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 partnership taxation. Their Partnership Task Force is comprised of volunteers from multiple state revenue departments, with the expert assistance of MTC Counsel Helen Hecht and Chris Barber. The first milestone was the development of a scheme that divided the task force’s responsibility into four sets of issues: taxation of income and partnership elements; taxation of the gain (loss) on the sale of an interest in a partnership; tax matters at the entity level; and administration and enforcement.

The first topic MTC staff selected and the task force approved for detailed analysis was “trillions of dollars flowing through investment partnerships.” MTC staff has prepared an extensive white paper, State Tax Treatment of Investment Partnerships, which is useful reading to understand the depth and scope of the issues. Section II.B. shows that investment partnerships, broadly defined as a segment of the financial and holding company industry, accounted for 70% of all reported partnership income in the years studied, arguing why investment partnerships and their partners should be analyzed first.

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

The result of the white paper is a proposed model that could be adopted as a statute or regulation, which was in its fourth iteration by the July 25 virtual working group meeting. The remainder of this article focuses on three main issues with the draft model identified by the authors, and in part draws parallels to the comment letter that the lead author of this article sent to the MTC on July 6. We first provide a broad overview of the draft model before delving into these issues.

The draft model, as last amended, contains a useful roadmap:

This draft model is designed to impose three independent qualifications for the provision of a safe harbor. 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 procurement rules must be a [sic] Qualified investment partnership income (loss). …If the partnership, or the partner, or the income does not qualify, then the income or loss is not a source of residence under this safe harbor rule. Again, it can still be delivered to a residence under other rules or general principles of the country of supply. But to determine whether the income will be a source of residence, it must come from a qualified investment partnership, it must flow to a qualified investment partner, and it must be income from a qualified investment partnership.

There are approximately 20 countries that have a minimum legal framework for the taxation of investment partnerships and their partners. However, as the white paper points out, although there is some convergence between these countries, there are also differences. For example, only four of these states—Alabama, Idaho, Kentucky, and New Jersey—refer to investment partnerships as qualified investment partnerships, or QIPs, while a dozen other states recognize the same or a similar definition of QIP as an investment partnership or investment pass-through entity. The draft model is said to be based on, and indeed draws extensively, albeit selectively, from the language of the Alabama Investment Partnership Act of 2009.

The disjointed treatment by states of central issues in the draft model is why MTC member states are acting to ensure greater uniformity around these issues.

Ambiguous prohibitions against self-harm

A major area of ​​concern with the draft model stems from its substantial variation from both the Alabama Act and other state investment partnership acts in ways that create, rather than resolve, ambiguity. For example, section 3(b) overrides the general rule that a nonresident QIP partner may exclude from that state’s income tax that partner’s distributive share of the QIP income:

“The exclusion … does not apply to the qualified investment partnership’s distributive share of income to the extent received directly or indirectly from an investment in an enterprise if the non-resident QIP partner owns or has held in the last five years direct ownership interest in that legal entity, unless the legal entity is a publicly traded legal entity or the non-resident QIP partner does not participate or has not actively participated in the activities of the legal entity. For this purpose, active participation means being an officer or director or holding an ownership interest of more than 20% (italics added).

This language is ambiguous in several respects and substantially different from the Alabama Act, which was painstakingly negotiated between the private equity industry, the Alabama Department of Revenue, the Alabama Society of CPAs and others. To their credit, the authors of the draft model somewhat narrowed the exclusion from the previous draft, reducing the review period from 10 years to five years and defining “active participation,” although they did include the QIP partner who served as an officer or director of the target entity during the previous five years.

In contrast, the Alabama Act does not use such ambiguous terms as “directly or indirectly.” It also does not impose any look-back period or consider prior service as an officer or director a tainted act, nor does it prohibit anything less than majority ownership of the target entity by the non-resident QIP partner. The authors recommend that the draft adopt the more workable language of the Alabama Act. Also, only a few of the 20 states impose such restrictions, including California, Arkansas and Illinois.

Language against steroid abuse

Section 4(b) is also troubling. It allows the state tax authority to revoke a QIP’s certificate if it “determines that this law has been used to avoid [state] income tax liability.” If so, the state tax director may “distribute, apportion, or apportion the income of the partnership” in accordance with state law.

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

Finally, if the draft is to be based on Alabama’s Fair and Balanced Act, the drafters must reconcile that statute’s limitation on the authority of the state tax director if it is determined that the primary purpose of the QIP is to avoid income tax liability of this state. Alabama law clearly limits the authority of the Commissioner of Revenue to that analogous to IRC Section 482 to “clearly, fairly and equitably reflect” the income of a QIP or other entity engaged in similar tax avoidance. We believe that statutory guidance such as this would be beneficial to both states and taxpayers.

Need for a self-correcting procedure

Despite the helpful drafter’s notes, which state on several occasions that the supply rule under the draft model is only a “safe harbor,” in the authors’ experience, many DOR state auditors view failure to meet the criteria for a specific safe harbor as automatically creating a tax liability on basis of this default. The lead author’s July 6 comment letter raised this concern.

Thus, some administrative grace is needed when the QIP, for example, discovers after the end of the year that it has fallen below one of the 90% thresholds or the managing partner has not submitted the QIP certificate on time. Similar to the self-correction procedures provided to qualified retirement plans and IRAs by the Internal Revenue Service, there should be a comparable procedure to allow retroactive reinstatement of QIP status within a limited period of time after the end of the year, such as nine months. look IRS Rev. Proc. 2021-30, IRB 2021-31.


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

While the authors agree that there is a need for uniformity among States in dealing with investment partnerships and their foreign investors, we urge MTC staff and the Partnership Task Force to consider the ability of taxpayers—and States—to enforce these provisions. Given the time spent perfecting this model, it would be a shame if it went unused because it proved unworkable or unwanted by the 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; Bradley Arant Bult Cummings LLP Summer Associate Lillian H. “Lily” Rucker contributed invaluable research to this article.

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

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