AICPA weighs in on state partnership income sourcing rules

The American Institute of CPAs has sent a letter to the Multistate Tax Commission and a related work group recommending changes in their proposed approach to state tax sourcing of partnership income.

The AICPA comment letter includes recommendations regarding the approach of the MTC’s draft white paper on partnership structures, special allocations, related-party transactions, the effect on the ability of states to tax partnership income, and the determination of how partnership income is sourced. The letter asks for a definition of which rules partnerships should apply when computing entry-level taxes. Other recommendations ask the MTC to update its language regarding states not applying the same approach to sourcing multistate income of a business regardless of form of business, and add language to address where states have sourcing rules for income of businesses that are fundamentally different for nonresident or corporate partners.

“We understand the complexity of partnership structures, special allocations, and related-party transactions and their effect on the ability of states to tax partnership income and the determination of how partnership income is sourced,” said the AICPA letter. 

The AICPA wants to clarify why the sourcing rules are applied at the partner level rather than the partnership level, and have the MTC add a recent decision by the DC Circuit Court in the case Rawat v. Commissioner of Internal Revenue regarding the appropriate law for determining the character of a partner’s gain on disposition of their interest in the partnership. It also wants the MTC to apply its alternative approach only when there’s evidence the original transfer was intended to evade tax regarding transactions between partners and partnerships or other related entities.

It wants the MTC to offer guidance on transactions involving partners or shareholders who act outside their capacity as partners or shareholders to clarify the reason for the difference in treatment for partnerships versus corporations. The Institute recommended the MTC add a step or consideration to its framework to first determine if the taxpayer is carrying on a trade or business before determining whether it is unitary, and add language noting that the state sourcing rule should not automatically assume the partnership is engaged in a business activity that gives rise to apportionable income.

Taxpayers should have the flexibility to apply the item-based approach as an alternative approach in addition to allowing the distributive share-based approach for determining the share of a partner’s apportionment factors, the AICPA suggested  The MTC should also remove the phrase “while not clearly required for blended apportionment” from the statement on the unitary business principle, the letter recommended. 

“Taxpayers and practitioners face much complexity with partnership structures, special allocations and related-party transactions,” said Ning Yim, senior manager for tax policy and advocacy with the AICPA, in a statement. “In addition, the effect on the ability of states to tax partnership income and the determination of how partnership income is sourced is a challenge. Accordingly, we offer additional recommendations regarding the approach of the MTC white paper on these issues.”