecht went even further, noting that there are many complex parts and that this is one of the biggest projects the MTC has ever attempted.
Some of our longtime readers may recall that over a decade ago the MTC attempted to address some of these issues – specifically, whether certain PTEs should be subject to company-level tax. However, in May 2013 the MTC Executive Committee decided to discontinue the project and simply issue a project report summarizing the problems and telling the story of the project, which MTC Uniformity Counsel Helen Hecht generously provided to the authors.
There are more problems to be resolved now than when the MTC last entered the partnership tax area. Recent changes to the federal tax law and their impact on states have certainly brought PTE tax issues into the spotlight. For example, the 2015 bipartisan budget law introduced the Centralized Partnership Audit Regime (CPAR), which the MTC recently addressed through its Partner Audit / Revenue Agent Report (RAR) project. There is clear evidence that the IRS has begun these corporate-level partnership reviews in earnest, and larger PTEs can expect review notices in the not too distant future.
Additionally, to date, more than a dozen states (most recently Colorado) 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 modules (excluding Connecticut). Corporate taxes on partnerships and certain other PTEs.
Many tax professionals also believe that the US Supreme Court ruling in Wayfair eliminating physical attendance for a material connection under the trade clause related to sales and use tax has encouraged states to establish a connection with foreign taxpayers – including PTEs and their partners – under a variety of other taxes, particularly income taxes.
Demographics also play a large role in the rise in PTE taxation as retired baby boomers sell or otherwise transfer their stakes in PTEs and generate significant income events when they hand over their business to the next generation or to liquid mutual funds.
These trends have brought PTE taxation to the US 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 high profile PTE tax rulings from state courts, such as the Idaho Supreme Court Noell ruling, as well as YAM Special Holdings, Inc. v. Comm & # 39; r of Revenue of the Minnesota Supreme Court and Vectren Infrastructure Services Corp. v. Dep & # 39; t of Treasury of the Michigan Court of Appeals (vacated and remanded on appeal to the Michigan Supreme Court).
There are concerns from some quarters that the MTC may not only seek to resolve some of the technical or politically sensitive issues that courts have avoided, but may also seek to resolve the outcome of future disputes in order to be more beneficial to the state tax authorities.
The March recommendation
The recommendation of the Standing Subcommittee, formally presented to the Uniformity Committee and dated March 18, 2021, marks the culmination of the subcommittee's deliberations on why the MTC should embark on a multi-pronged project on taxing government partnerships. The March recommendation concluded that a partnership study project met the formal criteria used by the Uniformity Committee to evaluate new projects:
- the MTC has sufficient expertise to address the problems;
- the work would build on the successful MTC Partnership / RAR project dealing with government adjustments related to the federal CPAR; and
- The taxation of partnerships is becoming increasingly important, as shown by the increasing share of corporate income that is reported by companies that are classified as partnerships according to subchapter K.
The March recommendation defines the scope of the project with reference to the key issues identified in the working draft on which the Uniformity Committee relied, along with the recommendation to set up a working group to deliberate and present its results to the Uniformity Committee. The March recommendation also outlines four key issues to be addressed, the first three of which were the focus of the working group's organizational meeting on June 15:
- Partnership operating income, in general (pass-through treatment);
- Sale of a partnership stake;
- administrative and other issues; and
- Taxes at partnership level and 10 subtopics. The authors will focus on three of the four main themes here.
Operating result of the partnership
The working draft concludes that there is a consensus among states (albeit no explicit law) on the view that states are empowered to impose reporting obligations on a partnership based solely on a partner directly or indirectly resident in the state. She also believes that the majority of states agree that there is a link in taxing a non-resident / non-resident direct partner on the partner's share of the state-received partnership income, even if the partner's only link to it State Owning and generating income from the state is in the company's interest, and the partner is neither a general partner nor actively involved in the company's business.
The working draft recognizes the traditional distinction between limited partners and general partners, but treats this distinction as a proxy for active vs. passive participation in the company. The working draft also points to the disagreement as to whether a state has a link to tax an indirect partner on that partner's share of the income from a partnership operating in the state; but here, too, the consensus between states seems to be that they actually have this power.
Questions about the taxation of non-resident partners are different from questions about the division of the income of a partnership or the income of a non-resident partner from the partnership. Complex partnership structures make it difficult to properly classify business or non-business income, and the working draft recognizes at least four ways that states classify business or non-business income into tiered structures. The working draft suggests that the majority of states retain the character of income as business or non-business income in tiered partnership structures when this income is passed on to a partner.
However, she adds that this rule is more common when the income is classified as non-business income first – in which case it always appears to remain non-business income. Income that begins as business income in the hands of a subordinate partnership, apparently, can often become non-business income in the hands of a higher-ranking partner. The working draft also claims that the majority rule among the states that have looked at the issue is to combine allocation factors, which results in them being "rolled up" on higher-ranking partners. However, it acknowledged that the application of this rule in tiered structures remains unclear.
Problems related to the sale of a partnership interest
One of the driving forces behind the new efforts of the MTC appears to be the divergent judicial decision as to whether the profit from the sale of a non-resident partner's stake in a partnership operating in the tax jurisdiction is attributable to that state, if the seller has no other connection to that state . Though not cited, a recent example of this inequality is the difference not only in outcome but also in the analysis used (we believe ruled correctly) in the analysis used by the Idaho Supreme Court at Noell Industries, Inc. New York City Tax Court of Appeal in Goldman Sachs Petershill Fund Offshore Holdings (Delaware) Corp. (wrongly decided in our opinion). In the former, the uniform business principle was applied by the court, while in the latter, the judgment of the parties that the partner and society were not uniform was essentially disregarded by the court and a different, unconstitutional test was used.
The working group will likely try to deal with this issue in a spirit of consistency, while the authors predict that there could be some backing out on the part of tax professionals when a model law tries to rewrite the due process clause and the trade clause Establish definition boundaries in this context according to the uniform business principle.
Partnership-level taxes paid to partners in lieu of taxes
Ironically, although the new genre of state PTE taxes is cited as one of the driving forces behind the MTC's renewed effort, it was listed last among the four main topics to be addressed by the working group and was not given much time during the organizational meeting . Achieving some degree of consistency among states that have adopted or are considering one version or another of these PTE taxes is a laudable goal in itself. So far it can really be said about these new taxes that “no two snowflakes are alike”.
In addition to these and a handful of other top-level issues, the task force also needs to address important subtopics, including: government adjustments / federal compliance; Taxation of so-called investment companies; and transfer pricing between related parties. Though pushed into the background in the Working Draft, one of the most cited goals by tax practitioners for this project is to address the state tax credit – or lack thereof – for net income taxes paid by other states, or specifically the OSTC related to corporate-level taxes that are levied on PTEs from multiple states.
Likely result
The March recommendation implies that the final product of the project will be a model law or a summary of existing state laws that represent best practices, and no suggestion of any other direction was made during the June 15 organizational meeting. Regarding existing law in states without mature tax regulations for partnerships, the recommendation states: “Some of the changes may or may not require law – but as consensus seems to be developing on a number of issues, there is (is) no reason to expect a concerted political opposition to resolve these issues. ”While MTC member states can find consensus on one issue, taxpayers and their advisors may have a very different view.
Congress adopted Sub-Chapter K to allow maximum flexibility in taking into account the commercial content of agreements between the partners. Each partnership structure is a unique economic arrangement in its own right, and the CPAR is a recognition of the challenges the IRS faces in managing an income tax structure that allows for such tailor-made adjustment. The superposition of state constitutional restrictions on taxation and federal and state nonconformities adds complexity. However, uniformity in some areas may be undesirable. Perhaps, with the broader expertise now available to the MTC, the recent U-turn by states and taxpayers on the popularity of PTE taxes and the contribution of motivated public volunteers, the outcome will be different this time – and for both sides beneficial – be.
Republished with permission. This article, "The MTC Undertakes an Ambitious Study of Partnership Taxation" was published in Bloomberg Tax's Daily Tax Report on June 30, 2021.