Corporate Close-Up: States Take Varied Approaches to Taxing Sales of Pass-Through Entity Interests


 

Each year, Bloomberg BNA’s Survey of State Tax Departments queries state tax department officials on the gray areas of state taxation. One of these topics is the tax treatment of nonresidents whose only connection with the state is an ownership interest in a pass-through entity operating there. Although a state supreme court ruled on this issue last year, the 2017 Survey of State Tax Departments showed that states have adopted varied approaches.  

Some states indicated that they would impose income tax on the gain recognized by a nonresident individual’s disposition of a limited ownership interest in a pass-through entity doing business in their jurisdiction, according to the survey. Among these states were Arizona, Missouri and New Jersey. 

The survey responses appear to run counter to the Ohio Supreme Court’s ruling in Corrigan v. Testa, 2016 Ohio 2805 (2016), in which the state’s high court held that Ohio was not allowed to tax a nonresident pass-through entity owner’s gain as if it were income from the business itself. Doing so, the court found, would violate due process requirements because neither the individual nor the sale of the LLC interest had a taxable link to Ohio. Instead, the court applied Ohio’s statute requiring that a capital gain derived from the sale of an intangible asset be allocated to the taxpayer’s domicile. 

“Apparently a number of state tax departments haven’t yet digested the Ohio Supreme Court’s landmark 2016 ruling in Corrigan v. Testa,” said Bruce P. Ely, a tax partner with Bradley Arant Boult Cummings LLP in Birmingham, Ala., and a member of the Bloomberg BNA State Tax Advisory Board. “If the state doesn’t even have a statute to rely on, I think they’re really skating on thin ice.”

Ely noted the “surprising number” of states that responded to the recent Bloomberg BNA survey that they would impose their income tax on a nonresident partner’s gain on the sale of its interest in a partnership doing business in their state under a variety of conditions.

“There are both constitutional and state law challenges to states taxing sales of pass-through entity insterests for nonresidents, except in relatively rare circumstances where nexus has been created independently and the partnership interest has established a ‘business situs’ in the taxing state,” Ely said.

Continue the discussion on BNA’s State Tax Group on LinkedIn: Will Ohio’s Corrigan case influence other states’ tax treatment of pass-through entity owners?

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