Navigating the State Income Tax Obligations of Pass-Through Entities and Their Owners

Businesses that operate in more than one state are not only subject to each jurisdiction’s tax but must also adhere to each state’s rules for sourcing certain types of income. State income tax compliance is even more complex for pass-through entities (e.g., partnerships, limited liability companies or S corporations), which must apply varying state tax rules at the entity and individual owner levels. Below is a discussion of the states’ general approach to taxing multistate pass-through entities (PTE) and their owners.

For businesses that operate in more than one state, business activity income must be appropriately assigned among the states in which the business has a taxable presence for purposes of computing its state tax liabilities. Depending on the activity giving rise to the income and the type of taxpayer generating the income, states use different methods for distributing or sourcing income to their respective jurisdictions. For multistate income earned by a PTE, state sourcing rules vary depending on the PTE’s specific income-producing activity, and the type of partner or shareholder who ultimately receives the respective flow-through income. Additional complexities arise in tiered scenarios in which a PTE is a partner or shareholder of another PTE.

How Andersen Can Help

An in-depth analysis is required to determine the state income tax liabilities of multistate PTEs and their owners. Andersen’s State and Local Tax (SALT) team can help multistate PTEs and their owners evaluate the various state approaches to the taxation of PTE income to determine their compliance obligations and manage the impact to their business. For example, Andersen can analyze current PTE structures and recommend restructuring that will assist in providing beneficial sourcing results at the outset of an eventual sale or liquidation. Additionally, Andersen can provide an apportionment analysis to determine whether a PTE’s multistate activity is properly sourced and can recommend remedies, such as alternative apportionment, to properly reflect the PTE’s business attributable to a jurisdiction.

General State Sourcing Methodologies

States generally source multistate income based on either an apportionment methodology or an income allocation based on the taxpayer’s connection to a certain jurisdiction. Apportionment requires taxpayers to apply a ratio based on the taxpayer’s sales, payroll and/or property located in a state to their total multistate income to determine the amount of the multistate income that should be subject to tax in that state. Allocation requires that a taxpayer assign income to a specific jurisdiction based on its direct connection to that jurisdiction (e.g., allocating income from the sale of real property to the state of where the property is located). Multistate income that is apportioned must have a sufficient connection with the taxpayer’s business or operations in a state, otherwise such income will be considered non-apportionable and will be allocated to a different jurisdiction.

Sourcing of PTE Income and Transactions

Individual Partners or Shareholders

Individual partners or shareholders who receive business or apportionable income earned by a PTE based on its multistate operational activities are generally required to pay tax on their distributive share of income in the states in which the PTE operates even if the individuals are not residents of these states. The amount of PTE income on which a nonresident individual partner or shareholder must pay tax is based on a look-through approach in which the amount of the nonresident’s sourced income will be based on the PTE’s own sourcing at the state level (i.e., via apportionment or allocation).

Individuals who receive PTE income that is not connected to the PTE’s general business activities (i.e., nonbusiness income) will source this income to their state of residence absent a separate and distinct connection between the individual and the income that would subject the individual to tax in another jurisdiction. Such assignment of income from the sale of a PTE interest and other PTE nonbusiness income is akin to the state tax treatment of an individual’s passive investment income such as dividends, capital gains or the gain from the sale of securities such as stocks, which are all typically sourced to an individual’s state of residence due to the lack of a taxable connection to any other state.

Individual partners or shareholders of multistate PTEs can pursue various options to minimize their liabilities associated with PTE income. These options include determining whether a PTE and corresponding individual owners would benefit from electing to pay tax at the entity level in the various states that have enacted pass-through entity taxes. Additionally, Andersen’s SALT Team can assist in ensuring that an individual owner has properly analyzed his or her residency profile and can assist the owners undergoing a change in their residency to ensure that any investment income received from PTEs is sourced to a low tax or no-income-tax state.

Corporate Partners or Shareholders

Corporate partners or shareholders are often required to adhere to different sourcing rules than individuals since they may not necessarily source all their passive investment or nonbusiness income to their corporate domicile or headquarters. Additionally, unlike individual partners, corporate partners have their own apportionment factors due to their own independent multistate business activities and therefore must determine whether to utilize their own apportionment factors, the PTE’s factors or a hybrid of both to determine how much of their distributive share of the PTE’s multistate business income that flows up to a corporate partner should be apportioned to a particular state.

Tiered Structures

In tiered structures where PTEs have other partnerships or other PTEs as partners, sourcing methodologies for income earned becomes more complex as an analysis of both the lower-tier PTE and upper-tier PTE is required. In many states, it is imperative to analyze the income earned by the lower-tier PTE that flows up to the upper-tier PTE and what relationship the income has to the upper-tier PTE’s business and operations. Generally, if it is determined that the income flowing up to the upper-tier PTE from the lower-tier PTE is business income to the upper-tier PTE that is subject to apportionment, the ultimate partners, the upper-tier entity will be required to source their income as if they had realized the income directly as the upper-tier partnership themselves. A determination that the income flowing through from a lower-tier PTE to an upper-tier PTE is considered business income to the upper-tier PTE is often accompanied by a finding that the lower-tier PTE and upper-tier PTE are in a unitary relationship. A unitary relationship exists when both PTEs have (1) a flow of value between their operations, (2) some form of contribution to each other or dependency upon one another, and/or (3) have intercompany control present among each other. Commonly, the sales of a lower-tier PTE’s assets by an upper-tier PTE will be considered apportionable business income with the upper-tier PTE’s partners or shareholders using the same sourcing methodology.

Conversely, income that flows up from a lower-tier PTE to an upper-tier PTE that is nonbusiness income will usually be allocated to the upper-tier partners or shareholders based on the specific allocation or assignment rules applicable to each type of taxpayer. As discussed above, individuals will likely source such income to their state of residence, while corporate partners will be required to allocate the income based on their specific state assignment rules (i.e., commercial domicile, headquarters state or other).

Sourcing Gains (Losses) from Sales of Partnership Interests

An analysis of a tiered structure is usually coupled with an analysis of income sourcing from the gain of a sale of lower-tier PTE interest and may implicate some form of unitary analysis. For example, an upper-tier partnership will sell a partial or full interest in a lower-tier partnership, requiring the upper-tier partnership as well as its ultimate partners (e.g., a nonresident individual partner and/or a corporate partner) to determine the appropriate sourcing of income from the upper-tier partnership’s sale of its lower-tier partnership. Typically, if the upper-tier’s relationship and involvement in relation to its interest in the lower-tier partnership is that of passive investor, the income from the sale of the interest in the lower-tier partnership will be nonbusiness income. This will allow nonresident individual partners of the upper-tier entity to source their income to their state of residence, while corporate partners are required to use specific state assignment rules.

The Takeaway

Determining the state income tax liabilities of multistate PTEs and their owners is a complex process. While general distinctions of sourcing passive investment income and operational business income are commonly applied among the states, an in-depth analysis to determine the extent of the business activities and connections between the PTEs and ultimate partners is required to properly establish what sourcing provisions apply. To find out more about how different state approaches to taxing PTE income and transactions may impact your business, contact a member of Andersen’s SALT Team.