Mississippi Gov. Tate Reeves signed a law Thursday that allows pass-through entities to elect to be taxed at the entity level. Many states have adopted such measures as a workaround to the federal cap on state and local tax deductions. (AP Photo/Rogelio V. Solis)
Meanwhile, with President Joe Biden's tax plans seemingly on hold, states are acknowledging that the $10,000 cap on the federal deduction for state and local taxes paid, as provided for in the 2017 federal tax overhaul , is here for the foreseeable future. And after the Internal Revenue Service and U.S. Department of the Treasury blessed entity-level taxes on pass-through entities, more than half of states and Washington, D.C., are providing a tax or credit.
Finally, state tax practitioners were disappointed that the U.S. Supreme Court recently took a pass on hearing a company's claims that New Jersey's partnership filing fee violates the U.S. Constitution's commerce clause. But there is still plenty of controversy brewing around partnership issues, including a high-profile matter before Massachusetts' high court on whether the commonwealth correctly assessed tax on an out-of-state corporation's capital gains from the sale of interest in a Massachusetts partnership.
Here are three things to know about state taxation of partnerships now.
Multistate Tax Commission Enters the Conversation
The MTC presented a draft paper last month dealing with the state taxation of investment partnerships, part of its sweeping project on how states tax partnerships. The commission announced the project a year ago, saying it would study topics including the general treatment of a partnership's operating income and sales of partnership interests. Within those broad categories, the partnership work group would look at sourcing, the nexus of nonresident partners and information reporting and audits, among other issues, the MTC said.
Helen Hecht, the MTC's uniformity chair, told Law360 that the partnership work group decided to begin with investment partnerships because about half of states designate them for special treatment. She said the draft paper has not yet established findings; that will come after the MTC's spring meetings, which begin Tuesday. But Hecht said she expects that one of the findings will be to tell states they should have a rule that pertains specifically to taxing investment partnerships. Such partnerships hold a large percentage of their assets in intangible investments such as stocks, bonds and options.
"Even if the rule is, 'We don't treat them any differently,' you need to say that," Hecht said.
Bruce Ely, a tax partner at Bradley Arant Boult Cummings LLP and a specialist in the federal and state taxation of partnerships, said the taxation of investment partnerships is a challenging topic even for practitioners like him who spend a lot of time immersed in it. He said the MTC is wise to try to give guidance to state officials, who may have little idea of what is involved.
Part of the trouble, Ely said, is that investment partnerships may be multitiered, which makes the reporting of income and the subsequent sourcing particularly complex.
"Without a lot of hard work and understanding [of investment partnerships], which many state auditors don't possess, they can't really drill through to figure out — is their state receiving the fair share of income?" Ely said.
Ely said the entire project the MTC has taken on is an immense one, and he expects it to last for years because of the breadth and depth of what it could potentially cover. He said it appears the commission is attempting to do things a chunk at a time, which he said seems prudent.
Hecht said that after the investment partnerships portion is finished, the MTC will turn its attention to other partnership taxation issues, including possible comments on the wave of new taxes on pass-through entities. These are targeted at the entity level, rather than on the income that flows down to the partners, and are meant to help partners work around the SALT deduction cap.
"I think this is just step one," Hecht said.
The Trend Toward Entity-Level Taxes Is Now a Wave
With Thursday's signing of H.B. 1691 by Mississippi Gov. Tate Reeves, a Republican, more than half of states now permit a tax on pass-through entities, such as partnerships, at the entity level. Washington, D.C., allows a credit for such taxes paid to other jurisdictions.
Under such arrangements, which are elective in every state except Connecticut, owners of pass-through businesses may receive a federal tax deduction and either a state tax credit or an exclusion. In November 2020, Treasury and the IRS indicated via a notice that they found such taxes acceptable and said they would issue guidance, although that guidance has still not materialized. A few states had adopted entity-level taxes before the agencies' notice, but after it, the number more than tripled.
Brian Reardon, president of the S Corporation Association, which lobbies for pass-through businesses, said he expects the number will be at least 30 by the end of spring. A few states still have bills in the pipeline that Reardon said he expects will pass.
"For the other 11, what is taking you so long?" Reardon said, referring to 11 states of the 41 with an income tax that have not yet created an entity-level tax or are on the verge of doing so.
Reardon said he often hears the entity-level tax is a benefit for large businesses, but said that is a misconception. Small-business partners, who can also take the standard deduction, can get the pass-through benefit on top, Reardon said. He said the tax can be particularly valuable for them.
Still, some practitioners have cautioned that there are circumstances where the election may not be the right choice. Some concern centers on state tax credits and whether nonresident partners' home states will provide them a credit to offset the tax they pay to the state where the entity is located.
Another concern is whether a resident partner of a state that has an entity-level tax who elects the tax in another state would be able to get the benefit in the partner's state of residency, said Kelvin Lawrence, tax partner at Dinsmore & Shohl LLP.
"If the result is that electing in a state other than your state of residence will ultimately increase your tax burden, no, that doesn't make sense," Lawrence said.
State Partnership Tax Law Presents Many Controversies
With many nuances and a frequent lack of clear guidance, state tax partnership law lends itself to controversy, and often at very high levels.
Most recently, many practitioners were disappointed when the U.S. Supreme Court on April 4 declined to hear a company's allegations that New Jersey's partnership filing fee violates the Constitution's commerce clause by not offering multistate businesses an ability to apportion the levy. But the court's decision not to grant certiorari in the case, brought by Ferrellgas Partners LP, may not be the end of the question, as a similar case is pending in federal court and at least 14 others are before the New Jersey Tax Court, according to the state's Division of Taxation.
And more developments are on the horizon. Prominently, the Massachusetts Supreme Judicial Court is set to decide whether the state's Department of Revenue has the statutory authority to tax capital gains realized by an out-of-state corporation. That complaint, brought by VAS Holdings & Investments, is similar to another high-profile matter decided Tuesday by a New York state appeals court. There, the court affirmed the New York City Tax Appeals Tribunal's ruling that capital gains realized by a Goldman Sachs unit on the sale of its interest in a New York City-based business incurred general corporation tax.
David Hughes, state and local tax partner at HMB Legal Counsel, said both cases involve an out-of-state owner of a pass-through business in which that owner had no nexus with the taxing jurisdiction and in which the owner and the business are not unitary with one another.
"And so, if you apply traditional unitary rules, the taxing jurisdictions should not be allowed to tax the out-of-state owner when they sell their interest in the flow-through," Hughes said.
But, he said, the states are arguing that taxation here is not based on unitary concerns, but rather whether the business being sold, referred to as the investee, is within the taxing jurisdiction. Hughes noted that appellate courts in both New York and Massachusetts have sided with the states and now practitioners are closely watching the Massachusetts high court.
"So far, the states are winning that battle," Hughes said, but he said he expects a lot more controversy.
"I think that's huge," Hughes said. "We're going to start seeing cases like that in a bunch of jurisdictions."
--Additional reporting by Asha Glover and Paul Williams. Editing by Aaron Pelc and Roy LeBlanc.
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