Update on Taxation of LLCs, LLPs and Their Owners  

Author:
Bruce P. Ely, Esq.
Bradley Arant Rose & White LLP
Birmingham, AL

Editor's note: For more information on this subject, Mr. Ely can be reached at (205) 633-0200 or bely@barw.com .

Several significant developments in the past year have affected state taxation of limited liability companies (LLCs) and limited liability partnerships (LLPs), and their members or partners. For example, both the California and Montana legislatures have amended their LLC acts to permit the organization of single-member LLCs (SMLLCs). Congress also recently approved the formation of SMLLCs in the District of Columbia. Massachusetts is now the only state that expressly requires a domestic LLC to have two or more members to operate. However, even this may change, as its legislature has reintroduced SMLLC legislation, which may pass this year. Several other state legislatures (e.g., Alaska, Hawaii, New Jersey and South Dakota) have recently adopted the Revised Uniform Partnership Act (RUPA), giving RUPA a majority among the states. RUPA typically governs the internal affairs of LLPs as well as general partnerships, and may also affect partner nexus determinations.

In another favorable development, the Kentucky Supreme Court has amended its rules of practice to broaden the choice-of-entity horizon for attorneys. Previously, the court had ruled that attorneys practicing in Kentucky could not practice as either an LLC or an LLP. Kentucky law firms now have those entities to choose from, provided they maintain a stated amount of professional liability insurance coverage.

Several key issues, however, remain unresolved in the area of the state tax treatment of LLCs, LLPs and, to a lesser extent, limited partnerships, limited liability entities (LLEs) and their owners. Among the hottest topics subject to debate today in the state tax arena are entity-level taxation and nexus issues regarding LLE members or partners.  

Entity-Level Taxes

Wyoming, Tennessee and Alabama are the latest examples of states that impose significant entity-level taxes on LLEs. Both the Tennessee and Alabama legislatures blamed a fiscal crisis in their state as the primary impetus. For example, the Alabama legislature made the new net worth-based "business privilege tax" applicable to most LLEs, effective Jan. 1, 2000, in an attempt to distribute the tax burden more evenly among the business community (following the U.S. Supreme Court's March 1999 ruling in South Central Bell, 526 US 160 (1999), that Alabama's corporate franchise tax impermissibly discriminated against foreign corporations in violation of the United States Commerce Clause). Two other states tried to make similar attempts last year, but the legislation failed. Other states will probably attempt this in the near future.

Some states, however, have recently bucked the trend. Pennsylvania enacted legislation that, beginning last year, phases out its capital stock and franchise tax over the next eight years. Michigan is phasing out its single business tax over the next 22 years, and Washington reduced its business and occupation (B&O) tax. All three taxes apply to LLEs. Florida law gradually eliminates the intangibles tax, applicable to membership interests in LLCs, but not to partnership interests in LLPs.  

Nexus Issues

The states sometimes disagree about whether mere ownership of a membership interest in an LLC doing business in a state is sufficient to allow that state to assert its taxing jurisdiction over a nonresident or foreign corporation member. To rationalize the attribution of nexus to nonresident LLC members, several states have used a direct-ownership-of-property theory, analogizing LLC members to general partners. However, this theory appears to be flawed, at least with respect to multi-member LLCs treated as partnerships, because modern LLC statutes and the Uniform LLC Act explicitly state that members are not direct owners of the LLC's property. State RUPA statutes contain similar provisos applicable to general partnerships and to LLPs. Exhibits 1 and 2 list the states that have enacted RUPA or RUPA-type statutes. (The following exhibits are in Adobe PDF format. Click here to view them. For simple instructions on one-time downloading of Adobe Acrobat Reader, a free, easy-to-use piece of software one must have for viewing and printing PDF documents, click here.)

Recently, however, both an Illinois appeals court in Borden Chemicals and Plastics, L.P., 726 NE2d 73 (2000), cert. denied, 731 NE2d 762 (2000), and the North Carolina Department of Revenue in Secretary of Revenue of North Carolina v. Perkins Restaurants, Inc., N.C. Tax Review Board, Dkt. No. 351 (1999), found that limited partners were "doing business" in the respective states merely by virtue of their ownership of a limited partner interest in the partnership. Further, interpreting a statute more broad in scope and specifically directed to the income taxation of "individual" nonresident partners, the Georgia Court of Appeals reversed a lower court and found that two Tennessee residents, limited partners, were subject to Georgia income tax on their distributive shares of the limited partnership's income; see Georgia Dept. of Revenue (DOR) v. Sledge, 528 SE2d 260 (2000), cert. denied (2000).

Several states have specifically addressed this issue, usually in the form of a safe harbor or creation of an "investment LLE" exemption; New York, Georgia and Connecticut are examples. On the other hand, the Georgia DOR recently issued proposed regulations that automatically deem a nonresident limited partner or LLC member (other than an "investment limited partner"), either individuals or corporate entities, to be doing business in that state for income tax purposes merely because of its status as a partner or member. Many question the ability of a state taxing authority to issue valid regulations that extend beyond the reach of the state nexus statute, especially if the statute is of the "doing business" or "owning property" variety.

Arguably, nexus could also be attributed to nonresident LLC members under an alternative theory that the LLC is acting as an agent on behalf of the member or that the intangible membership interest has been somehow put to use within the state (an analogy to the controversial Geoffrey theory). Fortunately, the "agency" theory appears to have fallen out of favor and, the "intangible nexus" theory, although advocated by the Multistate Tax Commission (MTC) in 1994, has not yet been applied in any reported case. But states may also assert at least their income tax jurisdiction over the nonresident members/partners if their levy statute is more broadly worded than simply "doing business" or "transacting business." The Sledge case is a good example of that.

Another trend finds several states enacting a California-style requirement on LLEs doing business in their state: to avoid an entity-level income or net- income-based franchise tax, each of the nonresident or foreign corporate members or partners must consent to jurisdiction and agree to pay the state tax on their distributive share of the entity's income; Ohio, Alabama and New Mexico are recent examples. The Georgia DOR proposes to expand its withholding rules to cover all nonresident or foreign corporation partners and members, not just individuals, effective for tax years beginning after 2001.

The MTC's Uniformity Committee is currently considering a proposal for its member states that would go a step further, by mandating entity-level withholding if the LLE has any nonresident members or partners, regardless of their willingness to file jurisdictional consents. The AICPA's State and Local Tax Technical Resource Panel has already written in opposition of that idea. If the states have their way, entity-level withholding or the requirement of nonresident jurisdictional consents would likely become the rule rather than the exception, and would seem to avoid the member/partner nexus issue altogether.