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Checking Oneself Into a Box: State Tax Issues For Federal See-Through Entities

Two federal income tax developments occurred last year which have a profound effect on classic "choice-of-entity" decisions. August 20, 1996 saw the enactment of the Small Business Jobs Protection Act of 1996, which included new rules permitting S corporations to own subsidiary corporations that, for federal income tax purposes, will not be considered to be separate corporations. Then, on December 17, 1996, the Treasury Department finalized "check-the-box" regulations that (among other things) passed a similar cloak of invisibility over certain single-member LLC's.

From the perspective of tax planning, the introduction of these "see-through" entities is revolutionary, providing myriad opportunities, and great flexibility, for federal tax planning. But while the federal tax law now ignores the separate existence of these see-through entities, they are nonetheless very much alive under local law. It is therefore an oversimplification -- and sometime a dangerous one -- to assume that the federal Subchapter S legislation or the Check-the-Box regulations translate into see-through status for state and local tax purposes, or that such status will be desirable for state income or excise tax purposes.

This article poses a variety of questions that arise with respect to the state taxation of see-through entities. Because the crazy-quilt of state and local taxation is so complex, and the arrival of see-through entities so recent, it will take years to surface all of the issues, let alone develop comprehensive answers. And because the tax regimes of different states, and even the various taxes within a state, can be premised on fundamentally divergent policies, answers developed in one jurisdiction or under one tax may not be readily exportable to another.

At this stage in the development of the law, therefore, the mission is to identify the issues, and to ensure that the vagaries and unknowns of state and local taxation do not throw an unexpected monkey wrench into an otherwise lovely plan. To assist in this mission a variety of questions about the state and local tax treatment of see-through entities are outlined below. I offer this outline secure in the knowledge that it will grow over time, as more uses for see-through entities develop, and the unknowns of their state and local tax characters become better identified.

1. The Operative Federal Tax Rules

The see-through single-member LLC ("SMLLC") is a creation of the classification regulations issued by the Treasury Department under Internal Revenue Code Search7RH7701. Regulation section 301.7701-2(a) provides as follows:

"A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner."⁽¹⁾

The see-through qualified subchapter S subsidiary ("QSSS") arises under Code Search7RH1361(b)(3). That section now provides that, for purposes of the Internal Revenue Code,

"(i) [a] corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation, and

(ii) all assets, liabilities, and items of income, deduction and credit of a qualified subchapter S subsidiary shall be treated as assets, liabilities, and such items (as the case may be) of the S corporation."⁽²⁾

A corporation is a QSSS if it is 100% owned by an S corporation and that S corporation elects to treat the subsidiary as a QSSS. As clarified in the Blue Book,⁽³⁾ QSSS status can flow through chains of 100% owned corporations, provided each link in the chain is a QSSS. An S corporation need not elect QSSS status for all 100%-owned subsidiaries, however, and may be both a shareholder in a C corporation and the deemed owner of the assets, etc. of its QSSS's.

The Blue Book and other subsequent developments indicate that Congress was a bit too over-expansive in providing that the QSSS would be disregarded for all purposes; issues have already surfaced regarding the appropriate treatment of Excess Loss Accounts⁽⁴⁾ and special bank tax rules.⁽⁵⁾ Nevertheless, while the concept may require fine tuning, the articulation of see-through status in Search7RH1361 probably stands as the best explanation of the essential federal tax nature of these two new creatures, which is:

(i) The SMLLC or QSSS itself does not exist; and

(ii) All of the attributes of the SMLLC or QSSS reside in its owner.

2. See-Through Entities Are Not Nothings

We all know that federal tax law lies at the heart of the universe. Nevertheless, things that have no income tax existence still can lead productive and significant lives in alternate universes. A QSSS is formed under state corporate law, and possesses all of the well-established characteristics of duly formed corporations, notwithstanding the income tax mumbo jumbo that makes it disappear. Similarly, an SMLLC will be formed under state law, and will share with its sister LLCs whatever attributes are provided under that law, irrespective of whether the LLC is a nothing, a partnership or a corporation for income tax purposes. Outside of the federal tax law, therefore, see-through entities will be very much alive.

Two simple examples help bring that point home. First, while the income tax attributes all of the liabilities of an SMLLC or QSSS to its owner, it is clear that under local law neither the owner nor the property interest of the owner (stock or the LLC interest) is liable for or subject to the debts of the see-through entity.⁽⁶⁾ Second, while the income tax may deem the member or shareholder to own all of the entity's assets, the rest of the world will deal with the entity as the owner of such assets; no one should, for example, accept a deed to SMLLC property from its member.⁽⁷⁾

Moreover, the rights and relationships provided to juridical entities under the relevant state law may be of considerably greater significance to certain aspects of state and local taxation than federal tax classification is. As discussed more fully below, long-established concepts of nexus have generally eschewed attributing nexus to shareholders based on corporate presence,⁽⁸⁾ yet generally attributed nexus to partners based either on aggregate principles or on principles of mutual agency.⁽⁹⁾ A federal tax rule that deems an S corporation to own the assets of its subsidiaries does not necessarily mean that there now is Constitutional nexus between that S corporation and the states in which the QSSS (but not the S) is present.

The existential problem of being a nothing for some purposes and something for others is the seed of many questions. In addressing the unknowns it is important to be respectful of that dichotomy, for it can hold the key to the outcome.

3. Issues in State and Local Income Taxation

a. Basic Classification Issues

Generally, the first state and local tax issue see-through entities bring to mind is one of conformity. How do the states and localities with taxing jurisdiction over the see-through entity and/or its owner classify them? Surveying the states (and New York City which, at least in the area of taxation, has aspirations to statehood) one finds three general patterns -- conformity, intentional nonconformity, and waffling. A brief foray into the tax laws of New York, California and Florida illustrates these patterns.

Both New York State and New York City have published guidance stating that they will conform to the federal classification of SMLLC's in applying their corporate, personal and unincorporated business income taxes. In a 1996 Advisory Opinion,⁽¹⁰⁾ the New York State Department of Taxation and Finance opined that:

"Since it has been established that the classification of an LLC for New York State tax purposes will follow the classification accorded the LLC for income tax purposes, New York State would follow the federal classification of an LLC under [the proposed check-the-box regulations].

Following federal conformity with respect to classifying LLC's, a single member LLC which . . . does not make the election for federal income tax purposes [to be treated as a corporation], would not be classified as an entity separate from its owner. If its owner is a corporation, it would be considered a branch or division of the owner corporation."

An "Addendum to Instructions" for the New York City general corporation tax ("GCT") and unincorporated business tax ("UBT") issued by the City in early March states that:

"Eligible entities having a single owner that elect under the 'check- the-box' rules, either affirmatively or by default, to be disregarded and treated as a branch or sole proprietorship will be similarly treated for New York City tax purposes. The activities of such a single owner eligible entity in New York City will be considered activities of the owner for purposes of determining whether the owner is subject to the GCT, Banking Corporation Tax, Utility Tax or UBT."

The City's acknowledgment of conformity to the federal classification rules follows a 1996 amendment to the City's tax law which changed the definition of "corporation." Previously, the City's general corporation tax defined "corporation" simply to include incorporated entities, joint-stock companies and associations, and certain trusts.⁽¹¹⁾ Last year's amendment changed that provision to define "corporation" to include "an association within the meaning of [Code Search7RH7701(a)(3)] (including a limited liability company)."⁽¹²⁾ The 1996 amendment modernized the City tax law, in the process bringing unincorporated associations into the corporate fold⁽¹³⁾ while clarifying that entities that are not taxable as corporations under federal law also are not covered by the City's GCT. The City's UBT generally applies to all businesses conducted in the City, but excludes "any entity subject to tax under [the GCT]."⁽¹⁴⁾ The effect of the 1996 amendments can therefore be said to be the conforming of City income tax classification rules to the federal.

The foregoing pronouncements clearly show that the income tax classification of SMLLC's in New York will conform to the federal classification. Moreover, both the State's TSB and the City's Instructions are fairly comprehensive in stating that SMLLC's are disregarded "for tax purposes." Whether the scope of the see-through treatment of SMLLC's is in fact so broad is considered in various contexts discussed below.

Neither the TSB nor the Instructions address the topic of QSSS. Indeed, the see-through status of a QSSS in New York is not yet clear.

The State's published analysis of the 1996 federal tax legislation ducked on the question of QSSS conformity. In a document analyzing New York State's conformity or nonconformity with various provisions of the 1996 legislation, the Office of Counsel stated that "[p]olicy decisions are required stemming from the inherent conflict between the federal approach, that the S sub is not viewed as a separate entity from the parent, and the 9-A franchise tax theory, that a franchise tax is required from each corporation for the privilege of the franchise. The 9-A theory also requires dealing with situations where there is not NY nexus with both parent and sub."⁽¹⁵⁾

In the context of qualified REIT subsidiaries the State issued an Advisory Opinion in 1990 which held that the REIT subsidiary was subject to minimum tax but otherwise would be disregarded, with its assets, etc. attributed to its REIT parent.⁽¹⁶⁾ Whether the State will similarly conform to the see-through status of QSSS's, imposing a minimum tax but otherwise attributing the subsidiary's items to its parent, remains to be seen. Since S corporations are subject to a small state income tax in New York,⁽¹⁷⁾ it can be important to know whether taxable S corporation income is computed by aggregating in the single parent all of the items of the various QSSS's, or whether such subsidiaries will somehow remain separate. See also part 3(c), below. Similarly it is not at this point clear whether New York will impose a separate QSSS election requirement, as it currently does for S corporations.⁽¹⁸⁾

On the New York City front things are complicated by the fact that New York City does not recognize S corporations. There is a 1990 City ruling which held, like the State, that a qualified REIT subsidiary was a separate corporation "subject to GCT in its own right," but that federal conformity mandated the attribution of all of the subsidiary's items to the parent.⁽¹⁹⁾ A comparable analysis in the QSSS area would result in the imposition of City GCT measured by the income and capital of the parent S corporation, taking into account all items of all QSSS's, with each QSSS also being liable for a small annual minimum tax.

Requiring the payment of a few hundred dollars of State and City minimum taxes each year obviously is not much of a departure from federal conformity. And the attribution of all QSSS income to the parent does seem to be the necessary result under State and City income tax statutes that define taxable income by reference to the federal income tax law. Moreover, any different system would require the creation of State and City tax returns where none exist on the federal level, a singularly undesirable result that likely will create a great deal of complexity, as well as a need to consider state or city combination (discussed below). Accordingly, while the New York State and City income tax treatment of a QSSS remains officially unresolved, the analyses underlying the REIT rulings should hold for the QSSS as well. Assuming they do, what may be most significant is the State's and City's unwillingness to ignore altogether the separate legal existence of an incorporated entity. As presaged by the State's 1996 analysis, this position may impact other tax questions as well, particularly in the nexus area (see part 4, below).

New York thus conforms on the subject of SMLLC's and probably will do so as well for the QSSS; the left coast, however, is still finding its way. On December 6, 1996, the California Franchise Tax Board issued FTB Notice 96-5,⁽²⁰⁾ in which it announced its nonconformity with the federal see-through classification of SMLLC's (as then proposed) and QSSS's. Reasoning that its tax law was grounded in the federal income tax as it existed on January 1, 1993, the FTB concluded that "any subsequent federal changes must be specifically adopted by the Legislature before they become effective for California purposes." This means that the pre-1996 requirements for S corp. qualification continue to apply in California, and the QSSS legislation does not exist in California. In addition, since California has its own set of classification regulations cast in the four-factor mode, those regulations continue to govern the classification of unincorporated entities in California. With respect to single-member LLC's, the FTB specifically stated that, under their regulations, "a single-owner entity will be taxed as a corporation."⁽²¹⁾

Since the promulgation of California's Notice 96-5 Subchapter S conformity has gained a following. Legislation currently is pending to conform California's tax law to the 1996 Subchapter S changes.⁽²²⁾ The story in California is therefore not yet told, leaving it in the "Waffling" category.⁽²³⁾ As discussed below, if California and others like it conform their tax laws to the federal many state tax pitfalls will be avoided. There will however continue to be many important questions regarding the state and local taxation of SMLLC's and QSSS's.

Florida is in some respects an intentionally nonconforming state, although it fails to conform in its own particular way. Florida does not impose any income tax on individuals. It does impose an income tax on corporations, currently at 5-½%.⁽²⁴⁾ In Florida, a "corporation" is defined to include "limited liability companies, under [Florida] chapter 608."⁽²⁵⁾

Chapter 608 is Florida's limited liability company law. Among other things, Florida requires two or more persons to form an LLC.⁽²⁶⁾ But Florida law also provides that foreign LLC's can do certain things without being considered to "transact business" in Florida, some of which (e.g., selling through independent contractors) could have tax ramifications.⁽²⁷⁾

Under Florida law, the conduct of business in Florida by an SMLLC seems to be of uncertain provenance. And if an SMLLC engages in potentially taxable activities in Florida without rising to the level of "transacting business", it also is unclear (at least to this author,) whether the SMLLC falls into Florida's corporate tax as a "limited liability company," or falls out of that tax because the SMLLC is not a "limited liability company under . . . Chapter 608." It will be interesting to see whether single-member LLC's can exist in Florida to any extent without bearing the corporate tax imposed on their multiple-member sisters.

Although Florida taxes LLCs, it does not generally impose tax on S corporations. Its income tax defines the taxable income of a corporation "for which there is in effect for the taxable year an election under s.1362(a)" as being equal to "the amounts subject to tax under s.1374 or s.1375 of the Internal Revenue Code for each taxable year."⁽²⁸⁾

QSSS status is elected under Code section 1361(b), not section 1362, and the QSSS is not itself an S corporation, but is instead absorbed into its S corporation parent. As a technical matter, therefore, Florida's S corporation definition of taxable income is an ill fit for QSSS's. However, because the taxable income of a corporation is defined in Florida by reference to federal taxable income,⁽²⁹⁾ that ill fit may not be a real problem. Following the New York analysis of qualified REIT subsidiaries, all of the income of a QSSS is attributed to its S corporation parent, which then can satisfy the above definition. If Florida follows the same approach neither the S corporation nor its QSSS's would be subject to the Florida corporate tax.

As the foregoing illustrates, there are a variety of patterns in states' approaches to see-through entities. Moreover, states may view SMLLC's differently from QSSS's. It is therefore important to bear in mind that even in states and localities whose income taxes are thought of as conforming to the federal tax law, one can run into problems when it comes to the classification of see-through entities. And both in states that conform to the federal characterization of SMLLC's or QSSS's, and in states that do not, questions abound.

b. Issues Arising From Nonconformity

It goes without saying that ascertaining the correct state and local law characterization of an SMLLC or a QSSS is necessary to ensure that the entity and its owner fulfill their respective filing obligations and pay the correct amount of tax. Where all of the players are confined to a single state, the classification question can involve differences in tax rates, tax computations, or administrative procedures. These need to be fully considered in choosing among one's planning options. For example, as a New York City resident I probably will prefer to conduct business through an SMLLC or chain of SMLLC's, rather than an S corporation with QSSS's, because the 4% UBT is less expensive than the 8.85% GCT the City imposes on subchapter S corporations. If I am a Floridian I should opt instead for an S corporation, in part because I am constrained in the use of an SMLLC, and in part because the Florida tax law taxes LLCs as corporations but treats S corporations as pass-throughs. In the corporate arena, if a state or locality does not conform in the treatment of QSSS's, consideration should be given to the desirability of, and qualification for, combination.⁽³⁰⁾

Once we move into the multi-state arena the stakes become even higher. When see-through entities conduct business in more than one jurisdiction, or when the see-through entity is in jurisdictions different from its owner's, discontinuities in state classification regimes can present both opportunities for avoiding state tax, and risks of multiple state taxation.

Consider for example a New York individual who owns an SMLLC doing business in California. If California considers the SMLLC a corporation it will impose corporate tax, on the California income of the SMLLC. New York, by contrast, will ignore the SMLLC and will tax the individual directly on the California income. And while New York generally gives its residents credit for taxes paid to other states on income sourced there, would a credit be available for corporate taxes paid by an SMLLC? A similar question arises with S corporations, in which context New York's personal income tax law was specifically amended to provide that resident individuals may not claim credit for "tax imposed upon or payable by the [S] corporation."⁽³¹⁾ If a state does not provide such a credit, use of an SMLLC to conduct business in a jurisdiction that does not conform can produce a double whammy.

Quite a different result can ensue where, for example, a New Yorker owns an S corp. conducting business in Florida. If the New Yorker does not make a New York S election, income of the Florida S corporation is not included in his New York taxable income. On its part, Florida imposes no tax on the S corporation or its shareholder. Putting these regimes together enables the New York owner to defer or (if he moves) escape entirely state income tax on the S corporation's Florida earnings.

Corporate-owned see-through entities also may find risks and opportunities in inconsistent state treatments of see-through entities. Under California's approach a corporate-owned SMLLC is a separate corporation. Absent a unitary relationship with its owner the SMLLC would be taxed in California on a stand-alone basis. New York, by contrast, rolls all of the SMLLC's income, assets, etc. into the corporate owner. Depending upon the composition of the payroll, property and receipts of the two entities, or their respective incomes or losses, the effects of separation in California and amalgamation in New York could be beneficial, or could be costly. For example, New York factors residing in the owner will be of no relevance in the computation of the SMLLC's California tax, and thus will not dilute the SMLLC's California apportionment factors in the same way that the SMLLC's California factors dilute the parent's New York apportionment.

As another example, under UDITPA⁽³²⁾ corporate investment income is allocated to the commercial domicile of the corporation. The commercial domicile of an SMLLC taxed on a stand-alone basis may not be considered to be the same as the commercial domicile of the "amalgamated" parent, and this could result in differing state taxation of the same income. The throwback rules may be another case in which differing tax treatment from state to state might prompt inconsistent treatment.

The examples are myriad, but the lesson is simple. Whenever the state income tax characterization of a see-through entity differs from the federal, and/or from the regime of another state, there is the possibility that planning may reduce the state income tax burden, and the risk that failing to plan will unfairly increase that burden. It is necessary not only to address the more obvious federal/state inconsistencies, but also to consider any state/state inconsistencies, looking both at the tax laws that apply to the see-through entity and the tax laws applicable to its owner.

c. Automatic Combination

One commonly cited consequence of the use of see-through entities is "automatic combination" for corporate groups. "Automatic" means it is no longer necessary to request consent, demonstrate unitariness, or prove distortion to achieve combined reporting of the results of the various entities. "Combination" in this context means that all of the income, assets, etc. of various separate see-through entities are simply reported by the owner. In some senses this result is beyond classic combination, for the separate character of the see-through entities is obliterated entirely.

The automatic combination that stems from conformity to the treatment of see-through entities can have a number of salutary effects. Simply eliminating disputes as to whether a group is combined will put a big dent in state and local tax litigation, allowing taxpayers and governments alike to devote their resources to more productive endeavors. Automatic combination permits the group to net a loss of one entity against income of another, resulting in a single tax on overall net income, rather than the possibility of taxable income in one pocket and wasted losses in the other. Automatic combination also eliminates transfer pricing issues between see-through entities and their owners. And because combination means intra-group transactions are eliminated, the possibility of changes in the character of income or expense resulting from such transactions likewise is eliminated. For example, an owner who lends money to a see-through entity will no longer report interest income while the entity reports interest expense and, say, income from the sale of widgets; instead the group will simply report the widget income.

As evident from the many tussles taxpayers have had, however, combination is not always a good or desirable thing. Blending together income, losses and factors will in some cases result in a higher state tax burden than that visited on the members separately. For instance, if the owner in our widget example is taxable on a more favorable basis on interest income, the conversion of income from interest earned by the owner to widget income earned by the group may not be a step forward.

More broadly, combination can be detrimental if it dilutes losses, increases income, or concentrates factors in a high-tax jurisdiction. Consider an example. Corporation A owns Corporation B. A does business in States 1 and 2; B does business only in State 2. State 1 has a 5% corporate income tax; State 2 has a 10% tax. The income and factors of A and B are as follows:

	Income	Payroll	Property	Receipts*
A	100
State 1		50	10	600
State 2				100
B (State 2)	100	200	400	900
Total	200	250	410	1600
* Single-weighted in both States 1 and 2.

 

On a combined basis the group's tax liability is computed as follows:

State 1	50/250=20%	10/410=2.5%	600/1600=37.5%
	20 + 2.5 + 37.5 = 60/3 = 20% $200 x 20% x 5% = $2.00
State 2	200/250=80%	400/410=97.5%	1000/1600=62.5%
	80 + 97.5 + 62.5 = 240/3 = 80% $200 x 80% x 10% = $16.00
Total Tax = $2.00 + $16.00 = $18.00

 

Computed separately, the tax liabilities of A and B are as follows:

A
State 1	50/50=100%	10/10=100%		600/700=85%
	100 + 100 + 85 = 285/3= 95% 100 x 95% x 5% = $4.75
State 2	0/50=0	0/10=0		100/700=15%
	0 + 0 + 15 = 15/3 = 5% $100 x 5% x 10% = $0.50
B
State 2	200/200=100%		400/400=100%	900/900=100%
	100 + 100 + 100 = 300/3 = 100% $100 x 100% x 10% = $10.00
Total Tax = $4.75 + $0.50 + $10.00 = $15.25

 

In this example, the group's tax liability is 15% lower if they remain separate. This is because by combining, more of A's income is dragged into State 2, due to the concentration of the group's factors in State 2. And since State 2 has the higher tax rate, apportioning more income to State 2 is not good planning.

This example illustrates that with significant income in a low-tax jurisdiction and high relative amounts of factors in a high-tax jurisdiction, you can run into trouble by combining. We could do examples all day long and demonstrate any number of outcomes. The point simply is this: one should not assume that the automatic combination that flows from federal conformity is a good thing for state tax purposes. In some cases automatic combination will be terrific -- reducing burdensome reporting requirements, providing certainty, eliminating pitfalls that can result from separate reporting by a wholly-owned group. But it can be expensive if its effect is to shift income into, or change the character of income in, higher tax jurisdictions.

The only way to figure out one's preference is by running pro-formas with alternative scenarios. The only thing you need to do that is accurate projections of income, expenses, payroll, property, receipts and opportunities for inter-company dealings for the foreseeable future. (Should be a snap!) The thing to be alert for is (i) character shifts, and (ii) imbalances in relationships of income to apportionment factors from state-to-state, and whether those imbalances, when combined, draw income into or out of higher-tax jurisdictions.

Combination is not, in its classic sense, an issue of relevance to individual taxpayers. Nevertheless, the "automatic combination" effected through the use of see-through entities may have consequences to individuals, particularly in multi-jurisdictional settings. The amount and character of income may change if inter-entity transactions are disregarded as a result of federal conformity. These changes, in turn, may affect the amount of income subject to tax in a given jurisdiction, or the amount of tax credit available for taxes paid to another state.

For example, consider an individual who forms an SMLLC to conduct business. Assume further that the SMLLC pays the individual a salary, which may be a reasonable device to withdraw "profits" from the business without raising the ire, or lengthening the reach, of the LLC's creditors. If the payment is respected as a salary it will be subject to one sourcing regime.⁽³³⁾ If instead it is treated simply as profit from the business it may be sourced differently.⁽³⁴⁾ As another example, if the effect of federal conformity is that the entire profit of the enterprise is considered net earnings from self-employment, the use of a see-through entity, as compared to a limited partnership, may trigger such things as New York City's Earnings Tax on Nonresidents.⁽³⁵⁾

Accordingly, while one does not generally think of combination as an issue for individuals, and while see-through treatment may not differ much from the netting previously achieved through the use of pass-through entities, there are aspects of the combination achieved with see-through entities that may change, for good or ill, the state tax position of their individual owners.

d. The Significance of What One Owns

State and local income taxation depends in certain instances on the character of an asset owned or sold by a taxpayer. In such cases it is important to consider the ramifications of using an SMLLC or QSSS where that results in the owner being treated for local tax purposes as holding directly all of the assets of the see-through entity.

For example, New York exempts from its corporate tax any income derived from subsidiary capital.⁽³⁶⁾ In New York, therefore, the sale of the stock of a subsidiary is tax free. By contrast, the sale of the assets of a business produces income taxable by New York (to the extent apportioned to the state under the selling corporation's Business Allocation Percentage). Under this kind of tax regime, the use of an SMLLC or QSSS rather than a wholly-owned corporation could prove more costly.

UDITPA states similarly employ a distinction between business and nonbusiness income. Business income is apportioned among the states in which a corporation does business, usually under some variation on the three-factor formula scheme. Nonbusiness income is allocated to specific jurisdictions, based on specific allocation rules. If the use of a see-through entity changes the character of what a corporation is deemed to own, the UDITPA rules might change the place in which income is taxable.

Obviously, a decision to incorporate a subsidiary rather than use an SMLLC will involve numerous considerations, many more significant than the potential state tax burden or savings on a future disposition. That said, it still is important to establish up front the state and local tax costs and opportunities that may flow from different structures.

The taxation of individuals likewise may be affected by the use of SMLLC's. For example, New York State imposes tax on income derived by nonresidents from intangibles only if such intangibles were used in a New York trade or business,⁽³⁷⁾ not the usual situation. It has been held that income from the sale of a partnership interest constitutes income from an intangible.⁽³⁸⁾ As a result, in most cases, a nonresident individual's sale of an interest in a partnership doing business in New York would not be subject to New York income tax. By contrast, if an individual is treated as owning and disposing of the assets used by a see-through entity in a New York business, the gain would (to the extent properly sourced in New York) be taxable.⁽³⁹⁾ For individuals in such a position, the use of a see-through entity again should be carefully considered.

e. New York City's Unincorporated Business Income Tax

The unincorporated business tax imposed by New York City gives rise to some interesting questions, and the City's recently amended Instructions give some indication of their resolution.

Corporate owners of SMLLCs face questions as to whether the SMLLC is a UBT taxpayer, or instead its business is simply absorbed into the corporation and reportable under the GCT. The City's Instructions, consistent with the federal rules and City statutes, suggest the latter outcome. This amalgamated treatment is helpful if the SMLLC otherwise might have had to pay UBT, and its owner could not use the UBT paid as a credit against its own GCT liability.⁽⁴⁰⁾ Similarly, collapsing all SMLLC's into their owner avoids the possibility that some SMLLC's may have net income and pay tax, while others (or their owners) have losses no one can use.

The amalgamation of SMLLC's in their owners for UBT purposes could, however, affect the determination of "dealer" status under the UBT,⁽⁴¹⁾ and in some cases that could result in otherwise exempt income becoming subject to the UBT.

The effect of see-through status on the owner's exposure to the City taxes also can be significant. This group of issues is discussed more fully in part 4, below. It suffices here to note that businesses conducted within and without the City need to carefully examine the repercussions of using an SMLLC if, as the City has announced, the effect of see-through status is that the owner is deemed to conduct business in the City.

f. Other Special Types of "Income" Taxes

Some states impose different tax regimes on specific kinds of businesses. New York, for example, has the Article 9-A franchise tax on Business Corporations; the Article 32 tax on Banking Corporations; gross receipts taxes under Article 9 on oil companies, transportation and telecommunication companies, utilities, and agricultural cooperatives; and a premiums tax on insurance companies under Article 33. Many times these kinds of specialized tax regimes are quite old, and even more obtuse. And because they often diverge from basic income tax concepts, these cul-de-sacs of state taxation may be particularly vulnerable to unforseen results from the use of see-through entities.

New York's taxation of utilities provides an illustration of the kinds of issues these specialized regimes can raise. Under New York State law a corporation "principally" engaged in furnishing utilities is subject to a 0.75% tax on gross earnings, and regulated utilities and vendors of utilities pay another 3.5% tax (plus surcharges) on gross income; New York City similarly imposes a 2.35% tax on the gross income of utilities. New York City's recent amendment to the Instructions states that their conformity to the federal treatment of SMLLC's applies for purposes of the utility tax. Under such a rule, presumably, one would test all of the earnings, receipts, or whatever of the owner and its SMLLCs to determine whether a special taxing regime applies. Furthermore, transactions among members of the owner's "group" should be disregarded in measuring the gross earnings, gross income, etc. subject to tax.

Whether inferences of such specificity are in fact valid, and will be followed by other jurisdictions and for other taxes, remains to be seen. Moreover, decisions like GTE Spacenet,⁽⁴²⁾ which held that the utilities business of a partnership could not be imputed to its 50% "passive" general partner, raise questions about a state's ability automatically to ascribe an entity's activities to its owner under these specialized tax regimes. This is therefore an area in which one needs to evaluate whether the application of a special taxing regime is desired, and weigh the risks that see-through status might interfere with the desired result.

It also is possible that there will be fine-tuning at the federal level that affects these questions. New York City announced that its conformity to federal see-through treatment of SMLLC's covers the Bank Tax; the City's view of QSSS's and the Bank Tax is not yet known. Federal tax issues regarding the treatment of QSSS's where banks affiliate with nonbanks⁽⁴³⁾ suggest, however, that the pure form of see-through status may not obtain for all purposes. Distinctions along the lines identified at the federal level may also begin to be drawn by the states as they gather experience in applying specialized tax regimes to see-through entities.⁽⁴⁴⁾

4. Issues of "Nexus"

States operate under two sets of constraints in imposing their taxes on multistate businesses and persons not present in their jurisdiction. The first set of constraints is federal. The United States Constitution, most significantly the Commerce Clause⁽⁴⁵⁾ and the Due Process Clause,⁽⁴⁶⁾ limits the reach of state taxing jurisdiction. For states to impose tax on someone or something there must be a Constitutionally adequate relationship between the state and the thing taxed. State's jurisdiction to tax may also be constrained by federal legislation. Congress has not intervened much in imposing limitations on state taxing jurisdiction, but there are some provisions of federal law, notably Public Law 86-272,⁽⁴⁷⁾ that may be important to particular taxpayers.

The second set of constraints on the reach of state taxation is found in provisions of state constitutions and state taxing statutes that limit a state's ability to impose tax. These self-imposed boundaries sometimes are born of provincial interests in expanding or protecting local business,⁽⁴⁸⁾ and therefore can fall inside, rather than be coterminous with, federal constraints on state taxation.⁽⁴⁹⁾

The arrival of see-through entities creates a number of very interesting questions concerning the ability of states to impose tax on such entities and on their owners. These questions are referred to generally here as questions of "nexus;" issues of income tax nexus, sales tax nexus and the application of Public Law 86-272 are discussed below. Each of these areas reflects the fundamental tension that arises when a state law gives see-through creatures life while a federal tax rule denies their existence.

It is of course not news that the income tax treatment of a transaction may differ from its local law characterization. For decades the tax law has found grounds to recharacterize leases, sales, loans, salaries, ownership and any number of other rights or relationships respected under local law. In many cases the federal tax reclassification of a transaction raises state tax questions as well. For example, is the lessor under a lease the owner of property for state tax purposes if the lease is considered a financing for income tax purposes? The answer(s) to that question can affect not only state income taxes but also property taxes (an exempt owner pays no property tax⁽⁵⁰⁾); transfer taxes (a sale-leaseback would not be taxable if disregarded⁽⁵¹⁾); sales taxes (materials used in making improvements to real property may not be taxable if an exempt person owns the property⁽⁵²⁾); income taxes (ownership of property in a state may subject the titleholder to taxes in that state⁽⁵³⁾); commercial occupancy tax (rent is taxable, debt service is not⁽⁵⁴⁾); and who knows what else. Some of these questions have been addressed in some states. Yet even where the answers are established they are not always consistent, for different state and local tax provisions can lead to different conclusions.

SMLLC's and QSSS's add a new dimension to these questions. We are likely to see these entities used very widely, and by taxpayers less sophisticated than those who heretofore engaged in federally recharacterized transactions. We also are likely to encounter these entities in domains that are already contentious, where states are sensitive to incursions on their revenues. This should make things interesting.

The plot is further thickened by the fact that the jurisprudence of state taxation treats, or in many cases appears to treat, partners differently from corporate shareholders in testing whether a state has the power to assert tax. SMLLC's are neither partnerships nor corporations, but whether their characteristics land their owners in the nexus regime of partners or that of shareholders remains to be seen. Similarly, QSSS's are corporations, but possess a unique pass-through character. Whether that uniqueness results in special nexus rules for their corporate owners also remains to be seen.

a. Background on the Nexus of Partners and Shareholders

Partners in partnerships often are presumed to be engaged in the activities of the partnership, and thus subject to tax in the jurisdictions in which the partnership conducts business. The rationale for this result is sometimes expressed in terms of "agency"⁽⁵⁵⁾ -- the relationship between partners and partnerships is such that the partners themselves conduct the partnership business. Under the agency theory, New York's Attorney General opined in 1954 that limited partners were subject to tax based on the partnership's conduct of business in New York.⁽⁵⁶⁾ In 1986, New York's Appellate Division concluded that the Washington partners of a New York law firm had a "significant" connection to New York, and therefore had sufficient nexus to sustain a New York income tax on the portion of their income apportioned to New York.⁽⁵⁷⁾

The agency theory of imputing partnership business to the partners has, however, met some bumps in the road. In an interesting about face, New York State issued several Advisory Opinions in 1988 concluding that, as applied to limited partners, "the agency doctrine simply has no place in analyzing the status of the typical limited partner who remains passive in the business."⁽⁵⁸⁾ Analogizing a passive "disinterested" limited partner to a preferred shareholder, and citing American Bell (discussed below), the Department of Taxation and Finance concluded that the partner was not conducting business in the state within the meaning of the franchise tax law. Whether these opinions also reflected a broader rethinking of the Constitutional validity of the agency theory of nexus to limited partners is unknown. What is known is that this strain of Departmental analysis was rather short lived.

In 1990, New York State reversed course again, issuing amendments to the franchise tax regulations which offered only a limited version of the no-agency theory. Under these new regulations, foreign limited partners are taxable in New York if they engage in managing a partnership (other than a portfolio limited partnership). Limited partners are deemed to be managers (and therefore doing business) in a variety of cases, including any case in which the corporate partner's interest is at least 1% and/or its basis in the interest is at least $1 million.⁽⁵⁹⁾ New York's 1990 regulations are widely perceived as reflecting the mainstream view that partners, including limited partners, are deemed to be engaged in the partnership's activities, and have Constitutional nexus to any state in which the partnership has nexus.

The view that the special relationships among partners and partnerships create a unity of identity that conveys nexus is essentially a concept of nexus de jure. Whether expressed in terms of agency, or as an offshoot of aggregate principles,⁽⁶⁰⁾ this source of nexus lies in the legal incidents of partnership. Other bases for attributing nexus may be more factual -- the partner's involvement in the operations of the partnership, the relationship of the partnership business to the business of the partners, the failure of partner and partnership to maintain separate "uninterested" lives.⁽⁶¹⁾

There are, however, reasons to believe that traditional theories of automatic nexus to partners have some problems. In GTE Spacenet, for example, the Appellate Division reasoned, that "the general partners were mere passive investors and did not participate in the day-to-day management or operations of [the partnership];" the partners were, therefore, engaged in an investment business, not in the partnership's business.⁽⁶²⁾