State Complexities in K-1 Aggregation

Despite the states’ broad and largely successful assertion of jurisdiction over the investors in alternative investments, partnership investors have had some notable successes in challenging this nexus position through a number of arguments and positions, including the following:

• Narrow interpretations of state laws governing tax jurisdiction. Most states’ tax laws include a “doing business” statute that nominally defines the limits of the states’ taxing jurisdiction.   A number of courts have interpreted this statutory language as a self-imposed limit on the states’ ability to tax non-resident partners, especially limited partners. 7 It should be noted, however, that over the past decade, states have revised their doing business statutes to include more subjective and broad statutory nexus standards, such as “deriving income” or even a standard based on the amount of gross receipts derived from the state.8
• State statutes governing the creation and operation of flow-through entities and the partner’s rights and duties with respect to the flow-through entity. Under the Revised Uniform Partnership Act and the Uniform Limited Liability Company Act, the partnership and LLC, respectively, are considered “entit[ies] distinct from [their]” partners and members, respectively. There are arguments under these and similar statutes that would support a position that an investor should not be subject to taxation in a particular state based on mere ownership of a limited partnership interest. This argument is largely untested at this point, but merits consideration in every case.9
• Arguments based on federal Constitutional limitations to tax. In 2011, a New Jersey appellate court upheld a pro-investor decision by the Tax Court of New Jersey based on   the application of the unitary theory (see below) to the determination of whether a limited partner investor had nexus in the state. 10 The limited partner held a 99% limited partnership interest in an investment that generated $24,688,054 of New Jersey-source income during the years in question. The limited partner and general partner were related and shared corporate officers. The court ruled that the limited partner did not have nexus with New   Jersey based on its ownership interest in the underlying partnership as its operations were   not unitary with the underlying investment. A significant basis for the decision was the limited partnership agreement, the provisions of which limited the limited partner’s ability to manage the investment.
• Investment partnership rules. Nearly half of the states have created safe harbors to protect investment partnerships and non-resident partners from state tax. 11 There is significant diversity among the states in how they have approached this “investment partnership rule” exemption, but a number of larger states, such as California and Illinois, have taken the same general approach. These states define an investment partnership as any partnership that has as assets and derives substantially all of its income from intangible debt or equity securities. If the partnership meets the specific criteria outlined in the respective state statutes, the partners are exempt from state taxation in these states.
• Arguments based on a “securities” analogy. One of the conceptual bases of the investment partnership rule is the fact that if securities are held directly by an individual, income earned from them is taxed only in the individual’s resident state. By asking why these securities    should be taxed in any other state just because they are contributed to a partnership, taxpayers have successfully challenged state attempts to tax such partnerships. 12  In Appeal of Robert M. and Ann T. Bass, No. 87A-1552-CB:DB (California Bd. of Equalization, 1989), [Cal.] ST. Tax Rep. (CCH) ¶401-709, a wealthy couple who resided in Texas established a limited partnership to manage their investment securities and established its office in California. The partnership had four employees in California, including an investment analyst, a bookkeeper, and two secretaries who managed the Bass assets. Citing California statutes, the California Franchise Tax Board (FTB) took the position that all of the income earned by the partnership was California-sourced. The California State Board of Equalization (BOE), rejected the FTB’s position, basing its decision to treat the income from the managed assets as sourced to Texas on federal “trade or business” tax concepts. Examining the substance of the partnership’s trading activities, the BOE concluded that the partnership’s activities did not constitute a trade or business and that California did not have authority to tax the income.
• Arguments based on taxability of the investment itself under federal law. Congress has the power to regulate commerce among the states, and by extension to regulate state taxation of interstate commerce, under the Commerce Clause of the U.S. Constitution. Congress has historically used this authority sparingly. 13 While there are a number of examples of Congress’ exercise of this power, the most generally applicable instance is with respect to the Interstate Income Tax Act of 1959, 14 also known as P.L. 86-272. Under P.L. 86- 272, a taxpayer engaged in the business of selling tangible personal property may be exempt from state tax in those states where (1) its activities are limited to solicitation of sales through employees and sales agents, (2) orders are accepted from outside the state, and (3) goods are shipped from a location outside the state. While the interpretation of elements of this statute are relatively   well settled (such as the scope of solicitation), others, such as the scope of delivery, are not.   As this exemption is heavily audited and frequently challenged by the states, a number of taxpayers in these situations take a “conservative” position with respect to its application and concede to nexus in a particular state. The risk that an underlying alternative investment (e.g., an operating business formed as a flow-through entity) may take a conservative nexus position is heightened in the flow-through entity context. There, it   is the investor who bears  the tax consequence of conceding to nexus while the flow-through entity, its successors, or its responsible executives would likely bear the risk of penalties, interest, and additional tax should the state successfully challenge a position that the flow- through entity’s activities did not create nexus. Therefore, it may be worthwhile for a partner in an operating partnership with a business that would otherwise meet the requirements of P.L. 86-272 to evaluate the reasoning for the investment’s position that it has nexus in a particular state.

Apportionment and allocation in the partnership context

One of the most significant concerns of multistate tax law is how income is divided among the states. A fundamental principle that has its grounding in federal and state constitutional law, as well as in state and local tax statutes and regulations, is the idea that taxable income should be divided into two categories for this purpose. The first and most common category includes operating or business income. The second category, which is commonly referred to as non-business income, is typically defined in the negative as all income other than business income. It commonly includes proceeds from the sale of an asset held strictly for investment and proceeds from the liquidation of the business itself.

Business income is apportioned among the various states that gave rise to the income. Non-   business income is generally allocated to a single state based on a generally agreed-upon set of rules and conventions. For example, non-business income from the sale of an intangible is generally allocated to the state of the partner or partnership’s commercial domicile.  Non-business income from the sale of real estate is generally allocated to the state where the real estate is located. States generally discourage taxpayers from treating any of their income as non-business income. A number of states have either eliminated this concept from their statutes or have effectively eliminated this concept based on administrative practice. However, as this concept is also grounded in the U.S. Constitution, states’ ability to eliminate the concept is limited.

Operating or business income must be apportioned. To apportion income, the taxpayer must calculate a ratio of its activity in the taxing state or locality over all of its activity everywhere, or everywhere in the United States, depending on the state’s or locality’s particular law. State and local tax practitioners spend a significant amount of time scrutinizing the numerators in these formulas as states’ and certain localities’ statutes and regulations in this area are fairly complex and often provide opportunities to overpay or to manage a taxpayer’s multistate liability.

The unitary business principle

The constitutional concept that relates to the business/non-business distinction discussed  above is called the “unitary business principle.” A thorough discussion of the definition of a unitary business is beyond the scope of this article. In broad terms, however, a unitary business is generally defined according to how legal entities or divisions that are commonly owned relate to each other. If the legal entities or divisions are in the same general line of business, managed by the same management group, supported by the same corporate services group (accounting, legal, finance), and engaged in significant intercompany transactions, those entities and divisions would be considered unitary. If one or more of these elements (common ownership, functional, and operational integration) does not exist, the related entities and divisions may not be considered unitary. The presence of some part of a unitary business within a state means that all of that business’s income may be apportioned — but not necessarily allocated — to that state.15

A unitary business may be contained within one legal entity or many. Because the constitutional focus is on the substance of defining the scope of the unitary business, there may be more than one unitary business – for example, in a separate division – within a single legal entity.

The unitary business principle provides a limit to  the states’  ability to  tax  a multistate  enterprise. In general, under the unitary business principle, income that has been determined to derive from a unitary business is generally required to be apportioned among the states. Income that derives from outside the unitary business is generally required to be apportioned along with the “unitary income” (i.e., from a unitary business). The income that is determined not to be unitary is not necessarily allocated to a particular state. The only restriction on the non-unitary income of which the authors   are aware is that it may not be apportioned to a particular state along with the unitary income.

The case law defining the unitary concept has developed almost exclusively within the context of controversies involving multistate corporations and their concerns regarding how income from subsidiaries and affiliates should be treated for purposes of apportionment and allocation. How the unitary concept applies to flow-through taxation remains a largely untested area. 

Aside from the general principles discussed above, the legal framework for the unitary concept in a flow-through environment derives from state statutes, regulations, rulings, forms, and cases. While a few exceptional states have provided detailed guidance in this area, many states and localities provide little to no guidance on these fundamental issues.

Application of the unitary business concept to investment management

The unitary test described above has little practical relevance in the context of the taxation of investment income. An investment, such as a bank account or a limited partnership interest,    is likely never to be unitary with the investor taxpayer according to the traditional analysis (ownership, operational integration, functional integration, etc.). The reason is that the traditional analysis has been developed and applied in case law in the context of how various entities’s managements, operations, etc., relate to one another. Take the example of a bank account. Under the traditional test, the taxpayer would be required to own  a significant  percentage  of the  bank and be otherwise functionally integrated with the bank based on its operations and management before (1) it could be considered unitary with the account and (2) the income from the account  could be constitutionally apportioned.

The unitary test continues to apply in this case, however. A handful of Supreme Court cases have considered how investment income should be treated from a unitary perspective. 16 The current state of the law appears to require that income be treated as unitary if the investment itself is a unitary part of the investor’s business. The question of what an investor is required to do with the income, and the underlying apportionment factors of a so-called unitary investment, remains largely unaddressed.

The leading case in this area, Meadwestvaco v. Illinois, 553 US 16 170 L Ed 2d 404 (2007), contains the clearest explanation to date of how investments and income from investments should be analyzed under the unitary business principle. In this case, the Court noted that the “traditional” unitary analysis, which relates to whether affiliated corporations may be included in the same unitary group based on various factors related to the integration of control, management, and function, makes little sense in the context of a particular investment asset as the investor is rarely, if ever, unitary with the investment or the investment advisor. The Court held that the correct analysis with respect to such assets is whether such an investment asset is a “unitary part of the business being conducted in the taxing State rather a discrete asset to which the State had no claim.”17

This “discrete asset” concept looks to the context in which the asset is held to make the determination of whether the income from that asset is included in the unitary business and, therefore, is potentially subject to apportionment. An example of a unitary asset given in the case, which relates to another Supreme Court case, 18 is income from a taxpayer’s futures contract. Because the taxpayer used the futures contracts to hedge price risk of a key input of their product, the income from these contracts and the contracts themselves were determined to be part of the unitary business.

The concepts discussed above define the questions that need to be asked to determine whether income from an investment is unitary. The “discrete asset” concept requires the taxpayer to ask whether the asset is a “unitary part of the business being conducted in the taxing State.” In the context of investments in intangible securities, a positive answer to this question results in a relatively simple exercise of assigning the receipts from the investment to the correct state based on  the states’ respective sourcing rules. In the context of investments in partnership interests, a positive answer to this question leads to more questions, such as: How does the “discrete asset” concept  apply in the flow-through context? Is the partner required to include the underlying investments apportionment factors in its return? How does an investor practically accomplish this given limited visibility of the underlying investment’s operations? As this emerging area  of law  continues  to develop, the authors expect that the state and federal courts that address these issues will recognize come of the practical difficulties of apportioning and allocating income from alternative investments.

General state statutory framework for reporting income from alternative investments

While there are a number of aspects of state reporting of alternative investments that vary significantly from the federal model, this discussion focuses on three that have proven to be particularly problematic:

1. States tax individuals, trusts, and estates in an entirely different way than they tax corporations. Individuals, trusts, and estates are subject to  state  tax  in their resident  state  based on all  of their income regardless of source. They are also subject to tax on any income sourced to a non-resident state. There are credit mechanisms to reduce double taxation. Corporations and tax-exempt organizations are generally not taxed based on their residence/commercial domicile. The credit mechanism concept does not exist for such taxpayers in the context of state and local income-based taxes. Corporations, including  tax-exempt  organizations,  are  primarily  taxed based on their state apportionment factors without regard to their residence.
2. States require non-resident taxpayers – including individuals, trusts, estates, corporations, and tax-exempt organizations – either to (1) treat income apportioned to the state by the partnership as sourced to that state for all purposes (“partnership-level apportionment”) or (2) disregard partnership level apportionment and take the partnership’s income and apportionment factors into consideration in calculating their own apportionment to that particular state (“partner-level apportionment”).
3. A significant and growing number of states require partnerships to withhold and remit an amount   of tax equal to partnership-level apportionment multiplied by state taxable income. The rules in this area vary from state to state and require significant administrative effort to manage.

Different state tax schemes for different types of taxpayers

As indicated above, the states have adopted two fundamentally different approaches to taxing multistate taxpayers that own an interest in an alternative investment.  Individuals,  trusts,  and estates are subject to tax in their resident state on all of their income from whatever source derived. They are also subject to tax in non-resident states on the income that is sourced to those states. To minimize double taxation of this type of investor, most states allow a resident partner to receive a credit for taxes paid to non-resident states.

Corporations, partnerships, and tax-exempt organizations are subject to state tax  only on income that is earned in the state based on the application of the particular states’ apportionment and allocation rules. Their residences or commercial domiciles are relevant only to how items of income are sourced for apportioned or allocation purposes. Partnerships are required to report information on K-1 forms relevant to both individual as well as corporate investors.

Partnership reporting

Individuals, trusts, and estates are generally required to report all of their income to their state of residence. The only state K-1 information relevant to these taxpayers includes state level modifications to federal taxable income and specialized state credits. Based on the authors’ experience, most state K-1s are well designed to convey this information.

Non-resident individuals, trusts, and estates are required  to  be  taxed  only  in  the  non-resident state based, typically, on partnership-level apportionment or other allocation.  While  there  are several exceptions, most states would require  non-resident  individuals,  estates,  and  trusts  to source income based on the partnership-level apportionment. Income sourced to a particular state should generally equal the partnership’s apportionment ratio to that particular state multiplied by state taxable income. Because non-resident individuals, trusts, and estates presumably would be taxable on the same income in their home states that the home state is entitled to tax regardless of source, nearly all states provide residents with a credit  mechanism  to  minimize  the  risk  of double taxation. The credit provided is typically  limited to the amount of income actually taxed in the non-resident jurisdiction multiplied by the resident state tax rate. There are notable variations on this rule, however.

Partnership reporting of apportionment factors and allocated income to corporations and foundations

Nearly half of the states require corporations to include the apportionment factors from the partnership with their other apportionment factors to apportion the partnership income at the corporate level. Most of the remaining states limit this treatment to those situations in which the partner is unitary with the partnership (cf., California, Illinois, etc.). A minority of the states require corporations to source income to a state based on partnership-level apportionment in a manner similar to that used in the taxation of individuals.  

State partnership withholding tax regimes

Many states and localities have enacted what are effectively entity level income taxes on the   alternative investment. These taxes, which are commonly  referred to  as “withholding at  the source” or “mandatory composite return” taxes, are generally  calculated  based  on  the  “distributable” income of the partnership. 19 The statutes are typically structured so that the responsibility for the tax   is on the partnership and those individuals or entities responsible for making material decisions on behalf of the partnership.

In general, there are two exemptions from  state  income tax  withholding. The first  is generally designed to accommodate non-resident individuals while the second is designed to limit multiple impositions of tax in a tiered structure. The exemption designed for non-resident individuals is typically referred to as the composite return. In the typical composite return, non-resident individuals are permitted to satisfy their tax filing obligations to a particular state as long as the alternative investment is the only source of income for the individual in that particular state. Partnerships with a significant number of individual members, such as multistate professional service partnerships, are frequent users of this type of exemption. In these situations, it should be noted that the partnership would still be required to withhold on distributable income for those taxpayers not included in composite returns.

The second exemption, which is designed to limit multiple impositions of the withholding tax in a tiered structure, is typically available only to other partnerships and entities treated as pass-through entities for federal income tax purposes (e.g., Subchapter S Corporations) that are also partner/ members of a lower-tiered partnership and through the formal execution of a consent form to be subject to the state’s  withholding regime on its own account. While the administrative practices for   this exemption vary among the states, the common thread is that the responsibility for the tax is passed up to the partnership that is the partner in the alternative investment.

Withholding in a tiered partnership structure

The available exemptions to withholding are difficult to  administer,  especially  when  there  are multiple unrelated management groups responsible for tax compliance at different tiers of the partnership investments. In a tiered environment, a partnership that is a partner in a lower-tiered partnership may apply for and be granted an exemption from withholding. While the exemption has the practical effect of absolving the lower-tier flow-through from  remitting  the  tax,  the  tax  is now due at the upper-tier partnership level. The rules then require the same withholding be made at that level, or the exemption to be executed by the next-tier-up partnership or otherwise exempt entity.

There are several practical limitations:

1. Cost. State laws in this area are by no means consistent. Regardless of this extremely high-level characterization of how these laws work, there is very little guidance beyond what has been described above that holds true in more than a handful of states.
2. Timing. The time frame for compliance with these rules varies significantly from state to state. Time frames for obtaining the required signatures may also be very short, especially in the    context of a typical tax compliance season. For example, the tax preparer may not be aware of a large taxable gain in a particular state until the deadline for obtaining an exemption has passed for the year.
3. Incentives. Because the withholding tax is generally an obligation of the partnership, the risks of non-payment remain with the executives responsible for running the partnership. Based on general principles of successor liability and responsible party liability, a rational practice would appear to be for the partnership to remit the withholding tax unless otherwise notified by a concerned partner.
4. Disconnected tax base. As discussed above, the state tax base at the partnership level is based on the partnership’s apportionment factors. The state tax base at the partner level is often based on the partner’s apportionment factors in that particular state, which, depending on a particular state’s statute, may or may not include the partnership’s apportionment factors. The withholding  tax base is nearly always based on the partnership’s apportionment factor. Therefore, in those  states that require partner-level apportionment, it unlikely that the amount withheld with respect   to the partner’s partnership interest bears any relation to the partner’s actual state tax liability in that particular state.

Effective management of state taxable income is more than just assembling tax information and randomly filing state tax returns. It is also risk management. The nine largest states account for more than half of the U.S. economy measured by gross state product (GSP). 20 As tax liabilities increase, especially in these larger states, it is in the taxpayer’s best interest to understand the tax requirements and how they apply to their individual entity’s state tax information.