Corporate partners, both pre- and post- reform, use the Article 9-A rules to determine their New York corporate income taxes. In other words, a corporate partner uses single factor apportionment with market-based sourcing, and not the partnership’s three-factor apportionment methodology using the origin method for sourcing receipts (i.e. the location of the office where a receipt is generated). Corporate partners generally use the aggregate method, so that the income/gain/loss/deduction from its partnership interest would be aggregated with the corporation’s own receipts and receipts from other underlying flow-through entities prior to apportionment. This aggregate method would also be used to determine whether the corporate partner had economic nexus in New York. A limited partner (or LLC member with limited decision making authority for the entity) would be required to pay tax in New York if it had a 1% interest or more and/or $1 million in basis in a partnership and had more than $1 million in combined New York receipts (including its own receipts and the total New York receipts of the underlying partnership(s)), even if it had no physical presence and none of its own receipts in New York.
This has been a headache for corporate partners with limited activities in New York, save its interest in a partnership doing business in New York. Partnerships are supposed to issue its corporate partners complicated New York K-1s that break down its receipts similar to New York’s corporate tax apportionment schedule. Most partnerships don’t have much incentive to comply with this requirement, particularly since they themselves apportion their income to New York under a totally different regime. Thus, a corporate partner is often left to figure out the nature of the income they receive from the partnership for apportionment purposes. This can be difficult to say the least for income from a partnership that has complex investments or for multi-tiered flow-through entities. With a very low nexus threshold, many corporate partners were caught in this compliance dragnet.
New York’s latest revisions to its draft regulations propose to narrow the category of limited corporate partners that would be required to file in New York solely or principally due to the underlying partnership. The revised regulations propose to increase the nexus threshold to a 5% interest or more than $5 million in basis in the partnership. This is a welcome change but one that is proposed only in conjunction with the elimination of a separate accounting election currently in the regulations that would have allowed a corporate partner in some circumstances to report only the receipts from the partnership doing business in New York rather than its aggregated receipts.
This change in and of itself, even with the required repeal of the separate accounting election, might not be a bad change for most partnerships. But the Department is also proposing rules that impact the treatment of income from a corporation’s sale of a partnership interest. Under current law, income or gain from the sale of a partnership interest is treated as taxable income, but it is not included in the apportionment fraction unless New York deems it necessary to properly reflect the income or capital of the taxpayer. [1] A new Example 3 to Regulation 4-4.1 (regarding discretionary adjustments) states that a corporate partner that realizes 75% of its gross receipts in the tax year from the sale of a partnership interest should include those receipts in its apportionment fraction because doing otherwise would result in an unfair apportionment to New York. This seems surprising given that the law presumes that the gain would not be included in the apportionment fraction unless the Department determines that it results in an unfair apportionment. This determination has always been a case-specific, fact-specific inquiry, and the draft regulations make clear that the party making the discretionary adjustment bears the burden of proof that the statutory formula results in an unfair apportionment. It thus seems surprising that the Department could assert in a regulatory example that simply the gain as a percentage of overall receipts could result in an unfair apportionment to New York.
Consider this scenario. Corporation X, located in Iowa, principally sells large agricultural equipment across the U.S. It has only a few customers in New York, which generates about $100,000 or about 10% of its gross receipts. It also owns a 5% interest in Partnership A that, among other activities, invests in commodities funds. Partnership A has its sole office in New York, but invests in funds all over the world. It also has a total of $1 million in New York receipts under the corporate tax rules. Corporation X decides to sell its interest in Partnership A and realizes a gain of $4,000,000. What’s the result? Under the revisions to the draft regulations, Corporation X would still meet the economic nexus rules using the aggregate method. But more importantly, it would likely have to source a significant portion of its $4 million gain to New York! Why? Because the revised apportionment regulations indicate that the gain would need to go into the apportionment fraction and create new rules to source that income. Example 3 mentioned above explains (and if an example needs to explain its underlying theory you know there will be questions!) that under the aggregate method, a corporate partner is treated as participating in the partnership’s activities. Therefore, the corporate partner will be treated as selling the underlying partnership’s assets. Huh? Moreover, since the sale price of many businesses is often primarily allocated to goodwill, New York uses another recent revision to the apportionment rules to source the gain from the sale of a New York partnership to New York. Goodwill is an intangible and under the revised rules, goodwill is sourced to the location where its value accumulated based on the partnership business allocation percentage in previous years. This seems extremely far removed from the market-based sourcing as laid out in the post-2015 law!
New York is still gathering comments to its proposed revisions and we can expect many questions about the proposed changes to the corporate partner rules. How this issue gets resolved with final regulations remains to be seen. But New York may be concerned about losing revenue under its new market-based sourcing regime and is looking for ways to neutralize some of those losses, even if they seem contrary to the law as written.
[1] Tax Law §210-A.5(2)(G).
