Alabama—Nexus over nonresident member unnecessary when enforcing composite income tax
Chief Administrative Law Judge Bill Thompson of the Alabama Department of Revenue upheld the imposition of the state’s mandatory composite income tax on an Alabama LLC owned in part by a nonresident who resided abroad. In his ruling, Judge Thompson reasoned that it was irrelevant whether the state had jurisdiction over the nonresident member, who lived in Greece, because the statutory composite filing/payment requirement was imposed on the LLC, which clearly had a sufficient nexus with the state to permit Alabama to enforce collection of the tax through the composite filing. Citing International Harvester Co. v. Wisconsin Dep’t of Taxation, 332 U.S. 435 (1944), Judge Thompson explained, “I agree with the Taxpayer’s representative that Alabama’s composite return and payment provisions were enacted … to avoid the jurisdictional problems involved in taxing a nonresident partner or member. But such provisions are clearly constitutional, and while the tax is measured by the nonresident’s distributive share of the entity’s income, it is levied on the in-state entity.” Tsitalia LLC v. Alabama Dep’t of Rev., Admin. L. Div., Dkt. No. BIT. 12-492 (Feb. 1, 2013).
Observation: In International Harvester, the U.S. Supreme Court upheld a Wisconsin statute that required an in-state corporation (International Harvester) to withhold and remit Wisconsin income tax on dividends it paid to out-of-state stockholders who themselves had no nexus with the state. The Court indicated that “[p]ersonal presence within the state of the stockholder-taxpayers is not essential to the constitutional levy of a tax taken out of so much of the corporations’ Wisconsin earnings as is distributed to them.” This decision serves as the legal foundation for the ubiquitous state income tax withholding requirements today.
Alabama—But nonresident individual LLC member may not be personally assessed for income tax due
In another Alabama Administrative Law Division decision, however, Judge Thompson ruled that while the state had authority to collect income tax from an Alabama-based PTE, that authority did not extend to the PTE’s nonresident owners. Thus, Alabama could not personally assess income tax against an individual who resided and worked in Minnesota and received income from an Alabama-based LLC because the taxpayer had no contacts in, or connections with, Alabama other than being a member of and receiving income from the LLC. Applying the Alabama Court of Civil Appeals’ landmark decision in Lanzi v. State Dep’t of Rev., 968 So. 2d 18 (Ala. Civ. App. 2006), cert. denied, Ala. S.Ct., Case No. 1051475 (Apr. 13, 2007), Judge Thompson held that Alabama could have assessed the tax against the PTE but cannot assess the tax against the nonresident member personally. As such, the final assessment was voided. Vogt v. State Dep’t of Rev., Admin. Law Div., Dkt. No. INC. 11-660 (Jan. 3, 2013).
Alabama—Registration with Secretary of State constitutes nexus
Alabama Chief Administrative Law Judge Thompson ruled that an LLC organized in the state but inactive since December 2007, though never dissolved, was subject to the minimum annual $100 business privilege tax, along with interest, for 2007-2012. Pointing to the state’s statute that imposes a privilege tax filing requirement on any corporation or LLC “doing business in Alabama, or organized, incorporated, qualified, or registered under the laws of Alabama,” Judge Thompson explained that “[b]ecause the Taxpayer was registered with the Alabama Secretary of State’s office from 2007 until 2012, it was qualified to do business in Alabama in those years, and thus liable for the minimum $100 business privilege tax in those years.” Interestingly, Judge Thompson waived the associated penalties. Old Lodge Catering, LLC v. Ala. Dep’t of Rev., Admin. Law Div., Dkt. No. BPT. 12-1402 (Mar. 27, 2013).
Observation: A 50-state survey conducted by Bloomberg BNA earlier this year revealed that 13 states take the position that the mere act of registering to do business is sufficient to trigger an income tax filing/payment obligation in the state. However, not all states agree. In Rylander v. Bandag Licensing Corporation, 18 S.W.3d 296 (Tex. App. 2000), for example, the question arose as to whether qualification to do business in a state, without more, was a sufficient basis for a state to assert jurisdiction. The Texas appeals court held that the Commerce Clause and Due Process Clause prohibited a state from asserting franchise tax jurisdiction over a corporation that had merely qualified to do business in a state without engaging in any other activity there. Bloomberg BNA 2013 Survey of State Tax Departments: Key Findings and Analysis, Vol. 20, No. 4 (Apr. 26, 2013).
California—General partner deemed to be doing business in state
A California State Board of Equalization (“SBE”) decision held that the taxpayer, a Nevada corporation, was liable for the state’s minimum franchise tax. The taxpayer was a managing partner of Horizon, a Nevada limited partnership. One of Horizon’s other general partners was USA Properties, a corporation located in California and registered with the California Secretary of State. The SBE held that Horizon was doing business in California through USA Properties because Horizon’s activities were attributable to a California corporation. The SBE explained: “When a corporation (here, appellant) is a general partner of a partnership doing business in California (here, Horizon), the corporation is considered to be doing business in California.” Thus, the SBE concluded that the Franchise Tax Board properly imposed late filing and demand penalties. Appeal of SUP, Inc., SBE, Case No. 571262 (Nov. 14, 2012, released March 7, 2013) (not to be cited as precedent).
Observation: Based on Bloomberg BNA’s recent 50-state survey, most states currently take the position that owning an interest in a PTE is in itself sufficient to create nexus. According to the survey, only two states—Vermont and West Virginia—responded that a general partnership interest would not trigger nexus. In Appeal of SUP, however, California took the position one significant step further by attributing the in-state activities of one general partner to the other. Incredibly, the BNA survey further indicated that all but six states take the position that nexus could arise from owning a non-management interest in an LLC. It is difficult to square these positions with the Due Process Clause of the U.S. Constitution, which ensures that a nonresident have advance notice before being subjected to judicial jurisdiction, unlike the Commerce Clause (which was devised to preempt burdens on interstate commerce). In 2011, the Supreme Court renewed its focus on the Due Process Clause in ruling that J. McIntyre Machinery, Ltd., a Great Britain machinery manufacturer, was not subject to personal jurisdiction in the state court of New Jersey (i.e., did not have nexus), even though an individual was injured in New Jersey using a machine manufactured by the company. J. McIntyre Machinery, Ltd. v. Nicastro, 131 S. Ct. 2780 (2011). The McIntyre decision affirms earlier Supreme Court due process jurisprudence holding that an out-of-state actor must purposefully target a particular forum (i.e., state) in order for the state to properly assert jurisdiction. Phrased in tax terms, in order for a state to assert jurisdiction over an out-of-state taxpayer and enforce the collection of tax, the nonresident must have purposefully directed its activities toward that particular state. In a recent ruling, a Kentucky federal court held that an ownership interest in an LLC that was conducting business within the state alone was insufficient to establish personal jurisdiction for the individual owners under the Due Process Clause. United States v. Bacara Partners, LLC, 109 A.F.T.R.2d (RIA) 2357 (May 31, 2012). Although this was not a case deciding taxpayer nexus under the Due Process Clause, the holding should signal to taxpayers that a mere ownership interest in a PTE should not create a due process tax nexus with a taxing jurisdiction. On April 25, 2013, the case was dismissed with prejudice due to the taxpayer’s settlement.
That this Due Process Clause argument was not mentioned in the SBE opinion is not surprising given the fact that the SBE does not have jurisdiction to consider whether a California statute or regulation is invalid or unenforceable under the U.S. or California Constitutions unless a federal or California appellate court has already made such a determination.
California—60,000 LLCs expected to receive non-filing notices
Each year, the California FTB contacts over 150,000 corporations through a Delinquency Control (“DLC”) program. Under the program, corporate taxpayers that are incorporated or qualified to do business in California but have not filed a return receive a notice. Annually, the program generates over $50 million in revenue for the state. The DLC Program has been expanded to include LLCs as of January 1, 2013. By expanding the DLC program to include LLCs, the FTB estimates an additional 59,000 taxpayers will be contacted per year. According to an FTB budgetary report made available to the public, “[t]he additional contacts will result in approximately $21 million in total revenue during the first 5 fiscal years and increasing to more than $7 million in annual revenue in later fiscal years.” Non-filers will receive a “Request for Past Due Return” notice 60 days after the extended due date of the tax return and, if the business still fails to file, an official “Demand for Past Due Return” notice, after which the business entity’s account enters the collection cycle. The FTB may also suspend a domestic entity or forfeit a foreign organization’s rights and privileges for failure to file returns and pay taxes due. California FTB Tax News December 2012.
Observation: California is stepping up its enforcement of LLC tax compliance. Under the state’s general filing requirement, an LLC—whether taxable as a partnership or disregarded federally—is required to file California Form 568 and pay the $800 annual tax if it is either (1) organized in California, (2) registered with the California Secretary of State to transact business in the state, or (3) doing business in the state. A taxpayer is “doing business” in the state if it actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California, or meets any of the state’s apportionment factor presence tests based on property, payroll, or sales in the state. Additionally, a foreign (i.e., non- California), nonregistered LLC that is a member of an LLC doing business in California, or is a general partner in a limited partnership doing business in California, is considered to be doing business in the state. Even if an LLC is a limited partner, if it exceeds the apportionment factor threshold mentioned above, it is considered to be doing business in the state.
Separately, the LLC may also be required to pay the LLC graduated flat fee, ranging from $900 to $11,790, based on its gross receipts. LLCs must pay the fee if any of the following conditions apply: (1) the LLC is organized in California; (2) the LLC is registered with the California Secretary of State to transact business in the state; or (3) the LLC is doing business in the state. The fee is only required, however, if total California annual income is at least $250,000. The fee is based on total California-source income rather than on worldwide total income. Unlike the $800 LLC tax, an LLC owner is required to remit the LLC gross receipts fee only if it has its own independent California operations, and only to the extent of its own activities.
Note also that California requires that quarterly estimated payments generally be paid on behalf of nonresident owners who exceed a de minimis distribution of California-source income, as well as a nonconsenting nonresident (“NCNR”) tax on the distributive share of California-source income received by nonresident LLC members.
Illinois—Nonresident partner who received guaranteed payments from Illinois partnership had nexus
The Illinois Department of Revenue ruled that an out-of-state individual taxpayer, whose only connection to the state was his receipt of guaranteed payments from a partnership operating in Illinois, had sufficient nexus with the state to be subject to Illinois income tax. The taxpayer had requested confirmation from the state that he did not have an Illinois filing obligation based on the fact that, in his words, he did not own property in state, had never visited the state, and did not possess an ownership interest in the PTE operating in the state. The Department rejected the taxpayer’s request, pointing out that he received an Illinois K-1-P, Partner’s Share of Income, Deductions, Credits, and Recapture, from the Illinois partnership indicating his receipt of guaranteed payments related to Illinois-source business income. The Department added that “guaranteed payments received by a nonresident partner from a partnership doing business in the state are subject to the state’s income tax, even when the partner has no other connection with the state.” The Department further explained the partnership’s duty to withhold income tax on those payments. Illinois Dep’t of Rev. General Information Letter No. IT 12-0028-GIL (Sept. 27, 2012).
New Jersey—Due Process Clause prohibits state from taxing resident shareholders on out-of-state income
This New Jersey Tax Court decision involved a New Jersey resident trust. Beginning in 2006, a New York resident served as the sole trustee of the trust, which he administered exclusively outside New Jersey. During 2006, the trust owned cash, bonds, and stock in four S corporations, each of which conducted business in New Jersey. The S corporations issued the trust a Schedule NJ-K-1 reporting the S corporations’ share of income/loss allocated to New Jersey—around $3 million of the approximately $5 million the trust received. The trust also reported approximately $100,000 in interest income, none of which was allocated to New Jersey. Thus, the trust paid tax on its pro rata share of S corporation income allocated to New Jersey but did not pay tax on the interest income or on the net pro rata share of S corporation income allocated outside the state. The trust was then audited, following which New Jersey issued an assessment of approximately $200,000, including interest and penalties. The state maintained that the trust was taxable on 100 percent of its undistributed income, including its pro rata share of S corporation income allocation outside New Jersey. In contrast, the trustee argued that the trust entirely lacked sufficient contacts with New Jersey for the state to subject the trust to tax on its income allocated outside the state. The court agreed with the taxpayer, explaining:
Trust A was not administered in New Jersey and the Trustee was a resident of New York. Therefore, Trust A could only be taxed on the undistributed income if it owned assets in New Jersey, thus running afoul of the precedent set by the Tax Court in Pennoyer and Potter and the guidance adopted by the Director. … [T]he owner of stock in an S corporation does not own or hold title to the underlying assets of the corporation. … [T]his court may not apply N.J.A.C. 18:35-1.5 as written [which subjects a resident shareholder to tax on its income from all sources] and subject Trust A to taxation on its out of state income because Trust A does not have sufficient contacts with New Jersey to satisfy constitutional due process requirements.
Thus, despite the language of the taxing statute, the Tax Court held that the trust was not subject to tax on its out-of-state income because it did not have sufficient contacts with the state to satisfy constitutional due process requirements. Accordingly, the trust did not owe tax on the interest income earned in the year in question. Residuary Trust A v. Director, N.J. Tax Ct., Dkt. No. 000364-2010 (Jan. 3, 2013).
Pennsylvania—Nonresident limited partner had income tax nexus
In Marshall, Jr. v. Commonwealth, 41 A.3d 67 (Jan. 3, 2012) (on appeal), the Commonwealth Court of Pennsylvania, an intermediate appellate court, affirmed an earlier decision in which it held that a Texas individual who owned a limited partnership interest in a Connecticut-based limited partnership had nexus with Pennsylvania. The partnership incurred losses from operations for financial accounting, federal income tax, and Pennsylvania income tax purposes for each year of its existence. However, in 2005 the lender foreclosed, resulting in cancellation of indebtedness income to the partnership related to discharged nonrecourse liabilities. The court acknowledged that the Texas individual was a passive investor who never participated in the management of the partnership or its underlying property, but nevertheless concluded that the individual had nexus with Pennsylvania (which could therefore assert jurisdiction over him), explaining:
[I]mposition of the PIT on Marshall, as a limited partner of the Partnership, as a result of the disposition of the Property at foreclosure does not violate Marshall’s Due Process rights. Marshall would have us focus solely on his status as a limited partner in the Partnership and, consequently, his limited, if not nonexistent, right to control the Partnership’s business affairs. That, however, is a superficial analysis. Marshall did not simply passively invest in a Connecticut limited partnership, as one would trade stocks on a stock exchange. To the contrary, he invested in a specific and limited purpose Connecticut limited partnership, whose “primary purpose was ownership and management” of a substantial commercial property in the City of Pittsburgh—“a sixty-four story office tower and related site improvements, known as the United States Steel Building ... and the underlying parcel of land of approximately 2.676 acres.” The investment objectives and policies of the Partnership were directed to maximizing the partners’ return on their investment through the Partnership’s ownership of the Property. Marshall knew all of this when he chose to invest in the Partnership as a limited partner. He purposefully availed himself of the opportunity to invest in Pennsylvania real estate through a partnership. These are sufficient minimum contacts for the imposition of a tax on Marshall and his fellow partners upon disposition by the Partnership of the Property.
As a result, the court affirmed a Board of Finance and Revenue decision that the Texas individual owed personal income tax to Pennsylvania on his distributive share of discharge of indebtedness income resulting from the foreclosure of commercial property owned by the partnership in Pittsburgh.
Observation: Many tax nexus judicial decisions to date have provided only a cursory analysis of due process considerations, focusing more on Commerce Clause nexus. In contrast, Marshall focuses on the due process requirement that a nonresident (here, Texan Robert Marshall), “purposefully avail” himself of the benefits and protections of a forum (here, Pennsylvania) in order for the forum to assert jurisdiction over the nonresident. In other words, the Texas individual must consciously direct his activities toward Pennsylvania; otherwise, it would violate his due process rights for Pennsylvania to assert jurisdiction over him. One would expect that in many, perhaps most, cases, a passive limited partner would have no specific knowledge of where the partnership in which the limited partner invests intends to operate. For that reason, the Commonwealth Court was careful to analyze the partner’s knowledge of Pennsylvania activities in which the limited partnership would be involved at the time the nonresident invested in the partnership.
Oddly, no mention is made in the decision of nonresident withholding. Pennsylvania began requiring pass-through entities to withhold and pay quarterly personal income tax for nonresident owners that are individuals, estates, or trusts for tax years beginning on or after January 1, 1992.
Finally, it is also worth noting the apparent disparity in treatment of the partnership’s nonresident investors compared to its Pennsylvania owners. While the Pennsylvania resident partners were permitted to offset their share of the gain on foreclosure with the loss on liquidation, the nonresident partners were not permitted to recognize the loss on liquidation for Pennsylvania tax purposes. The court’s explanation was that intangible assets, such as a limited partnership interest, typically reside where the holder is domiciled, with the result that any gain or loss resulting from the disposition of a limited partnership interest owned by a nonresident would not be sourced to Pennsylvania.
Tennessee—Chancery court holds that general partner had nexus
A Tennessee Chancery Court held that Vodafone, a British company that owned a 45 percent (non-managing) general partner interest in Cellco Partnership d/b/a Verizon Wireless, a general partnership, was doing business in Tennessee (i.e., had nexus) and therefore was subject to the state’s franchise/excise tax. During the relevant period, Verizon Wireless continuously and systematically engaged in the wireless voice and data business in Tennessee. According to the trial court, “a general partner of a general partnership doing business in Tennessee is present in Tennessee, is doing business in Tennessee, and meets all constitutional requirements for taxable nexus with Tennessee through the activities of the general partnership in Tennessee.” Vodafone Americas Holdings, Inc. v. Roberts, Tenn. Chancery Ct., Case No. 07-1860-IV (Mar. 19, 2013) (on appeal).
Observation: Vodafone illustrates a common view among the states that the activities of a general or limited partnership or LLC may be attributed to the general partner/managing member in all events. Expressed in due process terms, if a partnership is directing its activities toward a particular state, then the general partner or managing member must be consciously directing its activities toward that forum by virtue of its management role. While this may often be the case, it is not invariably true. As the Marshall decision illustrates, a limited partner, though passive by nature, could nevertheless purposefully direct its activities (e.g., the deployment of capital) toward a particular jurisdiction. It is similarly possible that a general partner, though possessing limited managerial rights, does not necessarily exercise managerial rights with respect to a decision to operate within a state and may be unaware of the partnership’s activities within that forum. Consequently, depending on the facts, the Due Process Clause may prohibit a state’s assertion of jurisdiction over the general partner. Vodafone filed a similar refund suit in Florida but that case has been settled by the parties.
Co-author - Patrick Smith, Director Baker Tilly Virchow Krause, LLP
Mr. Ely is a partner and Messrs. Thistle and Rhyne are associates with the multistate law firm of Bradley Arant Boult Cummings LLP in its Birmingham, Alabama office. Mr. Ely is Chair of the firm’s State & Local Tax Practice Group. Messrs. Ely, Thistle, and Rhyne co-author a chapter on the state taxation of PTEs in the treatise “Keatinge, Conaway and Ely on Choice of Business Entity” (West). Mr. Smith is the Tax Director at Baker Tilly Virchow Krause, LLP and is head of State & Local Tax Services for the firm’s Chicago office. Mr. Smith is a co-author of “State Taxation of Pass-Through Entities and Their Owners,” a treatise published by Warren Gorham and Lamont/West since 2005. Messrs. Ely and Smith have co-presented on this topic at NYU’s Institute on Federal Taxation, as have Messrs. Thistle and Smith for a webinar hosted by Strafford Publications in early June.