State Tax Issues Related to Flow-Through Investments Part Two: Determining State Source Income
This article is the second part of a three-part series on tax opportunities and issues facing nonresident owners of multistate flow-through entities (i.e., partnerships, limited liability companies, etc.).
Part One discussed statutory and regulatory safe harbor provisions that may protect nonresident investors in multistate investment partnerships from state income taxes. Part Three will discuss federal law that may limit a state's ability to assert a tax reporting obligation on nonresident partners. This article discusses how the flow-through entities' income is reported by the nonresident owner (corporate or individual), including compliance and withholding issues.
Various states impose entity level taxes on flow-through entities (i.e., Michigan, Texas); however, most states "flow-through" the imposition of tax to the ultimate owners. At the flow-through entity level, the determination of state taxable income may not be as complicated; however, the challenges arise when the ultimate owners have one or more flow-through investments and must determine their own state taxable income.
Apportionment and Allocation: What Does the Flow-Through Entity Report?
When a taxpayer is doing business in several states, it has a constitutional right to have its income fairly apportioned between the taxing states. The most common method to divide the income amongst the states is by using a formula that compares the taxpayer's property, payroll and sales in a particular state with those same factors everywhere. Flow-through entities apportion their income to a state using the state specified apportionment formula. The entity is also required to notify their partners of their distributive share of state source income – generally via a state specific Form K-1.
Furthermore, flow-through entities are generally required to decide whether income is business or non-business income in order to determine the distributive share of income attributable to each state. If the income is determined to be non-business income, it will be allocated to a specific jurisdiction; whereas if it is determined to be business income, it will apportioned among the states where the entity has activity as described above.
There are three primary methods to determine state taxable income for a corporate partner. Under any of these methods, the state taxable income and ultimately the tax liability can vary significantly.
- In most states, partnership income is aggregated with the corporate partner's business income. The total business income is then apportioned using an apportionment formula that combines the corporate partner's distributive share of the partnership's apportionment factors with the corporation's own apportionment factors. In other words, the apportionment factors flow-through from the partnership to the corporate partner.
- A few states, including California and Illinois, require the flow-through of apportionment factors only if the corporate partner and the partnership are unitary. The analysis for whether a unitary relationship exists typically consists of examining three factors:
- unity of ownership
- unity of operation
- unity of use
- Other states require a corporate partner to report only its specifically allocated share of state sourced income from the state Form K-1. If the corporate partner has operations of its own in the state, it computes its own state apportioned income and adds to the result the income from the partnership's K-1.
For the partnership's non-business income, the determination of the state to which the income should be allocated will depend on the sourcing rules in the states at issue. The income will be attributed to the state or states that are considered to be the source of the income. For example, Illinois and California require that non-business income, which is determined at the partnership level, should be sourced to the state where the partner is domiciled, unless it has attained a business situs in the state. Other states may require that the non-business income be determined at the partner level, which may yield a different result in those states because the corporate investment in the partnership is treated as an intangible asset. A few states, including Arkansas, require separate allocation of a corporate partner's distributive share of income because they presume the income is non-business.
Corporate partners that engage in business with the flow-through entities in which they own an interest must also determine whether a state will require elimination of these intercompany transactions for purposes of calculating the apportionment factor. Complexities may arise when the intercompany transaction takes place indirectly or with an affiliate. In addition, some states have only specified the elimination of intercompany transactions between partners and a partnership, but have not expanded the elimination for Limited Liability Companies (LLCs) and their members.
At the individual level, partners generally base their distributive share of income in the state on the K-1 (or equivalent) received. Generally, individuals must report all of their income in their states of residency. However, nonresident individual partners are typically taxed on their distributive share of business income derived from sources within the state. As a result of this same income being subject to tax in two or more states, the state of residency will usually provide a state tax credit for income taxes paid to the source state to mitigate the double taxation.
One often overlooked issue for nonresident individuals with flow-through investments in California is the requirement for partners who own 20% or more in a pass-through entity and whose business activity of the flow-through entity is unitary with another business activity of the partner, to determine state source income by utilizing an apportionment factor percentage.1 Similar to the method employed by corporate partners (described above), a nonresident individual partner would calculate an apportionment factor percentage by aggregating the distributive share of apportionment factors from the unitary flow-through investments.
Other issues that must be considered include passive activity losses and at-risk rules which can also limit or materially change the amount of reportable income.
Many states offer an administrative alternative to nonresident partners by allowing a flow-through entity to file a tax return and pay tax on their behalf via a composite (group) filing. Tax is generally calculated at the highest tax rate, without the benefit of possible graduated rates or exemptions/deductions. Eligible partners generally include nonresidents whose sole source of state income is the reporting pass-through entity, or if the nonresident owns multiple pass-through entities, the nonresident must be in a composite return for each pass-through entity investment in the state. In some states, a spouse's income may also jeopardize inclusion in a composite return. Although composite returns are generally only available to nonresident individuals, more and more states are allowing grantor trusts to be included in composite returns.
All of the above mentioned issues are also relevant when a tiered partnership structure exists. Income and apportionment factors can be flowed up through numerous levels of entities, depending upon applicable state law.
Many states responded to the failure of partner filings and payment of income taxes on their share of state source income by implementing withholding provisions on the pass-through entity. The imposition of the withholding tax on the share of in-state income that is attributable to nonresident partners helps to ensure, and at times accelerate, the payment of tax.
States differ on the method of withholding used, though it is generally based on the amount of distributable income rather than the actual distributions. Many times this can cause a cash-flow issue for the pass-through entity. In California, withholding is required on the distributable income of non-US partners; however, it is only required of domestic partners if a distribution was made. The states also differ on the method for remitting the withheld amounts. Some states require the payments to be remitted on an annual basis, often with the partnership return, while others require them to be made much like estimated tax payments throughout the year.
Many states that otherwise require withholding will not require it if the partner's pro rata share of income is less than a set amount, typically between $1,000 to $1,500, or if the partner elects to be included in a composite return or signs an affidavit agreeing to file a nonresident individual return.
The state tax treatment of flow-through entities and their owners can often result in unanticipated issues and compliance burdens. It is prudent for the entities and the owners to understand their obligations.
To view Part One in this series from the May 2010 newsletter, click here.
1 Regulation 17951-4(d)(4)