State Tax Issues Related to Flow-Through Investments Part One: Investment Partnership Safe Harbor
This article is the first part of a three-part series on tax opportunities and issues facing non-resident partners in multistate partnerships. The focus of Part One is on statutory and regulatory safe harbor provisions that may protect non-resident investors in multistate investment partnerships from state income taxes.
In subsequent newsletters, Part Two will discuss partnership withholding and apportionment of multistate income and Part Three will discuss federal law that may limit a state’s ability to assert a tax reporting obligation on non-residents.
Introduction: The Taxation of Nonresident Partners
Individuals who invest in partnerships that operate in multiple states may be subject to income taxes in each state where the partnership has activity or generates income. When the partnership conducts an active business, the states generally require partners to pay tax on their share of the partnership income apportioned or allocated to the state. However, when a partnership’s business is limited to investing the capital of its partners, there is significant controversy about whether the partnership’s activity creates a filing obligation.
While the states aggressively assert their taxing authority over multistate partnerships, adhering to certain statutory and regulatory safe harbors may minimize non-resident income taxation. Augmenting or supplementing the safe harbor rules is a patchwork of administrative decisions and case law that should be reviewed in determining whether a non-resident partner may be subject to the jurisdiction of a state merely by owning an interest in an investment partnership.
State Statutory or Regulatory Safe Harbors Generally Provide that Non-Resident Individual Investors who have Limited Partnership Interests in Partnerships do not have a State Tax Reporting Obligation
Approximately 20 states have created safe harbors to protect certain types of investment partnerships and non-resident partners from state taxation.1 While there is significant variation among the states’ approaches to these rules, they generally apply to protect investors in partnerships that invest in intangible assets. A typical example is an Illinois rule that became effective for tax years ending on or after December 31, 2004.2
Under Illinois law, the term “investment partnership” is defined by statute as an entity that is not a dealer in qualifying investment securities and that meets both an assets and income test.3 The assets test is that “no less than 90% of the partnership’s costs of its total assets consist of qualifying investment securities, deposits at banks or other financial institutions; and office space and equipment reasonably necessary to carry on its activities as an investment partnership.”4 The income test is that “no less than 90% of its gross income consists of interest, dividends, and gains from the sale or exchange of qualifying investment securities.”5
The term “qualifying investment securities” is defined by a specific list of intangibles that, among other things, includes stocks, bonds, foreign currency exchange contracts, derivatives and investments in other investment partnerships.6 Like most of these types of statutes, real estate and interests in physical commodities are not considered qualifying investments and, if owned by an otherwise qualifying investment partnership, would disqualify it should income from these interests or cost of these assets be 10% or more of the partnerships overall income or assets, respectively.
While several states have adopted Illinois’ approach by establishing a statutory definition that includes both an income and an assets test, other states have adopted a test that looks only to the nature of income or to the nature of the assets in making the investment partnership determination.7 For example, in Kentucky, the safe harbor is defined as “a pass-through entity that, during the taxable year, holds only investments that produce income that would not be taxable to a non-resident individual if held or owned individually.”8 In Virginia, the safe harbor is defined with respect to the nature of the property owned by the partnership.9 Some states look to the nature of the partnership interest, the amount invested and the number of other investors.10 For example, New Jersey requires that the investment partnership have more than 10 partners.11
Judicial and Administrative Decisions May Provide Alternative or Additional Opportunities for Partners in Investment Partnerships to Minimize their Tax Reporting Requirements
As noted above, approximately half of the states have enacted statutory or regulatory safe harbors. There may, however, be opportunities for taxpayers in the remaining states to minimize exposure by applying taxpayer favorable state court and administrative decisions. While the technical reasoning behind these decisions can differ from case to case, prevailing taxpayers are generally long-term investors that have a limited interest in a partnership, limited partnership or Limited Liability Company.
For example, in Appeal of Robert M. and Ann T. Bass,12 wealthy individuals who were residents of Texas established a limited partnership and located its main office in California. The California office consisted of four employees (an investment analyst, a bookkeeper and two secretaries) and space for the general partners. The limited partnership held only intangible assets and its business activities consisted solely of managing those assets.
The California Franchise Tax Board (FTB) asserted that all of the limited partners’ income from this partnership should be sourced to California. The FTB based its position on a California tax statute that requires intangible income to be treated as California source if the income has a “taxable situs in California.” As the limited partnership was headquartered in the state and had the “trappings of a business operation,” the FTB’s position was that the partnership was “doing business” in California and that all of its income had a “business situs” in the state.
The California State Board of Equalization (BOE), however, rejected the FTB’s assertion based on the reasoning in analogous federal case law. The BOE relied on federal decisions wherein income from assets that were managed for the purpose of long-term capital appreciation and income were not deemed to be from a trade or business, while income from assets managed in order to profit from short-term buying and selling were deemed to be from a trade or business. The BOE in Bass noted that the partnership held the assets in its portfolio for an average holding period of 5.78 years, which was similar to the portfolio holding period in a leading federal case that holding that such activity did not constitute a trade or business. The BOE dismissed the FTB’s argument that the investment portfolio operated like a business by noting that such an appearance would be unavoidable as “prudent investing” of the sums discussed in the case would require the dedication of “substantial human and other resources.”
The decision in Bass turns on whether the partnership’s investing activity constitutes “doing business.”13 Similarly, taxpayers in other states have prevailed by arguing that investing activity is not a business.14 Even though this issue has not been decided in published cases or administrative rulings in every state, the reasoning may provide a basis for a non-resident taxpayer to avoid taxes in multiple jurisdictions.
Investors considering placing funds in a multistate investment partnership should consider potential state taxes and the cost of potential filing obligations. If structured and operated within state safe harbor provisions, an investment partnership may limit the partners’ exposures to multistate taxes.
1 Ala. Code §40-18-24.2(c)(3)(b); Ark. Code Ann. §26-51-202(e)(1); Cal. Rev. & Tax. Cd. §23040.1(a)(1); Conn. Gen. Stat. §12-711(f); Ga. Code Ann. §48-7-24(c); Idaho Code §63-3026A(3)(c); 35 ILCS 5/305(c-5); Ky. Rev. Stat. Ann. §141.206(12); Me. Rev. Stat. Ann. §5142(3); Md. Admin. Release No. 6 (Md. Comptroller’s Office, Revenue Admin. Div., 09/01/2007); 830 Mass. Regs. Code 62.5A.1(4)(b); Minn. Stat. §290.17 Subd. 2(c); N.J. Rev. Stat. §54:10A-15.11(a); N.M. Admin. Code 184.108.40.206(A); N.Y Tax Law §631(d); NYC Admin. Code §11-502(c)(2); N.C. Admin. Code 6B.3503(c); Ohio Rev. Code Ann. §5733.401; Tex. Tax Code Ann. §171.0002(b)(3) & Tex. Tax Code Ann. §171.0003(a)(2); Utah Code Ann. §59-10-117(d); Va. Tax Bulletin No. 05-6, (Va. Dept. of Tax’n, 05/06/2005).
2 35 ILCS 5/205(b).
3 35 ILCS 5/1501(a)(11.5)(A)
4 Ill. Admin. Code 100.9730(a)(1)
5 Ill. Admin. Code 100.9730(a)(2)
6 35 ILCS 5/1501(a)(11.5)(B)
7 Arkansas, California and Ohio apply an assets and a gross income test: Ark. Code Ann. §26-51-202(e)(2); Cal. Rev. & Tax Cd. §17955(c)(1); Ohio Rev. Code Ann. §5733.401; Connecticut, New York, Idaho, New Mexico and Texas apply a gross income test only: Conn. Gen. Stat. §12-213(a)(26); N.Y. Tax Law §631(d); Idaho Code §63-3026A(3)(c); N.M. Admin. Code 220.127.116.11(C)(3); Tex. Tax Code Ann. §171.0003(a)(2); Georgia, Kentucky, Maryland, Massachusetts and North Carolina apply a nature of the assets test: Ga. Code Ann. §48-7-24(c); Ky. Rev. Stat. Ann. Sec. 141.206(12)(a); Maryland Administrative Release 09/01/2007 No. 6, Mass. Gen. Laws. Ch. 62, §17(b)(; N.C. Admin. Code §6B.3503(c).
8 Ky. Rev. Stat. Ann. Sec. 141.206(12)(a)
9 Va. Tax Bulletin No. 05-6, (Va. Dept. of Tax’n, 05/06/2005).
10 Mass. Gen. Laws. Ch. 62, §17(b); N.J. Admin. Code 18:7-1.21(a)-
11 N.J. Admin. Code 18:7-1.21(a). Furthermore, the regulation requires that the partnership “has more than 10 members or partners with no member or partner owning more than a 50 percent interest in the entity and that derives at least 90 percent of its gross income from dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stocks or securities or foreign currencies or commodities or other similar income (including, but not limited to, gains from swaps, options, futures or forward contracts) derived with respect to its business of investing or trading in those stocks, securities, currencies or commodities” If the partnership has 10 or fewer partners, the partnership can still be classified as a qualified investment partnership if: (i) it is managed by an independent third party for a fee, (ii) there is no direct or indirect relationship between the manager and any of the partners, and (iii) there is no direct or indirect affiliation between or among the
12 In the Matter of the Appeal of Robert M. and Ann T. Bass, No. 87A-1552-CB:DB (Cal. SBE Jan. 25, 1989), [Cal.] ST. Tax Rep. (CCH) Para. 401-709.
13 Cal. Rev. & Tax Cd. § 23101
14 See Ruling of Tax Commissioner, P.D. 07-77, Va. Dept. of Tax’n, 05/18/2004.