Tax Type
Individual Income Tax
Description
Limited partnership /LLC qualify for the credit in different circumstances
Topic
Credits
Date Issued
05-18-2007
May 18, 2007
Re: Request For Ruling: Individual Income Tax
Dear *****:
This will reply to your letter in which you request a ruling regarding the availability of the credit for taxes paid other states. I apologize for the delay in responding to your letter.
FACTS
In Public Document (P.D.) 05-18 (2/25/2005), the Department determined that a distribution of income from a limited partnership engaged in the rental of real estate did not constitute business income for purposes of the out-of-state tax credit in Va. Code § 58.1-332 A. You request clarification as to when income from a limited partnership or a limited liability company engaged in real estate activities would qualify for the credit.
RULING
Virginia Code § 58.1-332 A provides, in pertinent part, that the out-of-state tax credit will be computed based on earned income. For purposes of computing the credit, Title 23 of the Virginia Administrative Code (VAC) 10-110-221 states, "Only an income tax paid to another state on earned or business income from sources outside of Virginia qualifies for the credit." The regulation defines "business income" as "income derived from an activity which constitutes a 'business' for federal income tax purposes for which a federal Schedule C, E, or F must be filed."
The Department has ruled this definition contemplates a person engaging in a continuous and regular course of business. Sporadic activities or isolated transactions do not qualify as business income. The treatment of an activity as a business will be dependent upon the facts and circumstances.
Limited Partnerships
A partnership is an association of two or more persons to carry on as co-owners a business for profit that is considered a separate legal entity for most purposes. Thus, it is the individual general partners together who are engaged in a business activity. When a general partner withdraws from a partnership, the partnership must be dissolved, and if the remaining partners wish to continue the business, a new partnership is formed. For purposes of the out-of-state tax credit, a general partner will be considered to be engaged in a business activity.
Limited partners contribute capital to a common fund, but do not manage the partnership's business. Limited partners are not liable for debts of the partnership beyond the amount of the capital contribution. Under Va. Code § 50-73.45, an assignment of a limited partnership interest does not dissolve a limited partnership. The limited partner is, in essence, investing in a business conducted by others. In P.D. 94-275 (9/16/94), the Department ruled that a limited partner's interest in a limited partnership is an intangible asset.
Typically, a Virginia resident who owns a limited interest in a limited partnership is allowed a credit for state income taxes paid to another state as a result of activities of the limited partnership. In P.D. 94-240 (8/5/1994), the Department stated that shareholders of a Virginia S corporation that is a limited partner in a Louisiana limited partnership engaged in manufacturing would be eligible for an out-of-state tax credit.
The Taxpayer argues that passive income under Internal Revenue Code (I.R.C.) § 469 is not portfolio or investment income, but is merely a label used by the Internal Revenue Service to limit losses from certain business activities. Federal passive activity rules were enacted under the Tax Reform Act of 1986 in order to control the proliferation of tax shelters. The primary concern was business enterprises producing losses, in which individuals did not materially participate, which were offset against other sources of income. Rental activities were specifically targeted because they generally require less ongoing management, in proportion to invested capital, than businesses engaged in producing goods and services. In the case of real estate rental businesses, individuals could invest in an appreciating asset and reduce their income tax liability at the same time.
In P.D. 05-18, the Department references I.R.C. § 469(h)(2), which states, "no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates." The concept of material participation equates to the Department's standard that a person must be engaged in a continuous and regular course of business in order to constitute income from a business for purposes of the out-of-state tax credit. When a limited partner, without involvement in management, is involved in an activity that continually results in losses, the Department must question if the activity is part of the continuous and regular course of a business primarily engaged for profit.
Under Title 23 VAC 10-110-221 B 3, activities not engaged in primarily for profit are not considered to be business income, even if reported on federal Schedule C, E, or F. In the case addressed in P. D. 05-18, the evidence indicated that the rental real estate limited partnership reported net losses from real estate activities in which the taxpayers held a minority limited interest.
As a result of the losses, the taxpayers had no positive income to report in the other state and were able to fully use the losses to reduce Virginia taxable income. The Department found that the taxpayers were not entitled to a credit for income tax paid to other states on the gains resulting from the sale of real estate because the taxpayers did not participate in the management of the limited partnership and profit did not appear to be the primary motive for the investment.
As noted in P.D. 05-18, Va. Code § 58.1-332 A was amended by the Virginia General Assembly in 1999. Effective for taxable years beginning on and after January 1, 2000, the credit for income tax paid to another state may be computed on the gain on the sale of a capital asset not used in a trade or business. The determination in P.D. 05-18 applies to the sale of real estate during the 1999 taxable year and, therefore, was not affected by the legislation change. Thus, P. D. 05-18 is not applicable to the sale of a capital asset occurring in a taxable year beginning on and after January 1, 2000.
Limited Liability Companies
A limited liability company (LLC) shares characteristics of both partnerships and corporations. Like a partnership, a LLC is deemed to be a pass-through entity that passes its profits and losses through to its members. A LLC is a separate legal entity, distinct from its members and has full powers to conduct business in its own name.
A LLC can be managed by its members or by a manager designated by its members. Members of a LLC run by a manager are similar to limited partners in that they have a restricted role in the conduct of the LLC's business. The question is whether members of a manager-managed LLC are similarly situated with regard to the credit under Va. Code § 58.1-332 A.
As a separate legal entity, a LLC will generally be considered to be operating as a business. Therefore, a LLC that passes through its income to its members is merely electing to have its business income taxed in a different manner. Although LLC's are treated as partnerships for purposes of determining federal adjusted gross income, the election to have the income passed through to its members more closely resembles the treatment of shareholders in an S corporation. As such, the Department will not distinguish between members of a member-managed LLC and a manager-managed LLC. Thus, for purposes of the out-of-state tax credit, income passed through to any member would be eligible for the credit provided the LLC is engaged in a continuous and regular course of business.
State of Residence Credit
Virginia Code § 58.1-332 B provides a credit to nonresidents on income from Virginia sources when their home state provides a substantially similar credit to Virginia residents or imposes a tax upon the income derived from Virginia sources that is exempt from taxation by Virginia. This credit does not contain the same limitations as the credit under Va. Code § 58.1-332 A. Accordingly, the credit available to nonresidents is not limited to earned or business income. However, because it is dependent on another state granting a similar credit, it may be limited by the credit permitted by the other state.
CONCLUSION
The general rules set forth in this document should provide sufficient guidance to determine whether each set of circumstances presented in your letter results in income eligible for the out-state-tax credit. As indicated earlier, the determination as to whether certain income qualifies for the credit will depend on the facts and circumstances of each individual case.
The Code of Virginia sections under Title 58.1 and regulations cited are available online at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions about this ruling or one of the scenarios, you may contact ***** in the Department's Office of Policy and Administration, Appeals and Rulings, at *****.
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- Sincerely,
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- Janie E. Bowen
Tax Commissioner
- Janie E. Bowen
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AR/55490E
Rulings of the Tax Commissioner