The Multistate Tax Commission (“MTC”) has recently started its Project on State Taxation of Partnerships (“Project”).[1] The proposed scope of the Project is to consider a number of issues relating to state taxation of income associated with partnership income or partner income from the sale of partnership interests.
Importantly, the Project is commencing on the heels of the MTC’s amicus brief to the United States Supreme Court in Noell Industries, Inc. v. Idaho State Tax Commission, 470 P.3d 1176 (Idaho 2020), urging the U.S. Supreme Court to overturn an opinion of the Idaho Supreme Court that the state lacked constitutional authority to tax the sale of equity interests of a partnership’s subsidiary.[2] The MTC argued that “if the Idaho court’s analysis is correct, then the mere formality of creating a holding company can be used to undermine state tax jurisdiction in a way that raises a substantial threat to existing state tax systems.”[3] Ultimately, the U.S. Supreme Court refused to hear the case.[4]
Project Scope
The MTC recognized the need to create clarity around a number of issues related to state taxation of partnerships and partners.[5] Likewise, the MTC recognized that these issues are complicated by distinctions between operating partnerships and passive investment partnerships, tiered ownership structures, varied legal conclusions between the states, the lack of detailed guidance for many of the issues involving the state taxation of partnerships and partners, and constitutional limitations on the ability of a state to tax income.
With that backdrop, the MTC identified the following issues to be addressed:
- Partnership – Operating Income – Generally – Pass-Through Treatment
- Jurisdiction or Nexus over Out-of-State Partnerships and Nonresident Partners and Related Issues
- Sourcing of Income and Related Issues
- Investment Partnerships
- International Issues
- Sale of a Partnership Interest – Generally
- Nexus over Nonresident Partners
- Sourcing of Gain/Loss
- Investment Partnerships
- International Issues
- Administrative and Other Issues
- Credits for Taxes Paid
- Information Reporting and Audits
- Partnership Level Taxes – Generally
From this outline, it is obvious that the Project committee members have a significant number of issues to consider most of which could be resolved in any number of ways. The Project has a “roadmap” of planned meetings every two weeks.[6]
Sales of Partnership Interests
While the other topics within the Project’s scope are important, I would like to pay special attention to the Project’s consideration of sales of partnership interests. This item continues on issues I have discussed relating to state income taxation of trusts.[7] Certainly, anyone who regularly advises clients about tax planning needs to understand the state income tax implications of planning choices they make in their entity structure, ownership, operations, etc. This can especially be important in mergers and acquisitions, such as the sale of partnership interests. Partnerships are pass-through entities meaning that the partners pay tax on the partnership’s income rather than the partnership itself. It is quite possible that state tax of operating income is different from sales of partnership interests by a partner. This was at issue in Noell Industries where operating income apportioned to Idaho was consistently reported and paid to Idaho whereas income from the sale of partnership interests was not taxable by the state.
An issue identified by the MTC relating to taxation of partnership interest sales is nexus. It is clear that a state has the constitutional power to tax its own residents. However, what about a partner residing in another state? Does it matter that partnership operating income was generated in the state (even 100%)? Does it matter whether the non-resident partner was active in the business? Does it matter if the partnership’s income was active business income or passive investment income?
Critical to the analysis are the relevant U.S. Supreme Court authorities. Generally, under the due process clause of the U.S. Constitution (commerce clause considerations may also be relevant), a state may not tax a person who lacks sufficient nexus to the state.[8] Of course, multi-state businesses often operate through multiple entities. Theoretically, a business could shield business income from taxation in a particular state merely by using separate legal entities to avoid creating nexus to the taxing state. To avoid this result while also satisfying due process requirements, cases have set forth a “unitary business” concept whereby states will have constitutional authority to tax out-of-state business entities which are in a “unitary business” with other entities operating in the taxing state. In determining whether there a unitary business exists, the U.S. Supreme Court has used a three-part test: (1) functional integration; (2) centralized management; and (3) economies of scale.[9] When these tests are satisfied, the various legal entities can be aggregated for nexus purposes.
In Noell Industries, a Virginia holding company sold partnership interests in an operating subsidiary doing business in Idaho.[10] The Idaho State Tax Commission sought to tax the gain from the holding company’s sale arguing that the holding company and operating subsidiary were part of a unitary business and, therefore, Idaho had sufficient constitutional nexus to tax the parent’s apportionable gain as business income derived in Idaho (versus nonbusiness income allocated to the holding company’s state of Virginia).[11] Ultimately, the Idaho Supreme Court, after going through an analysis of Idaho statutes to determine business vs. non-business income and also the unitary business three-part test established by the U.S. Supreme Court, found the income to be nonbusiness income not subject to tax in Idaho.[12]
The MTC argued in its amicus brief filed in Noell Industries that the three-part test cited above should not be exclusive. In so doing, the MTC cited to Allied-Signal in stating that “the existence of a unitary relation…is one justification for apportionment…but not the only one”[13] and to MeadWestvaco stating that assets can be part of a taxpayer’s unitary business “even if what we may term a unitary relationship does not exist.”[14] The MTC noted the U.S. Supreme Court has recognized that due process limitations on a state’s ability to tax interstate commerce does not turn on a “formulistic test.”[15] The MTC argued that, departing from that formulistic test, the facts in Noell Industries would support adequate nexus over the parent holding company as being integral to and an operational functional part of the Idaho business operated by the subsidiary. The real question presumably would be “whether the state has given anything for which it can ask in return.”[16] The argument is that the unitary business test is a mere possible test to satisfy constitutional nexus, but not the only way to constitutionally support nexus.
In considering these issues, existing state court opinions relating to holding companies are important in understanding the current landscape, some of which were discussed in the Idaho State Tax Commission’s brief in Noell Industries[17]:
- BIS LP, Inc. v. Dir., Div. of Taxation[18]: In this case, New Jersey argued that the corporate partner was in a unitary business with the partnership. Therefore, the state had constitutional nexus to subject the parent to New Jersey corporate business tax. The holding company partner, which held 99% of the partnership interests, had no business activity separate and apart from the subsidiary partnership. The two entities also were managed by the same persons. Nonetheless, the court found the income of the holding company to be investment income from its passive investment in the operating subsidiary. Therefore, it was not subject to New Jersey corporate business tax. While this case did not involve the sale of partnership interests, it similarly involved a partner’s status as in a unitary business relationship with its subsidiary.
- Blue Bell Creameries v. Roberts[19]: This dispute involved the attempt by Tennessee to tax a Delaware holding company partnership from a stock transaction involving its operating subsidiary. The Tennessee Supreme Court determined that the holding company, without substantial business activity in Tennessee, was a unitary business with its subsidiary. Citing Mobile[20], the Tennessee Supreme Court stated that “to determine whether two separate business entities form a unitary business, we must look beyond the superficial divisions between parent corporations and their subsidiaries to the ‘underlying activity’ generating the income” and, citing Exxon Corp.[21], went on to say that “to be an unrelated business activity, the separate business entity must constitute a ‘discrete business enterprise’.” Failing to show any business activity independent of its subsidiary, the Tennessee Supreme Court found sufficient nexus existed to tax an apportioned share of gains from the transaction as business income relating to the unitary business operated by the parent and subsidiary.
- Corrigan v. Testa[22]: Here, the partner owned a majority interest in a partnership doing business in Ohio. At the time, Ohio statutes taxed gains from the sale of partnership interests of an out-of-state partner holding a 20% or greater interest in the partnership. The relevant partner was not active in the business of the partnership and was not engaged in any unitary business with the partnership. As such, gain from the sale was passive investment income of the partner. The Ohio Supreme Court found the statute which would tax the partner unconstitutional as applied to the facts of the case.
The ability of a state to tax an out-of-state partner’s gain from the sale of partnership interests is currently an open issue. The U.S. Supreme Court, by denying certiorari in Noell Industries, has left the issue for another day. Clearly, the MTC has a position it feels to be correct as argued in its amicus brief. While many cases have addressed the issue in terms of the unitary business test (i.e. if the parent is unitary with the subsidiary, then nexus may exist and/or otherwise allocable nonbusiness income may be apportionable), the MTC argues the law supports a broader reading of constitutional due process requirements.
Conclusion
It will be interesting to watch the outcome of the Project as well as ongoing litigation with states over these issues. As a tax advisor who regularly counsels clients on the tax consequences of business structures, it can be important to know the rules of the game. As noted by the MTC, in this area, the rules are unclear and often varied from state-to-state.[23]
Among other underdeveloped multi-state tax issues involving partnerships, the Project is intended to address issues involving taxing the sale of interests in in-state operating partnerships by non-resident partners. Hopefully, the Project is not a device by the MTC to reach a foregone conclusion – that states may tax the sale of partnership interests by non-resident partners if the partnership generated apportionable operating income in the state. Their brief in Noell Industries certainly seems to point that direction, stating that “the mere formality of creating a holding company can be used to undermine state tax jurisdiction in a way that raises a substantial threat to existing state tax systems” and “the expense and difficulty of creating a holding company is minimal. It can easily be incorporated in any state. And, while we acknowledge there are legitimate reasons for creating holding companies, avoiding state income taxes should not be one of them.”
There may be constitutional arguments to support a broader reading of the due process nexus requirements than purely fixating on the unitary business test. However, care must be taken not cast too broad a net. As admitted by the MTC, there are legitimate reasons for using holding companies. Broadly taxing all non-resident partners on gain from the sale of interests in operating partnerships certainly will have constitutional problems. From the cases cited above, even where the holding company has no independent business activity, has common management, and other connections to the operating subsidiary, courts are divided. Where the facts clearly show independent businesses operated by the holding company (or through other subsidiaries), show that the operating subsidiary is a mere passive investment by the parent (i.e. not part of an integrated operating business), or have other facts which show that the parent and subsidiary are independent beyond merely being separate legal entities, there seems much less support for constitutionally taxing the holding company.
While the Project, Noell Industries, and other cases in this area relate to holding companies, the outcome of the Project could affect individual partners as well. For sure, merely forming and contributing subsidiary interests into a holding company formed in a state without a state income tax on the eve of an equity sale may be perceived as abusive by the MTC. However, holding companies are used in many different situations, not only the type of holding companies about which the MTC appears to take issue (only income is generated from subsidiary, common management, no independent business activity, etc.). Likewise, not all partners are holding companies. Many individuals own partnerships that do business in states other than their state of residency. Should all of these partners be subject to tax in any state where the partnership does business? Do we not recognize a distinction between operating income of a pass-through business and income from the sale of equity interests in that pass-through business? Regardless of the other activities of the partner (even a holding company owning only the subsidiary), is not all income it receives from its investment in the subsidiary, i.e. passive investment income? These and other issues will need to be closely addressed by the Project.
[1] https://www.mtc.gov/Uniformity/Project-Teams/Partnership-Tax
[2] https://www.supremecourt.gov/DocketPDF/20/20-947/168867/20210212112729193_Amicus%20Brief%20of%20Multistate%20Tax%20Commission.pdf
[3] Id.
[4] I previously discussed the Noell Industries, Inc. case in a writing entitled “State Income Tax of Trusts and Estates – Late 2020 Update,” https://esapllc.com/te-salt-2020-update/. This is a continuation of a related writing entitled “Where does your Trust Reside? State Income Tax Implications,” https://esapllc.com/where-does-your-trust-reside-state-income-tax-implications/. While state taxation of partnerships has many differences from state income taxation of trusts, issues relating to pass-through treatment for partners/beneficiaries, tiered ownership complications, constitutional nexus requirements, and other important aspects substantially overlap.
[5] All of the items discussed in this section may be found via links available at the Project website at supra Note 1.
[6] https://www.mtc.gov/MTC/media/Partnership/Slides-Partnership-Project-August-31-2021_1.pptx
[7] See supra Note 4.
[8] Quill Corp. v. North Dakota, 504 U.S. 298 (1992) and Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).
[9] Mobil Oil Corp. v. Comm’r of Taxes of Vt., 445 U.S. 425 (1980); Exxon Corp. v. Dep’t of Revenue of Wis., 447 U.S. 207 (1980); ASARCO v. Idaho State Tax Comm’n, 458 U.S. 307 (1982); Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983); F. W. Woolworth Co. v. Taxation and Revenue Dep’t of N.M., 458 U.S. 354 (1982); Allied-Signal v. Dir., Div. of Taxation, 504 U.S. 768 (1992); and MeadWestvaco Corp. v. Ill. Dep’t of Revenue, 553 U.S. 16 (2008).
[10] Noell Industries, Inc. v. Idaho State Tax Commission, 470 P.3d 1176 (Idaho 2020).
[11] Id.
[12] Id.
[13] Allied-Signal, 504 U.S. at 787.
[14] MeadWestvaco, 553 U.S. at 29.
[15] Quill, 504 U.S. at 307.
[16] MeadWestvaco, 553 U.S. at 25.
[17] https://www.supremecourt.gov/DocketPDF/20/20-947/165886/20210111141133783_2021.01.11%20-%20Petition.pdf
[18] BIS LP, Inc. v. Dir., Div. of Taxation, 26 NJ Tax 489 (Super.Ct.App. Div. 2011).
[19] Blue Bell Creameries v. Roberts, 333 S.W.3d 59 (Tenn. 2011)
[20] Mobil Oil Corp. v. Comm’r of Taxes of Vt., 445 U.S. 425, 440-441 (1980).
[21] Exxon corporation v. Wisconsin Department of Revenue, 447 U.S. 207, 223-224.
[22] Corrigan v. Testa, 73 N.E. 381 (2016); later distinguished and limited by T. Ryan Legg v. Testa, 75 N.E.3d 184 (2016).
[23] And, relevant to these issues is that some states with income taxes have exemptions for the sale of domestic entities. For example, in my home state of Mississippi, we have an exemption for the sale of interests in domestic partnerships held for more than one year. See Miss. Code Ann. § 27-7-9(f)(10).
