State Complexities in K-1 Aggregation

The current practice of K-1 reporting has led to significant complexity and risk associated with federal, state, and international reporting requirements. Many that practitioners understand, and others that creep up in the event of a sale of partnership asset. The authors walk through these complexities in this series of white papers.

Thomson Reuters and Crowe LLP entered into a strategic collaboration to help tax professionals address the burdensome manual work related to Schedule K-1 forms.

The authors are tax accounting specialists from Crowe:

Geralyn R. Hurd, CPA
John V. Woodhull, JD
Jonathan M. Cesaretti, JD
Kristin N. Kranich, CPA

Our article, “The Four Dimensions of K-1 Aggregation: A Federal Overview,” focused on the height, width, depth, and time implications of K-1 aggregation. We touched on state issues only with respect to how data was received. We will now provide a more in-depth conversation around tax schemes for different entity types, allocation v. apportionment reporting, and withholding.

The state and local taxing regimes are diverse. Even in this context, though, one of the main reasons why accurate state reporting of alternative investment tax obligations can  be such a difficult task is that the forms and regulatory rules in the area generally are not designed to address the ever-growing, tiered, flow-through structures to which most investors seem to be attracted.

State tax reporting of alternative investments creates enormous difficulties for all partnership investors, including individuals, taxable and tax-exempt corporations, and upper-tier pass- through entities. State and local tax and jurisdictional concepts such as nexus, apportionment, allocations, and unitary business principles add levels of complexity and uncertainty not seen on the federal level.

The discussion that follows provides a framework for understanding state and local tax law in this area. Like any other article on multistate taxation, it cannot go into the details of tax law in each state and locality. For example, while one can reasonably generalize that states follow the federal practice of ignoring distinctions between different types of partnerships and partners, for purposes of Schedule K-1 reporting, this is not always the case in a number of important Jurisdictions. A number of states treat legally distinct entities such as a limited partnership and a general partnership differently for tax purposes. Also, some states provide for special treatment for particular entities based on their activity. For example, New Jersey has a taxpayer-friendly provision for hedge funds. Illinois, California, and other large states have taxpayer-friendly provisions for investment partnerships. New York has a taxpayer-friendly provision for taxpayers that trade on their own account. Each state’s laws should be analyzed on a stand-alone basis. Note also, as certain localities (e.g., New York City) have their own version of income-based taxes, those should be analyzed as well.

While the primary focus of this discussion is on the tax-reporting obligation flowing from the various state and local equivalents to the federal K-1, the discussion also focuses on important constitutional limitations to the states’ ability to impose a tax on the entity, the investor, and the income from the alternative investment.

Constitutional framework for reporting income from alternative investments

The word “nexus” is from a Latin verb meaning “to bind.” (Merriam-Webster Online, www.merriam-webster.com/dictionary/nexus. The first known use of “nexus” was in 1663).  A typical legal definition is a “connection or link, often a causal one.” (Black’s Law Dictionary, West, 1999. For example, “cigarette packages must inform consumers of the nexus between smoking and lung cancer.” Id.) In state and local taxation, much hinges on the term.