Oregon Rules That Owner is Not Required to Combine Income of Multiple Pass-Through Entities

The Oregon Tax Court ruled that the state could not require a resident individual owner of multiple pass-through entities to report the combined income of all of those entities, since combined reporting is authorized for C-corporations only.

In order to capture the complete activity of a business operated by multiple related legal entities, many states require combined reporting for income tax purposes. Under a combined report, the separate members of the group that are conducting a unitary business enterprise[1] aggregate the income and loss of those members and then apportion the combined result in each of the states where any one of the members are subject to tax.

In a recent case that was decided in the Oregon Tax Court,[2] the Department of Revenue attempted to apply these combined reporting mechanics to a group of pass-through entities that operated as a unitary business enterprise. Ultimately, the tax court ruled that state law only provided a legal basis for C-corporations to file combined reports, not pass-through entities, and ruled in favor of the taxpayer.

In this particular case, an individual nonresident of Oregon held interests in several limited liability companies (treated as partnerships) and one S-corporation, some of which had income attributable to Oregon. Both the LLCs and S-corporation were treated by Oregon as pass-through entities, which are not themselves subject to income tax.  Instead, those entities pass through their taxable income to their owners, who are ultimately the ones that are taxed. When the owner filed his Oregon nonresident tax return, he reported income to the state based on his distributive share of income from the pass-through entities as apportioned to Oregon at the entity-level.  Some of the entities did not do business in Oregon and so the owner did not include any income from those entities on his Oregon return. Under audit, Oregon determined that the taxpayer and these entities were conducting a unitary business and that his income should instead be apportioned to the state after combining his share of the operations of all of the entities, including the ones with no Oregon source income. This resulted in an aggregation and apportionment of the pass-through entity income at the owner-level.

Variations of the sort of combined reporting that Oregon sought to require is common among the states when dealing with unitary groups of C-corporations. Further, many states provide for owner-level apportionment of pass-through entity income when that owner is a C-corporation. However, it is rare that these methods are applied to pass-through entities owned by an individual person.

The Department of Revenue argued that, when a group of pass-through entities with a nonresident owner conduct a unitary business, the state may compute Oregon source income by first combining the owner’s total distributive shares of income or loss from all of the entities in the group and then apportioning that income to Oregon using the owner’s combined share of Oregon apportionment factors for the group. In support of this position, the Department pointed to the state’s case law history on combined reporting as well as the tax statute[3] that requires nonresident individual taxpayers to utilize the apportionment provisions of UDITPA[4] when determining the portion attributable to Oregon.

The tax court rejected this argument and provided a lengthy analysis of how the position was incompatible with Oregon’s existing statutes on partnership and individual taxation.

First, the tax court walked through a timeline of the state’s former and current laws on combined group taxation and their timing with respect to relevant common law, concluding that the statutory basis for requiring combined reporting must be explicit and not implied. No such explicit authority exists for pass-through entities.

Next, the court addressed the Department of Revenue’s reliance on the nonresident income tax statute requiring the apportionment of a nonresident’s income from a business, trade, profession or occupation to be consistent with the state’s incorporation of UDITPA. The court noted that although UDITPA addresses the determination of income by a business partly within and without Oregon, nothing within the underlying statutes serve as a basis for requiring combined reporting of income. In other words, combination is not inherent within UDITPA and may be required only if there is other statutory basis to do so.

Finally, the court walked through the language and context of Oregon’s statutes involving the taxation of partnerships, S-corporations and their individual owners to note their incompatibility with the Department of Revenue’s position. In each case, interpretation favored the taxpayer’s position rather than the Department of Revenue’s.

In conclusion, the tax court asserted that after considering the language and context of the partnership tax statutes, UDITPA, and the history of combined reporting in Oregon, it had determined that none are consistent with the state’s attempt to effectively impose a combined reporting result on a group of pass-through entities without explicit statutory authority to do so.

The rules regarding state taxation of multi-state pass-through entities and their resident and non-resident owners is one of the more complex areas in state taxation and one that is often lacking in helpful guidance.  While this case may only be directly applicable to Oregon, the comprehensive analysis in this ruling could serve as a good outline of the issues to examine and address if a taxpayer is facing a similar challenge in another state.

Aprio’s SALT group has experience addressing state tax issues related to multi-state pass-through entities and can assist businesses to make sure that they are allocating and apportioning correctly.  We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the October 2018 SALT Newsletter.

[1] State definitions of a unitary business group vary but generally entail common ownership, functional integration, economies of scale, and/or centralized management among the members.

[2] Thomas M. Cook v. Department of Revenue, State of Oregon, TC 5298 (Oregon Tax Court, August 17, 2018)

[3] OR Rev. Stat. §316.127(6).

[4] UDITPA (Uniform Division of Income for Tax Purposes Act) is a model tax statute that addresses the apportionment and allocation of income from a multistate business. Many states have incorporated UDIPTA in whole or part into their own tax statutes, although more and more states are beginning to diverge from it.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.