STATE AND LOCAL TAX ISSUES RELATING TO PASS-THROUGH ENTITIES

The U.S. allows pass-through treatment for partnerships and limited liability companies for federal income tax purposes. The issue remains how such entities and their owners will be taxed in those states and localities that impose income taxes. Most states and localities will respect the pass-through treatment of pass-through entities when applying their local income taxes. However, there are other state and local tax issues and consequences that relate to pass-through entities that can yield surprising or unexpected results. A recent article discusses some of these.

In regard to taxes imposed directly on the entity, some states will still impose entity level taxes on pass-through entities. Examples include the New Hampshire business profits tax, Tennessee corporate excise and franchise taxes, New York City taxes on ‘S’ corporations and unincorporated entities, and the Texas margin tax on limited liability entities.

States may also impose substantial fees on the entities. These may be based on dollar amounts per member, a percentage of income or assets, or a flat annual fee. At times, if the fees are material enough, they could be subject to challenge under Constitutional apportionment principles.

States and localities may impose estimated and/or withholding taxes on nonresident owners. These taxes may be imposed without regard to actual distributions from the entities, can create real cash flow issues for entities, could put entities at risk of violating loan covenants that restrict distributions or expenditures to or for the benefit of owners, and can create disproportionate distribution issues since such taxes are often not imposed on all owners.

A related and somewhat complex issue is state and local income taxes of owners on the income of the entity. Different regimes may impose different results based on residency of the owners, residency of the entity, types of income incurred, and may create double taxation issues when full credit for taxes imposed by other jurisdictions is not granted.

Clearly, tax planning for pass-through entities cannot be limited to federal taxes - applicable state and local tax issues also must be reviewed.

State Taxation of Taxation of Partnerships, Limited Liability Companies, and Their Owners, Business Entities (WG&L), Sep/Oct 2009 by Carolyn Joy Lee, Bruce P. Ely, and Dennis Rimkunas

NEXT IN THE IRS' SIGHTS - HIGH NET WORTH INDIVIDUALS

Basking in the glow of the recently completed offshore voluntary compliance program, IRS Commissioner Shulman in a recent speech revealed a new direction for IRS enforcement - high net worth individuals. The Commissioner noted the recent formation of a Global High Wealth Industry group housed in its Large and Mid-Size Business operating division. The IRS is concerned that the complicated legal structures of high net worth individuals often mask aggressive tax strategies.

Areas of possible abuse cover a large gamut of legal and tax structures, including trusts, real estate investments, royalty and licensing agreements, revenue-based or equity-sharing arrangements, private foundations, privately-held companies, and partnerships and other flow-through entities. For these purposes, the IRS may use taxpayers with a net worth in excess of $30 million as the target demographic of its scrutiny.

The Commissioner also indicated that the IRS will be continuing its international enforcement efforts. These efforts include increased scrutiny of annual FBARs or foreign bank and financial account reports, and updating definitions and instructions under the current FBAR rules. The IRS is also opening international Criminal Investigation offices in several new locations around the world - in Beijing, Panama City and Sydney, in addition to existing offices, such as Hong Kong and Barbados.

Remarks before the AICPA National Conference on Federal Taxation, October 26, 2009

SECTION 2053 REGULATIONS ADOPT "WAIT AND SEE" APPROACH

The IRS has issued final Regulations regarding the influence of post-death events on deductions under Code Section 2053 for claims and expenses. The Regulations intentionally adopt an interpretation under Section 2053 that events occurring after a decedent's death are to be considered when determining the amount deductible under all provisions of section 2053 and that deductions under section 2053 generally are limited to amounts actually paid by the estate in satisfaction of deductible expenses and claims.

This means that for claims against an estate that cannot be paid before the due date of the estate tax payment, estates will have to pay taxes without benefit of a deduction (except to the extent that the claims come within an exception to requirement of payment for deduction). This can have a substantial adverse effect on the estate. The ability to get a deduction LATER via a refund claim (with or without a protective refund claim if needed to keep the statute of limitations open) provides cold comfort for estates that may need to sell assets or otherwise position themselves so as to be able to make an estate tax payment that may ultimately have been needed.

The Regulations also provide guidance on other claim and expense deduction issues, including the weight to be given to court decrees, consent decrees, litigation settlements, and the like in regard to determining an amount and validity of claims against an estate, the deductibility of executor and attorneys fees, and interest on claims.

I have prepared a detailed outline of the new provisions. A Word version is available here or at http://tinyurl.com/yjz2277, and a mindmap version is available here or at http://tinyurl.com/yhfn7j6 (Adobe Reader or Adobe Acrobat is recommended to view the map).