The New York State Tax Appeals Tribunal has held that out-of-state corporations that had passive ownership of a partnership conducting business in the state had nexus for purposes of New York corporation franchise tax.1 Even though the corporations did not conduct business in New York in their own capacity, their ownership interest in the partnership was sufficient to establish nexus.

Background

The taxpayers were out-of-state holding companies organized under Delaware law. They did not conduct business in New York but they had a membership interest in an LLC ("LLC").2 LLC indirectly held a one percent general partnership interest and a 58.1 limited partnership interest in a limited partnership ("LP1") that filed partnership returns in New York. LP1 directly held a 99 percent limited partnership interest and through disregarded entities a one percent general partnership interest in another limited partnership ("LP2"), which conducted business, owned property and made sales in New York. Thus, LLC ultimately held a general partnership interest in LP2. For certain federal income tax purposes, LP2 was a disregarded entity. No tax was imposed on LP2's income until it passed through to the corporate members of LLC, the ultimate recipients of New York income.

The taxpayers filed forms claiming that they did not have tax liability in New York, but they indicated that they participated in a partnership, limited liability company/partnership or joint venture doing business in New York.3 The Division of Taxation audited the taxpayers and found that they were subject to New York corporation franchise tax. On appeal, the Administrative Law Judge ("ALJ") determined that the taxpayers were properly assessed tax as indirect recipients of New York income. Specifically, the ALJ held that the taxpayers, as members of the corporate general partner, LLC, which ultimately held a general partnership interest in LP2, a firm which did business in New York, were required to pay corporation franchise tax.

Taxpayers Owning Indirect Partnership Interest Subject to Tax

The Tax Appeals Tribunal affirmed the ALJ and held that the taxpayers had nexus with New York. Under New York law, LLCs that are treated as partnerships for federal income tax purposes are treated as partnerships under New York tax law.4 A corporation is subject to corporation franchise tax if it does business in the state, employs capital in the state, owns or leases property in the state or maintains an office in the state.5 A regulation expressly provides that if a partnership is doing business in the state, then all of the corporate general partners are subject to corporation franchise tax.6

The taxpayers argued that they did not have the contacts with New York that were necessary to impose the corporation franchise tax. According to the taxpayers, imposition of the tax on them violated the Due Process Clause and Commerce Clause of the U.S. Constitution as described by the U.S. Supreme Court in Quill Corp. v. North Dakota.7 Further, the taxpayers argued that imposition of the tax was contrary to the U.S. Supreme Court's four-part test in Complete Auto Transit v. Brady due to their lack of activity in New York.8

The Tax Appeals Tribunal rejected the taxpayers' arguments. The New York Court of Appeals has held that the state's power to tax does not need to be based on the taxpayer's own activities in the state.9 In order to justify the imposition of tax, the relevant inquiry is whether New York has given something for which it may impose a tax in return. New York satisfied this standard because it provided privileges and immunities that led to LP2's income, which was passed to its shareholders, including the taxpayers.

In support of its decision, the Tax Appeals Tribunal explained that the fact the taxpayers did not have any activities in New York in their own capacity was not the relevant issue. Rather, the issue involved the activities of LP2, which was wholly owned, directly or indirectly, by LP1. In turn, LLC had a substantial interest in LP1. There was no question that LP2, a disregarded entity for federal income tax purposes, did business in New York and that LP1 reported all of LP2's income and expenses on its informational return. In short, LP2's activities were the activities that were being taxed. LP2 met the four-prong test established in Complete Auto Transit, the physical presence required by Matter of Orvis Co. v. Tax Appeals Tribunal10 and the presence necessary to satisfy the Due Process Clause as described in Quill.

Commentary

New York has a reputation for imposing broad nexus standards, particularly in the area of sales and use taxation. However, taxpayers with a passive ownership interest in a business with activity in New York must be aware that they may have corporate income tax nexus with the state.11 Other than owning an indirect interest in a limited partnership that conducted business in the state, the taxpayers had no connection with New York. Although their ownership interest of the limited partnership was through multiple layers of pass-through entities, the taxpayers received income from New York sources that had not previously been taxed. Thus, a general partnership interest is sufficient to establish nexus even if it is far removed from the entity with activity in New York.12

Footnotes

1 Shell Gas Gathering Corp. #2 and Shell Gas Pipeline Corp. #2, New York Division of Tax Appeals, Tax Appeals Tribunal, DTA Nos. 821569 and 821570, Sept. 23, 2010.

2 The taxpayers were not licensed to do business in New York and they did not own property or have any employees in the state.

3 The taxpayers filed Form CT-245, Maintenance Fee and Activities Return for a Foreign Corporation Disclaiming Tax Liability.

4 N.Y. TAX LAW § 208(1).

5 N.Y. TAX LAW § 209(1).

6 N.Y. COMP. CODES R. & REGS. tit. 20, § 1-3.2(a)(5).

7 504 U.S. 298 (1992).

8 430 U.S. 274 (1977). To satisfy the Commerce Clause, the following tests must be met: (1) there is substantial nexus with the taxing state, (2) the tax is fairly apportioned, (3) the tax does not discriminate against interest commerce and (4) the tax is fairly related to the services provided by the state.

9 Matter of Allied-Signal, Inc. v. Commissioner of Finance, 588 N.E.2d 731 (N.Y. 1991). The Tax Appeals Tribunal relied on this case to support its decision. In this case, the New York Court of Appeals expressly stated that is was addressing both Due Process Clause and Commerce Clause issues when it found the New York City method of taxing the income of foreign corporations with an interest in New York businesses did not violate the U.S. Constitution.

10 654 N.E.2d 954 (N.Y. 1995).

11 Note that there are specific types of passive entities that can be used in a corporate structure where nexus would not result. For example, a portfolio investment partnership could be used in certain circumstances. N.Y. COMP. CODES R. & REGS. tit. 20, § 1-3.2(a)(6)(i).

12 Ownership of a partnership interest is sufficient to create nexus in many states. For example, this rule is followed in Kentucky (Revenue Cabinet v. Asworth Corp., Kentucky Court of Appeals, Nos. 2007-CA-002549-MR, 2008-CA-000023-MR, Nov. 20, 2009); New Jersey (N.J. ADMIN. CODE § 18:7-7.6) and Wisconsin (WIS. STAT. § 71.22(1r)).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.