The number of passthrough entities (which includes partnerships, limited liability companies, and S corporations) has been on the rise for the last 30 years. And along with the increase in the number of passthrough entities has been a decrease in the number of C corporations. According to the Tax Foundation, passthrough businesses now account for 94 percent of all businesses in the United States.
None of that is really news. The rise of the passthrough entity is well documented. It’s also not news that, at the federal level, partnership audits will be on the rise. Very briefly, under new federal rules, the IRS will assess tax on the partnership (at the entity level) and the partnership will be tasked with determining how to pass the tax through to partners. Stories have been written about the effect that the new partnership regime will have on state tax administration.
But I wonder what this means for states. Will states be able to manage an increase in federal adjustments to partnership returns? Will states be able to manage an increase in partnership audits in general? It seems unlikely. State taxing agencies are not well staffed to perform many additional complex or technical audits. This is one of the reasons states shied away from transfer pricing -- they don’t have staff that understands the complexities of transfer pricing or experts who could produce transfer pricing reports.
What will states do? And will they simply avoid doing partnership (and other passthrough entity) audits all together and turn to entity-level taxes?
There is certainly concern that states will struggle to adapt to the IRS’s new partnership audit regime. During a panel at the State and Local Taxes session of the ABA Section of Taxation meeting on May 6, representatives from the American Institute of CPAs, the American Bar Association, the Multistate Tax Commission, and the Council On State Taxation said they were discussing ways to jointly help states.
At the same panel, practitioners raised numerous concerns about how states would react. Bruce Ely of Bradley Arant Boult Cummings LLP said taxpayers want to avoid a situation in which states had 50 different reactions. That would set the stage for a compliance nightmare for taxpayers. Other issues raised included whether state laws would need to change for a partnership to be considered a taxpayer under state law and whether states would need to change composite return rules.
One state, Arizona, has enacted a measure to update the revenue agent report statutes to reflect the IRS’s new partnership audit rules. Beyond that, a few states have established working groups to examine these and other issues. It seems likely, however, that at least some states will consider their own entity-level tax regime and not bother trying to implement the new federal rules for partnerships. Currently, roughly half of the states impose some sort of entity-level tax on passthrough entities.
Some of the entity-level taxes are fixed annual assessments. For example, Connecticut imposes an annual “business entity tax” of $250 on LLCs and limited liability partnerships. Vermont imposes a $250 annual tax on LLCs and LLPs, and Rhode Island imposes a $500 tax on LLCs taxed as partnerships.
Other states impose entity-level taxes more analogous to an income tax. For example, Illinois imposes a 1.5 percent replacement tax on partnerships and LLCs. Kentucky imposes a limited liability entity tax that is equal to the lesser of 9.5 cents per $100 of Kentucky gross receipts or 71 cents per $100 of Kentucky gross profits.
Given the option of dealing with the many issues that will arise because of the new federal partnership audit rules or finding an alternative (hopefully less complex) means of taxing and auditing passthrough entities, I tend to think at least some states will choose the latter. In any case, it will be interesting to watch the discussion during the next year as states drill down and identify all the issues with the new federal partnership audit rules, and ultimately determine their next moves.