One of the main challenges for practitioners in the multistate tax arena is the lack of guidance on important compliance issues. This is especially so for issues involving pass-through entities. Questions include:
Below is a primer on each of these gray areas.
Legal Ruling 2014-01 (July 22, 2014) from the California Franchise Tax Board establishes that every member of multi-member LLC (treated as a partnership) doing business in California is also deemed to be doing business in California. In Swart Enterprises, Inc. v. California Franch. Tax Bd., No. 13CECG02171, 2014 BL 369879 (Cal. Super. Ct. Nov. 14, 2014), a California court carved out an exception for an out-of-state corporate investor in a manager-managed LLC because the investor was not personally liable for the LLC's obligations, played no role in management and could not act as agent for the LLC or bind it in any way.
Two questions for all states are whether ownership of a pass-through entity interest creates nexus for the owner and does nexus depend on the owner's involvement in management or protection from liability.
Business or Nonbusiness Income
California, Illinois, Arizona and Pennsylvania are among the states that have addressed the issue of whether income is classified as business or nonbusiness income at the entity level or owner level. California (Cal. Code Regs. tit. 18, § 25137-1(a)) and Illinois (Ill. Admin. Code tit. 86, § 100.3500(b)(1)) require that determination to be made at the entity level, but Arizona (Ariz. Rev. Stat. § 43-1412) and Pennsylvania (61 Pa. Code § 153.29(c)) require owners to classify the income.
States like California and Illinois generally attribute nonbusiness income to the state considered to be the source of the income, usually where the owner of a pass-through entity is domiciled, unless the owner has attained a business situs in the state. In states that classify income at the owner level, a corporate investment in a pass-through entity may be treated as an intangible asset and income derived from the entity is separately allocated.
But in many states it’s unclear how the business/nonbusiness income determination is made. A corollary question is whether states consider income derived from a pass-through entity to be business income unless proven otherwise.
Under the aggregate or flow-through approach to apportionment, pass-through entity income is aggregated with a corporate owner's business income. The total business income is then apportioned using a formula that combines the owner's distributive share of the entity's factors with the corporate owner's factors.
The entity approach treats a pass-through entity as separate from its owners. A corporate owner with business activities in the same state as the pass-through entity computes its own state-apportioned income and adds the result to its distributive share of the entity's income determined separately.
A question for state revenue departments is what approach does it take in apportioning the business income of a pass-through entity, and whether flow-through apportionment applies only if the entity and a corporate owner are engaged in a unitary business.
The majority of states impose withholding at the source on pass-through entities and nonresident owners. These rules are subject to numerous exceptions and exemptions and frequently changing. Illinois, for example, began requiring, in taxable years ending on or after Dec. 31, 2014, tax withholding on nonbusiness income allocated to Illinois in addition to withholding on business income apportioned to the state (35 ILCS 5/709.5(a)).
Among the basic compliance questions that arise are whether pass-through entity withholding is mandatory, whether the requirement applies to all types of owners (individual, corporate or other entities), how the withholding applies to tiered structures, and what exceptions apply.
Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: What questions would you pose to state tax departments about the taxation of pass-through entities and their owners?
Sign up for a free trial of the Bloomberg BNA Premier State Tax Library, a comprehensive research service that delivers deep, unique analysis, and time-saving practice tools to help practitioners make well-informed decisions.
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to firstname.lastname@example.org.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to email@example.com.
Put me on standing order
Notify me when new releases are available (no standing order will be created)