United States: Michigan Adopts Technical Corrections Addressing DRE Treatment

Recently adopted technical corrections legislation retroactively conforms Michigan's treatment of a disregarded entity (DRE) under the MBT and CIT to the federal income tax treatment of a DRE, potentially requiring the DRE's income and apportionment factors to be included in the income and apportionment factors of the DRE's parent, instead of being separately reported by the DRE, though some exceptions to the general rule have been created.¹ The legislation follows several pronouncements from the Michigan Department of Treasury treating a DRE as a separate filing entity, and is designed to put to rest potential controversies surrounding the proper filing method of a federally treated DRE.

Background

Historically, a taxpayer that was disregarded for federal income tax purposes was considered to be treated in the same manner for purposes of the Single Business Tax (SBT), the predecessor to the MBT and the CIT.² However, on May 12, 2009, the Michigan Court of Appeals held in Kmart Michigan Property Services LLC v Dep't of Treasury,³ that a federally disregarded single0member limited liability company was nevertheless required to file an SBT return separate from its owner.⁴ This decision was contrary to Treasury's position taken in Revenue Administrative Bulletin 199909⁵ that a taxpayer was restricted to the same entity filing status for SBT purposes that it had used for federal tax purposes for the same tax period.

In response to the notice issued in the aftermath of the Kmart decision, Michigan enacted what it termed to be "curative" legislation, preventing Treasury from: (i) assessing a taxpayer an additional tax or reducing an overpayment because the taxpayer originally included a DRE on its SBT return; and (ii) requiring the DRE entity to file a separate return.⁶ In addition, the legislation barred a taxpayer that filed an SBT return which included a federal DRE from claiming a refund based on the disregarded entity filing a separate return as a distinct taxpayer.⁷ As a result of the legislation, Treasury rescinded its notice discussing the effect of Kmart on the SBT.⁸

Undeterred, Treasury then issued several notices stating that federal DREs were required to file MBT returns separate from their owners, or file as a separate member of a unitary business group for all open periods under the MBT.⁹ The Treasury required amended filings even if the taxpayer's ultimate tax liability remained the same, and threatened penalties for noncompliance. Treasury's notices were considered to be not0so0subtle hints to the Michigan legislature to act in a manner similar to what happened for purposes of the SBT.

MBT Treatment

In ultimately taking its cue from Treasury, the Michigan legislature modified the Michigan treatment of DREs for purposes of the MBT and the CIT, but in a manner somewhat different than what was done for purposes of the SBT. With respect to the MBT, the change in DRE treatment is contained in one newly adopted section to the Michigan Compiled Laws. The general rule states that a person that is a DRE for federal income tax purposes is classified as a DRE for purposes of the MBT.¹⁰ This means that a DRE is not recognized for purposes of the MBT, the DRE includes its income and apportionment factors with the parent's income and apportionment factors, and a taxpayer that has filed MBT returns with a DRE filing as a separate entity must be amended to reflect the change in filing methodology. Unlike the amendment to the SBT, this rule does not specifically preclude taxpayers from pursuing refund claims in the event the change in filing methodology results in less tax than was previously calculated for prior MBT years.

There are two additional exceptions that potentially negate the general rule in certain instances. The first exception to the general rule states that a taxpayer with a federally treated DRE that prior to January 1, 2012, in an originally filed MBT return was treated as a separate entity, or prior to December 1, 2011, in an amended MBT return was treated as a separate entity for a tax year beginning after December 31, 2007, is not required to file an amended return to include the DRE's income and apportionment factors with the parent's income and apportionment factors.¹¹ This rule would appear to allow taxpayers who treated the DRE as a separate entity in their 2008, 2009 and/or 2010 tax years (originally filed before January 1, 2012, or amended before December 1, 2011 to file a return on which the DRE was separately reported) the option not to file an amended return for their 2008, 2009 and/or 2010 tax years, respectively. The second exception states that a taxpayer with a federally treated DRE that prior to January 1, 2012, in an originally filed MBT return was treated as a separate entity, or prior to December 1, 2011, in an amended MBT return was treated as a separate entity for its first tax year beginning after December 31, 2009, may treat the DRE as a separate entity for its tax year beginning after December 31, 2010 and ending before January 1, 2012.¹² Therefore, a taxpayer that treated the DRE as a separate entity on its MBT return covering the first tax period beginning in 2010 could treat the DRE as a separate entity on its 2011 MBT return.

The two exceptions to the general rule are expected to apply in very limited situations considering the clarification found in the general rule, the unitary business principle required to be followed in the MBT, and the unlikely circumstances where a domestic unitary group member actually could have filed separately from its owner.

CIT Effect

In addition to changing the treatment of a DRE for purposes of the MBT, additional technical corrections make changes to the newly adopted CIT.¹³ The corrections ensure that a federally treated DRE is treated in the same manner for purposes of the CIT, and confirms that a flow0through entity does not include an entity treated as a DRE (since the DRE would not be treated as a separate entity for Michigan CIT purposes, and the DRE's income and apportionment factors would be included in the DRE's parent's income and apportionment factors).

Commentary

The legislation essentially requires taxpayers to reconsider and potentially amend four years of MBT filings. For some taxpayers, refund claims may be available, while for others, additional tax exposure will exist. Some taxpayers with foreign DREs followed Treasury's initial guidance and excluded such entities from their unitary business groups, which did not have an independent filing requirement because they did not have nexus with Michigan for purposes of the MBT. As a result of this retroactive change, such foreign DREs may need to be included in the unitary business group. The question that will need to be considered is how the group's overall MBT liability is impacted. The group's MBT liability could increase if a formerly excluded DRE had some presence in Michigan and generated significant amounts of gross receipts and/or was profitable. In many cases, however, a DRE without significant Michigan presence will dilute the overall group's apportionment factors, and in some cases, the DRE may bring in losses and/or expenses which will offset the group's total gross receipts and/or net income.

Regardless of the impact on prior year MBT returns, the need to amend such returns could provide a good opportunity to reevaluate other aspects of the MBT, including the deduction from the modified gross receipts tax base, the MBT three0factor election based on Michigan's historic participation in the Multistate Tax Compact, and other issues.

The adoption of the legislation will have immediate ASC 740 consequences as well. As the legislation was adopted prior to the end of 2011, companies will take this law change into effect in the fourth quarter of 2011, even though the legislation potentially impacts tax liabilities for the 200802011 tax years. Taxpayers that now have a tax exposure item on this issue will be required to set an appropriate reserve.

Footnotes

1 Act 305 (S.B. 369), Laws 2011, effective Dec. 27, 2011.

2 The SBT was repealed effective December 31, 2007, and replaced by the MBT.

3 770 N.W.2d 915 (Mich. App. 2009), appeal denied, 772 N.W.2d 421 (Mich. 2009).

4 See former MICH. COMP. LAWS §§ 208.6 and 208.31.

5 Revenue Administrative Bulletin 199909, Michigan Department of Treasury, Nov. 29, 1999. This RAB was effective January 1, 1997 and covered the effect of a federal entity classification election on Michigan taxes.

6 Act 38 (H.B. 5937), Laws 2010, effective March 31, 2010.

7 Id.

8 "Rescinded: Notice to Taxpayers Regarding Kmart Michigan Property Services LLC v. Dep't. of Treasury, the Single Business Tax, RAB

1999)9, and RAB 2000)5," Michigan Department of Treasury, April 12, 2010. 9 "Notice to Taxpayers Regarding Federally Disregarded Entities and the Michigan Business Tax," Michigan Department of Treasury, issued November 29, 2010; revised April 30, 2011; further revised October 3, 2011; further revised Nov. 15, 2011).

10 Act 305 (S.B. 369), Laws 2011, § 512(1).

11 Act 305 (S.B. 369), Laws 2011, § 512(2).

12 Act 305 (S.B. 369), Laws 2011, § 512(3).

13 Act 309 (S.B. 678), Laws 2011, § 699, effective Jan. 1, 2012; Act 307 (S.B. 666), Laws 2011, eliminating § 605(3), effective Jan. 1, 2012; Act 306 (S.B. 653), Laws 2011, § 607(2), effective Jan. 1, 2012.

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.