State Tax Issues Related to Flow-Through Investments Part Three: Federal Limits on State Taxing Power
This article is the final 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 Two discussed partnership withholding and apportionment of multistate income. This article discusses federal law that may limit a state's ability to assert a tax reporting obligation on nonresident partners.
The principle that a state may not tax value earned outside of its borders is well established. However, the issues still remain: what business activity is sufficiently connected to a particular state to create a tax obligation, and how much of the income or value related to such activity may a state tax?
When a taxpayer conducts business activity in various states, the portion that one state may tax turns on the unit of activity sufficiently connected to the state. In limiting the reach of state taxes to activities connected to the state, the Supreme Court declared that “the linchpin of apportionability [the scope of the activity states may apportion and tax] in the field of state income taxation is the unitary business principle”.1 This concept of unity has become an ever increasing area of controversy and scrutiny. Under the unitary principle, businesses are considered unitary if there is some flow of value between the businesses, generally evidenced by functional (operational) integration, centralized management, and an achievement of economies of scale (the operation of one activity impacts the value of another).2
The Supreme Court issued a landmark opinion on the issue of unity in Allied-Signal.3 In Allied-Signal, the Court found that a state need not “isolate the intrastate income-producing activities from the rest of the business,” but “may tax an apportioned sum of the corporation’s multistate business if the business is unitary.” The Court found that dividends received from an unrelated subsidiary located outside of New Jersey could not be taxed by New Jersey because neither the dividends nor the subsidiary payor bore any unitary relationship to the corporation’s activities in New Jersey.
Allied Signal and its progeny created uncertainty as to when an investment may be viewed as unitary with other business activity. The Supreme Court addressed this issue in 2008 when it decided Meadwestvaco.4 Mead acquired a corporation that later evolved into the research service Lexis/Nexis. Mead was not involved in Lexis’s day-to-day affairs, and the operations of Mead and Lexis did not overlap in any form. When Mead sold Lexis for a large gain, the Supreme Court found that the gain was not required to be apportioned to the states where Mead conducted business after determining that Mead and Lexis were not unitary. The Supreme Court rejected the lower court’s application of a separate “operational function” test that would look to whether the investment in Lexis—and the income derived from that investment—served to further Mead’s business.
While there is voluminous law in a corporate context, the partnership rules are a patchwork of provisions that apply unitary principles inconsistently—or not at all. When investors own multiple business activities in flow-through entities that may or may not have related business activities, how do the unitary principles and the decision in Meadwestvaco impact the unit of activity a state may tax?
The states address the taxation of individual partners who invest in partnerships in various ways. A few of the states, including South Carolina, Utah (starting 1/1/2009) and Vermont, require all of the income and all of the factors to flow up to individual partners, thereby commingling all activities at the partner level. Vermont, for example, takes the following position with regard to partnership investments:
The partnership is merely a conduit for business income taxable to the partners. Income and losses flow through to the partners and are reported on their returns.5
On the other end of the spectrum, a majority of states allow a partnership to directly allocate the income to the state and flow that income to the partners, rather than flowing through the income and the factors. Arkansas incorporates the following regulation:
Every partnership filing an Arkansas partnership return shall state specifically the items of its gross income and the deductions allowed by this act and shall include in the return the names and addresses of individuals who would be entitled to share in the net income if distributed and the amount of the distributive share of each individual.6
However, it is important to consider the operational-function test. While a partner and a partnership might not be unitary, the partnership investment itself might serve an operational function to the business of the partner. In such a case, the flow through of income and apportionment factors may still be required. This is an area that is not yet fully resolved. The Court’s holding in Meadwestvaco challenges the existence of such a test. By finding that there was no need for additional analysis after concluding that two businesses are not unitary, the Court appears to invalidate the operational-function test.
In light of Meadwestvaco and other Supreme Court decisions, there may be alternative approaches to reporting income and apportionment factors when an individual partner is invested in multi-state flow-through entities. For an individual who is only investing in a partnership for pure investment purposes, the question arises as to the impact Meadwestvaco has on the income that flows through from the partnership to the partner. Take, for example, an individual who holds an investment in two separate partnerships: one operates a shopping mall and the other operates a gold mine. Both partnerships do business in Vermont.
Under the general rule in Vermont, the partner would flow up the income and the apportionment factors from both partnerships and apportion the income from both partnerships together on its state return. After Meadwestvaco, this may not be an appropriate result. If there is no operational connection between these two partnerships, they would not be unitary businesses and should be taxed separately.
What if, however, the partner used the income from the shopping mall to provide working capital for the gold mine? In this case, the businesses would not be unitary at a functional level. However, there is a connection between the two—the mall activity is funding the operation of the mine. Would this be enough of a connection to treat these businesses as unitary and blend the income and apportionment factors? Meadwestvaco may require that the businesses be separately apportioned notwithstanding the flow of funds.
What if the partnerships were held in a tiered partnership structure (i.e. the partner is invested in the shopping mall partnership, which is in turn invested in the gold mining partnership)? There may be a connection by common ownership and a flow of funds (i.e. the shopping mall partnership would be making capital contributions for its investment in the gold mining partnership), but would there be a unitary connection? Similar to the above situation, without a unitary connection, Meadwestvaco would appear to require separate apportionment of each business activity.
The same result most likely would occur when a single partnership operates multiple lines of business under the same partnership umbrella, or multiple partnerships that roll up into a single entity as with a hedge fund. As long as the lines of business do not commingle their operations, the businesses would not be unitary.
Investors in flow-through entities should take a fresh look at the state tax footprint of their business ventures. The state laws may be overreaching in taxing activities unrelated to the state, or by commingling activities that bear no relation to one another. The separation of business activities may impact the overall state tax cost and the return on flow-through investments.
1Mobil Oil Corp. v. Commissioner of Taxes Vermont, 447 U.S. 207 (1980).
3Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768 (1992).
4Meadwestvaco Corp v. Illinois Department of Revenue, 553 U.S. 16 (2008).
5Vermont Formal Ruling 88-18, 01/06/1989.
6Ark. Code Ann. Sec. 26-51-802.