State Tax Treatment of Foreign Corporate Partners and Llc Members after Check-the-Box

Abstract

Despite the rapid rise in the use of pass-through and disregarded entities since the advent of the federal check-the-box regulations, states have done little to adapt their taxing regimes to address issues raised by these entities, other than generally following the federal entity classification rules. While state adoption of the check-the-box regulations is intended to simplify matters for both taxpayers and tax administrators, a simple "me too" approach to these regulations leaves some holes into which taxpayers may tumble. One of the largest, and the one currently creating the most debate, concerns the question of whether a foreign corporate owner of a pass-through or disregarded entity will have nexus in a state based solely on that ownership interest.

There has long been debate as to whether a corporate limited partner automatically has nexus in a jurisdiction based solely on the fact that the limited partnership is doing business (and thus has nexus) in the state. Corporate limited partners have argued that a limited partner's control over a partnership is equivalent to a shareholder's control over a corporation and that limited partners and shareholders therefore should be treated similarly for nexus purposes. Now the same question is being asked with regard to corporations owning other limited liability entities that may elect to be treated as partnerships or disregarded entities for tax purposes.

There is also disagreement among the states as to whether corporate owners of entities electing partnership treatment should include their proportionate shares of the income and apportionment factors of these pass-through entities in their own tax bases and apportionment formulas when calculating state income tax or instead include only their distributive shares of partnership income. This decision often, but not always, revolves around the question of whether the partner and the partnership are engaged in a unitary business. In addition, not all states are in agreement as to how corporate owners should treat the sale of their interest in a pass-through entity when calculating income and apportionment factors (e.g., Does the gain from such a sale generate apportionable business income or allocable nonbusiness income?).

This Article will address some of the unanswered questions raised by the states' adoption of the federal check-the-box rules for state tax purposes, and it will also survey the general landscape of state taxation of corporate owners of pass-through or disregarded entities, which is often swampy and occasionally treacherous. For purposes of this Article, discussion will be limited to the treatment of corporate owners of partnerships (both general and limited) and LLCs (both single- and multi-member), although some of these same issues exist in relation to other pass-through entities (e.g., S corporations), and also to individual owners of partnerships and LLCs). Before delving into the substantive questions, the Article will provide some background into the formation and operation of partnerships and LLCs and the general federal and state tax treatment of each.