Partnerships, LLCs and LLPs:State Tax Issues

Presented by

Mike Galloway

Member

Bancroft Susa & Galloway, PC

www.arizonatax.com

Bancroft Susa & GallowayA PROFESSIONAL CORPORATION

State Tax Issues

• The Arizona Rules

• The Arizona Tax Traps

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In General

• An LLC will be classified for Arizona income tax purposes as either

– A partnership

– A corporation (including an S), or

– A disregarded entity

depending on its classification for federal income tax purposes under Treas. Reg. §§ 301.7701-1 etc.

Choosing The Right Tax

• If the LLC is classified as a partnership, it will report its income to Arizona on Form 165

• If classified as a corporation, on Form 120

• If classified as a S Corporation, on Form 120S

• If a single member LLC is disregarded as an entity separate from its owner, on the Arizona tax return of its owner

The Partnership Rules

• The old law — Arizona had its own independent partnership tax code

• Now — Arizona taxable income "piggy backs" from federal income — the federal "flows through" to the state

– Federal taxable income equals Arizona gross income

– Look at the tax return

The Partnership Rules

• Add or subtract the separate computation items of A.R.S. § 43-1412

• Make the individual statutory additions and subtractions

• Allocate this amount to the respective K-1s– Arizona K-1s make net adjustments

– Non-residents only report Arizona source income

• Report these amounts on the partner’s individual tax return

• Apply the appropriate individual state tax rate

• Apply the applicable individual state tax credits

Who Is Subject To Taxation?

• Generally if you are doing business in a particular state

• A state is subject to the limitations imposed by the Due Process and Commerce Clauses of the U.S. Constitution

– Quill says there must be physical presence

• If an LLC is subject to tax in more than one state, those states must apportion the tax burden among themselves

Arizona Apportionment Rules

They are generally based on the following formula:

Arizona Property Total Property

+

Arizona Payroll Total Payroll

+ Arizona Sales Total Sales

2

4

X Total p/s

income =

Income taxable

by Arizona

– This is the current Arizona version of the

traditional UDITPA three factor formula

Apportionment Is BasedOn Two Concepts

• Business Income

• Non Business Income

– Business income arises “from transactions and activity in the regular course of the taxpayers business . . .”

– Non business income is “all income other than business income”

Apportionment Is BasedOn Two Concepts

• Business income is apportioned among the states where the taxpayer engages in business

• Non business income is generally allocated to the one state where the income is generated

Non Business Income

• Non business income consists of:

– Rents

– Royalties

– Capital Gains

– Patent Royalties

– Copyright Royalties

– Dividends

– Interest

Business Income

• Business income consists of all income arising from the taxpayer’s regular business activity

• It is apportioned among all of the states where the taxpayer is doing business based on the percentage of three factors from the above formula:

– The property factor

– The payroll factor

– The sales factor

The Property Factor

• The percent of the taxpayer’s total property that is in Arizona

– Does not include intangible property

– The value of the property is its original cost as adjusted for improvements and dispositions but not depreciation

– If leased, the value is eight times the annual rent

– Property used to produce nonbusiness income is nonbusiness

The Payroll Factor

• The percent of the taxpayer’s total payroll that is in Arizona

– Only what is paid to employees, not independent contractors

– Applies to services performed entirely or mostly in Arizona

The Sales Factor

• The percent of the taxpayer’s total sales that are in Arizona

• Sales includes sales but also:

– Services

– Leasing

– Licensing

– Etc.

There are different rules for sales of tangible and intangible property

• Tangible Personal Property– Arizona uses the “destination” rules for sourcing

TPP

– A sales is Arizona source if it is shipped into Arizona

– The “throwback” rules have been repealed

• Intangible Personal Property– It is Arizona source if:

• The income producing activity is in Arizona, or

• Most of the income producing activity is in Arizona

• See Heller Western

Miscellaneous

• There are rules that allow alternative methods or factors to be used

• Many states, although not Arizona (with one exception), have special apportionment formulas for certain industries (banks, railroads, publishing)

In Summary

• An LLC will be taxed by Arizona under the federal rules with certain Arizona adjustments

• An LLC or group of LLCs can be taxed by all of the states in which they are doing business or physically present

• An LLC or group of LLCs can be taxed by states where they are not doing business or physically present if one of the LLCs is doing business or physically present and the others are unitary

• The total income of the LLC or LLC group will be apportioned among the states where they are subject to tax

The Corporation Rules

• The old law—Arizona had its own independent corporate tax code

• Now—Arizona taxable income “piggy backs” from federal income—the federal “flows through” to the state

– Federal taxable income equals Arizona gross income

The Corporation Rules

• Make the statutory additions and subtractions

• The result at this point is Arizona taxable income

• Apply the corporate income tax rate of 6.968% of the taxable income

• Apply the applicable corporate state tax credits

• Be aware of special state rules for certain types of corporations

The Unitary Concept

• Even though, for example, only one LLC may be physically present or doing business in Arizona, related entities may contribute to the income produced in Arizona.

• Under the unitary theory, Arizona may tax the total (apportioned) income of all of the related entities.

• The related entities must be unitary—effectively operating as a single unit (an “organic whole’) for business purposes.

• In Arizona, the test is “operational integration”– Contrast with California’s “functional integration”

• Arizona has a big regulation on point.

The Unitary Concept

• In Arizona, the limit on taxing is “water’s edge”

– Contrast with California’s “world wide” combined reporting.

The Individual Rules

• Same as the partnership, except:– Federal adjusted income equals Arizona

gross income

• Make the individual statutory additions and subtractions

• Report this amount on the individual tax return

• Apply the appropriate individual state tax rate

• Apply the applicable individual state tax credits

State Tax Traps

• City Speculative Builder Tax

• Transfers of Assets

• Intercompany Leasing

• Property Tax Exemptions

• Property Tax Affidavits of Value

• Successor Liability

• Multistate Taxation

Partnerships, LLCs and LLPs: Organization And Operation In Arizona

Presented by

Mike Galloway

MemberBancroft Susa & Galloway, PC

www.arizonatax.com

Bancroft Susa & GallowayA PROFESSIONAL CORPORATION