Special Comment: State Tax Treatment of Investment Partnerships | Bradley Arant Boult Cummings LLP

[co-authors: Kelvin M. Lawrence and Lillian H. “Lily” Rucker]*

As previously reported, the Multistate Tax Commission has undertaken an ambitious project on state taxation of partnerships. Their partnership task force is made up of volunteers from numerous state tax departments, with expert assistance from MTC attorneys Helen Hecht and Chris Barber. His first milestone was the development of a plan that divided the task force’s workload into four groups of issues: taxation of income and partnership elements; taxation of gains (losses) from the sale of an interest in a partnership; entity-level tax issues; and administration and enforcement.

The first topic chosen by MTC staff and the working group approved for detailed analysis was “the trillions of dollars flowing through investment partnerships.” MTC staff have prepared a comprehensive white paper, State Tax Treatment of Investment Partnerships, which is useful reading for understanding the depth and breadth of the issues. Section II.B. indicates that investment partnerships, broadly defined as the industry segment of financial and holding companies, accounted for 70% of all partnership revenue reported during the years studied, which explains why investment partnerships investment and their partners should be analyzed first.

These investment partnerships typically belong to one of three groups: 1) private equity funds, 2) hedge funds, and 3) closely held, often family-owned investment partnerships such as joint ventures. limited partnerships, special purpose entities or holding companies organized as partnerships. However, common law trusts and statutory or business trusts are also common investment vehicles, as discussed below.

The white paper outgrowth is a proposed model that could be enacted into law or regulation that was in its fourth iteration at the July 25 virtual task force meeting. The remainder of this article focuses on three major issues with the draft model that the authors have identified, and partly parallels the comment letter that the lead author of this article submitted to the MTC on July 6. We first give a general overview of the model project. before considering these questions.

The draft model, as most recently amended, contains a useful roadmap:

This draft model is designed to impose three independent qualifications for Safe Harbor provisioning. First, the partnership must be a qualified investment partnership. Second, the partner must be a qualified investment partner. Third, the income or loss subject to the supply rules must be a [sic] Income (loss) from a qualified investment partnership. … If the partnership, or the partner, or the income does not qualify, then the income or loss is not residency-related under this safe harbor rule. Again, it can still come from residence under other general government procurement rules or principles. But to determine if the income would come from the residence, it must come from a qualified investment partnership, must be paid to a qualified investment partner, and must be qualified investment partnership income.

There are approximately 20 states that have a minimum legal framework for taxing investment partnerships and their partners. However, as the white paper points out, while there is some uniformity between these states, there are also disparities. For example, only four of these states – Alabama, Idaho, Kentucky and New Jersey – designate investment partnerships as qualified investment partnerships, or QIPs, while a dozen other states recognize the same or a similar definition of a QIP as an investment. partnership or investment flow-through entity. The draft model would be based on and draws heavily, albeit selectively, from the language of the Alabama Investment Partnership Act of 2009.

States’ disjointed treatment of core issues in the draft model explains why MTC member states are acting to bring greater uniformity around these issues.

Ambiguous prohibitions on personal transactions

A major area of ​​concern in the proposed model stems from its significant departure from both Alabama law and other state investment partnership laws in a manner that creates rather than detracts from resolves the ambiguity. For example, Section 3(b) overrides the general rule that a nonresident QIP partner may exclude from that state income tax the distributive portion of that partner’s QIP income:

“The exclusion … does not apply to the distributive part of the income of the qualified investment partnership insofar as it derives directly or indirectly an investment in an entity if the Non-Resident QIP Partner holds or has held over the past five years a direct interest in that entity, unless the entity is a publicly traded entity or the non-resident QIP partner does not participate or has not actively participated in the activities of the entity. For this purpose, active participation means being an officer or director, or holding a stake greater than 20% (emphasis added).

This language is ambiguous in several respects and materially different from Alabama law, which was heavily negotiated between the private equity investment industry, the Alabama Department of Revenue, the Alabama Society of CPAs and d ‘other parts. To their credit, the drafters of the draft model narrowed the previous draft’s exclusion somewhat by reducing the look-back period from 10 years to five years and defining “active participation”, while including the partner of the PAQ who served as a partner. officer or director of the subject entity within the last five years.

In contrast, Alabama law does not use such ambiguous terms as “directly or indirectly”. It also does not impose a look-back period or consider prior service as an officer or director as a flawed act, and does not prohibit anything less than majority ownership of the target entity by the non-resident QIP partner. . The authors recommend that the draft model adopt the more practical wording of Alabama law. Additionally, only a few of the 20 states have similar restrictions, including California, Arkansas, and Illinois.

Anti-abuse language on steroids

Paragraph 4(b) is also troublesome. It allows the state taxing authority to revoke the certification of a QIP if it “determines that this Act has been used to avoid [state] liability to income tax”. If so, the state tax director may “distribute, apportion, or allocate partnership income” according to state law.

Consistent with the law of Alabama and several other states, the draft model should at least require that the alleged abuse be “primarily” for the purpose of avoiding or has the “primary purpose” of avoiding tax. on that state’s income through the use of a QIP. Several other states have anti-abuse provisions generally applicable to flow-through entities using similar language, including New York, Ohio, and Connecticut. However, most state laws specific to investment partnerships do not contain any kind of anti-abuse language, and we understand that even some members of the task force questioned the need for this.

Finally, if the draft model is to be based on Alabama’s fair and balanced law, the drafters should parallel that law’s limitation on the authority of the state’s director of taxes if it is determined that the main purpose of the PAQ was to avoid state income tax. . Alabama law clearly limits the powers of the Commissioner of Revenue to those analogous to Section 482 of the IRC, to “clearly, fairly and fairly reflect” the income of the QIP or other entity engaged in a such tax evasion. We believe that legal guidelines like this would be helpful to both states and taxpayers.

Need for a self-correction procedure

Despite helpful editor’s notes repeatedly stating that the supply rule under the draft model is only a “safe harbor”, in the authors’ experience, many state DOR auditors consider that failure to meet the criteria for a particular safe harbor automatically creates liability for tax on the basis of that failure. The lead author’s July 6 comment letter raised this concern.

Thus, some administrative pardon is required when the PAQ, for example, discovers after year-end that it has fallen below one of the 90% thresholds, or that the managing partner has not filed PAQ certification in a timely manner. Similar to the self-correction procedures granted to qualified pension plans and IRAs by the Internal Revenue Service, there should be a comparable procedure to allow retroactive reinstatement of QIP status within a limited time after the end of the year, such as nine months. See IRS Rev. proc. 2021-30, IRB 2021-31.


We commend the MTC staff for their hard work not only on the model project, but also on their thoughtful white paper. We also commend staff for making several necessary changes to previous drafts of the draft model, such as expanding the definition of an eligible QIP partner to include non-resident estates and trusts.

While the authors agree that there is a need for uniformity among states in their treatment of investment partnerships and their non-resident investors, we urge MTC staff and the Partnerships Task Force to consider the capacity of taxpayers – and States – to implement these provisions. Given the time spent perfecting this model, it would be unfortunate if it were not used as it is rendered impractical or undesirable by its target audience.

This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

*Kelven M. Lawrence Attorney, Dinsmore & Shohl LLP; Lillian H. “Lily” Rucker, summer partner at Bradley Arant Boult Cummings LLP, provided invaluable research for this article.

Republished with permission. This article was originally published by Bloomberg tax July 29, 2022.