Can a corporation treat income from its 17% interest in an operating LLC as a passive investment, exclude the LLC's factors, and allocate the income outside Virginia?

Plain-English summary

A corporation operating refineries owned 17% of an LLC that operated retail stores. It originally included its share of the LLC's property, payroll, and sales factors and apportioned the LLC's income to Virginia. It later sought refunds for 2013-2015 by removing those factors and allocating the income outside Virginia, arguing the LLC interest was merely a passive investment.

The Department rejected that position. Although the LLC elected federal partnership treatment, an LLC is a distinct legal entity whose business income passes through to its members. The Department does not treat a nonmanaging LLC member as a limited partner merely because the member has a restricted management role. For Virginia income-tax purposes, the member is treated as owning a share of the PTE's assets and liabilities, and PTE items retain their character under Va. Code § 58.1-391 B.

Virginia PTEs doing business inside and outside the state generally apply the corporate allocation and apportionment rules in Va. Code §§ 58.1-408 through 58.1-421. Here, the corporation's 17% interest also exceeded the 10%-or-less ownership condition in P.D. 95-19's limited-partner factor-exclusion test. The LLC actually operated a retail business, unlike a vehicle holding only passive investments, so its operating characteristics flowed through to the corporation.

The corporation also failed to show by clear and convincing evidence that the LLC interest was not a unitary part of its business or that an alternative method under Va. Code § 58.1-421 was appropriate. The Department therefore denied the requested refunds.

What this means for you

Corporate members of operating LLCs

Federal partnership treatment does not by itself turn an LLC interest into a passive limited-partner investment for Virginia apportionment. Expect the operating LLC's income and appropriate property, payroll, and sales factors to flow through.

Businesses seeking alternative apportionment

Calling an ownership interest an investment is not enough. The taxpayer bears the burden of proving that the interest is not operational or unitary and that the statutory method produces a result requiring an alternative.

Minority LLC owners

A minority ownership percentage and limited board representation did not control here. The 17% interest exceeded the Department's 10% limited-partner threshold, and the nature of the LLC's actual business remained central.

Common questions

Q: Does an LLC's federal partnership return make its corporate member a limited partner for Virginia tax?
A: No. The Department said federal partnership classification does not automatically qualify an LLC member for limited-partner treatment.

Q: Could the corporation exclude the retail LLC's apportionment factors?
A: No. It had to include the appropriate share of the LLC's property, payroll, and sales factors when apportioning Virginia taxable income.

Q: Was the requested alternative allocation method granted?
A: No. The corporation did not prove that the LLC interest was outside its unitary business or otherwise justify an alternative method.

Citations and references

• Va. Code § 58.1-391 B -- character of pass-through items for an owner
• Va. Code §§ 58.1-408 through 58.1-421 -- corporate allocation and apportionment rules
• Va. Code § 58.1-421 -- alternative allocation and apportionment
• Va. Code § 13.1-1022 A -- management of Virginia LLCs
• Va. Code §§ 50-73.23, 50-73.29 A, and 50-73.102 -- limited- and general-partner rights and duties
• P.D. 95-19 (2/13/1995) -- limited-partner factor-exclusion conditions
• P.D. 07-118 (7/19/2007) and P.D. 07-197 (11/30/2007) -- operating PTE interests distinguished from passive investments

Subject

Pass-Through Entity (PTE): Income - Income from PTE Interest; Allocation and Apportionment: Alternative Method - Nonbusiness Income

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 19-114

Original ruling text

October 4, 2019

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek a refund of corporate income tax paid * (the “Taxpayer”) for the taxable years ended December 31, 2013 through 2015. I apologize for the delay in responding to your request.

FACTS

The Taxpayer was a corporation headquartered and domiciled in * (State A) that operated refineries. It owned a 17% interest in *** (PLLC), a limited liability company treated as a partnership for federal income tax purposes that operated retail stores.

The Taxpayer included the apportionment factors of PLLC in its Virginia corporate income tax calculations and apportioned PLLC’s income to Virginia. The Taxpayer subsequently filed amended returns for refund, removing PLLC’s apportionment factors and allocating its income outside of Virginia. Under review, the Department denied the refunds because the Taxpayer owned more than 10% of PLLC. The Taxpayer appeals the denial of the refunds, contending that it should be allowed to allocate the income generated by PLLC because its ownership interest was a mere investment.

DETERMINATION

Limited Liability Companies

The Department has previously ruled that a corporation that holds a general partnership interest in a partnership must include its proportionate share of partnership property, payroll and sales in its own factors for purposes of apportioning Virginia taxable income. See Public Document (P.D.) 88-226 (7/12/1988).

In P.D. 95-19 (2/13/1995), the Department expanded this ruling to include a limited partner, unless all of the following tests are met: (1) a corporation holds a limited partnership interest; (2) all general partners are unrelated third parties; (3) the combined partnership interests held by the corporation and all related parties constitute 10% or less of the profit and capital interest of the limited partnership; and (4) the structure is not a device primarily designed to avoid Virginia taxation of the limited partnership's income. The corporate limited partner in P.D. 95-19 failed the test because the general partner was another corporation in the same affiliated group and the two corporations owned 100% of the partnership interests combined. Accordingly, the Department held that the limited partner in P.D. 95-19 was subject to Virginia income tax even though it had no other connection to Virginia other than its interest in the limited partnership.

The Taxpayer contends that its investment in PLLC was a passive investment in a limited liability company because it held a minority number of seats on PLLC’s Board of Managers. In addition, the Taxpayer did not participate in the day-to-say management of PLLC and did not share any of its corporate functions such as marketing, purchasing, accounting and legal. Further, the Taxpayer had no authority to unilaterally bind the limited liability company during the taxable years at issue. The Taxpayer argues that its limited role with PLLC is analogous to a limited partnership interest. As such, it should not be required to apportion PLLC’s income in accordance with P.D. 95-19.

Under Treasury Regulations § 301.7701-1 et seq., labeled “check the box” regulations, entities are permitted to choose a federal classification or be classified under the regulation’s default provisions. If a limited liability company elects to be treated as a pass-through entity for federal income tax purposes, it is required to file a partnership return pursuant to IRC § 761.

A limited liability company, however, is different from a partnership. It shares characteristics of both partnerships and corporations. Like a partnership, a limited liability company is deemed to be a pass through entity that passes its profits and losses through to its members. Unlike a partnership, a limited liability company is a separate legal entity, distinct from its members and has full powers to conduct business in its own name. Limited liability companies are created by statute while partnerships are created by common law. As a legal entity separate from its members, a limited liability company will generally be considered to be operating as a business. Therefore, a limited liability company that passes through its income to its members is merely electing to have its business income taxed in a different manner.

A limited liability company can be managed by its members or by a manager designated by its members. The Taxpayer appears to assert that PLLC is managed by other members or by a management team, and its interest should be treated as if it was a limited partner. The United States Tax Court has distinguished between manager members and other members of LLCs, but defers to state law to distinguish between limited liability companies and partnerships. See Paul D. Garnett, et ux. v. Commissioner , 132 TC 368 (2009). Thus, the mere fact that PLLC files federal partnership returns does not automatically make the Taxpayer a limited partner eligible for treatment under P.D. 95-19.

Pursuant to Virginia Code § 13.1-1022 A, the management of a limited liability company in Virginia is vested in its members unless the articles of incorporation or an operating agreement provides for the management by a manager or managers. Limited partners in a limited partnership do not participate in the management of the enterprise unless a partnership agreement grants the right to vote upon business matters. See Virginia Code § 50-73.23 and First Union Nat’l Bank v. Allen Lorey Family L.P. 34 Va. Cir 474 (1994).

In Virginia, members of a limited liability company run by a manager are similar to limited partners in that they have a restricted role in the conduct of the limited liability company’s business. Limited liability company managing members have a fiduciary duty to act in good faith to the limited liability company, but not to the other members. See Credit Experts, LLC v. Santos (In re Santos), 2012 Bankr. LEXIS 3076 (Bankr. E.D. Va. 2012).

Under Virginia Code § 50-73.29 A, a general partner of a limited partner has the same rights and powers of a partner in a partnership without limited partners. In addition to the fiduciary duties a general partner owes to a partnership, they are also responsible for the duty of loyalty and care to other partners, whether limited or not. See Virginia Code § 50-73.102

As a result of the differences under Virginia law, the Department has concluded that, although limited liability companies 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. See P.D. 07-70 (5/18/2007). As such, the Department does not distinguish between members of a member managed limited liability company and a manager managed limited liability company.

For federal income tax purposes, attributes and activities of the PLLC will flow through to the Taxpayer. Further, the Department considers a taxpayer to be the owner of a share of the pass-through entity’s assets and liabilities. See P.D. 97-343 (8/28/1997). Virginia Code § 58.1-391 B provides:

Each item of pass-through entity income, gain, loss or deduction shall have the same character for an owner under this chapter as for federal income tax purposes. Where an item is not characterized for federal income tax purposes, it shall have the same character for an owner as if realized directly from the source from which realized by the pass-through entity or incurred in the same manner by the pass-through entity.

Pass-through entities that have income from activity both within and without Virginia are required to compute their Virginia source income in accordance with the corporate statutory formula set forth in Virginia Code §§ 58.1-408 through 58.1-421. As such, pass-through entities generally must allocate dividends to the state of commercial domicile and apportion all other income. Income is apportioned using a three-factor formula based on the property, payroll and sales within Virginia. See P.D. 88-165 (6/29/1988) and P.D. 07-150 (9/21/2007). Therefore, the Taxpayer will include income or loss of PLLC in determining Virginia taxable income and the appropriate amount of PLLC’s property, payroll and sales in determining income apportioned to Virginia.

Alternative Method of Apportionment

If the entire business of the pass-through entity is not deemed to have been transacted or conducted within Virginia, then such pass-through entity’s income from Virginia sources is the portion of income allocated and apportioned to Virginia in the same manner as corporations. See P.D. 07 150 (9/21/2007).

Accordingly, LLCs that have income subject to tax in Virginia and at least one other state are required to apportion income as provided in Virginia Code §§ 58.1-408 through 58.1-421. The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer’s entire federal taxable income, adjusted and modified as provided in Virginia Code §§ 58.1 402 and 58.1 403, less dividends allocable pursuant to Virginia Code § 58.1-407, is subject to apportionment. The Taxpayer’s protest has been treated as a request for an alternative method of allocation and apportionment in accordance with Virginia Code § 58.1-421.

In any proceeding with the Department, the Taxpayer bears the burden of showing that the imposition of Virginia's statute is in violation of the standards enunciated by the United States Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation , 504 U.S. 768, 119 L.Ed.2d 533 (1992) and clarified in Meadwestvaco Corporation v. Illinois Department of Revenue , 553 U.S. 16, 128 S.Ct. 1498 (2008). In order to meet the standards set by the United States Supreme Court, a taxpayer must demonstrate that its investments are not operational assets involved in a unitary business.

In considering the existence of a unitary relationship, the United States Supreme Court has focused on three objective factors: (1) functional integration; (2) centralization of management; and (3) economies of scale. See Mobil Oil Corp. v Commissioner of Taxes , 445 U.S. 425 (1980); F. W. Woolworth Co. v. Taxation and Revenue Dept. of N.M. , 458 U.S. 352 (1982); and Allied-Signal .

The decision of the United States Supreme Court in Allied-Signal also made it clear that the payee and payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. In Meadwestvaco supra at 29, 128 S.Ct. 1507, the Supreme Court clarified that the decision in Allied-Signal did not create “a new ground for the constitutional apportionment of extrastate values in the absence of a unitary business.” Still, it opined the operational function analysis in Allied-Signal could be influential to the finding that an asset was a unitary part of a business being conducted in the taxing jurisdiction. Accordingly, the form of an entity’s business and the purpose of its investments are both relevant in determining if an asset was a unitary part of the business conducted by such entity.

As indicated above, Virginia Code § 58.1-391 B provides “[e]ach item of pass-through entity income, gain, loss or deduction shall have the same character for a partner under this chapter as for federal income tax purposes.” For Virginia income tax purposes, income retains its character as income from the operations of a pass-through entity in computing Virginia taxable income and is properly included in the apportionable income of the shareholder. This means that, for income tax purposes, the owners are considered to be reporting the operating income of the business conducted by the pass-through entity. As such, the Department generally presumes that the income passed through from a pass-through entity to be operational. See P.D. 07-197 (11/30/2007).

The Taxpayer contends that P.D. 93-140 (6/4/1993) and 7-Eleven, Inc. f/k/a the Southland Corporation v. Comptroller of the Treasury , Court of Special Appeals of Maryland, No. 1661 (6/13/2001) are applicable to its case. Both P.D. 93-140 and Southland Corporation can be distinguished from the Taxpayer’s facts because the income at issue resulted from the sale of assets. In this case, the Taxpayer received income from the operations of PLLC, not from the sale of its interest in PLLC.

In P.D. 07-197, the income generated by investments in stocks, bonds, and limited partnership interests made by a partnership formed by a group of corporate taxpayers was considered an investment, rather than operational income. The Department’s rationale is that the assets and income of the partnership were not used to supplement or enhance the operations of the group. In P.D. 07-118 (7/19/2007), however, a pass-through entity that was a member of another pass-through entity that operated a hotel was required to include the hotel’s apportionment factors in its Virginia taxable income. The Department determined that the characteristics as an operator of the hotel would flow through to the Taxpayer.

In P.D. 07-197, the income was generated by passive investments in stocks, bonds and limited liability companies whereas in P.D. 07-118, the investment was in a pass-through entity that actually operated a business. In this case, PLLC operates a retail business. Therefore, the characteristics of the operator of the retail business would flow through to the Taxpayer. Because it is considered to be operating a retail business for income tax purposes, PLLC is considered to be a unitary part of the Taxpayer’s business.

CONCLUSION

Because the Taxpayer’s interest in PLLC was greater than 17%, its interest in PLLC does not qualify for the factor exclusion permitted by PD 95-19. In addition, the Taxpayer has not demonstrated that its ownership interest in PLLC was not a unitary part of its business operations. Because it has failed to provide clear and convincing evidence that an alternative method of allocation and apportionment is appropriate, the Taxpayer's request for a refund for the taxable years ended December 31, 2013 through 2015 is not granted.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1600.B

Related Documents

88-226

95-19

07-70

97-343

88-165

07-150

07-197

93-140

07-118