Creative Planning May Reduce State Taxes
State and local taxes represent an increasing portion of the overall tax cost of any real estate transaction. As more businesses become national and even global, state and local tax planning become more crucial.
In early March, the New Jersey Division of Taxation confirmed the applicability of a controversial regulation that may provide corporate taxpayers that hold real estate through limited partnerships in that state with a unique tax-planning opportunity.
New Jersey Reg. Sec. 18:7-7.6 provides that an out-of-state corporation that is a limited partner in an LP doing business in New Jersey is not required to file a New Jersey corporation business tax return just because the LP has business in the state.
No State Taxes
Generally, state tax authorities require out-of-state corporations that derive income from sources within that state to file a corporate income tax return in that state.
Accordingly, corporations may be taxed twice, subject to apportionment, on the same out-of-state income: once in the state in which they are legally incorporated and once in the state where the income is sourced. However, some corporations are able to avoid one of these state tax layers by incorporating under the laws of a state that does not levy a corporate income tax, such as Delaware or Nevada.
While eliminating one layer of state income tax is a positive result, creating a structure to eliminate both layers of state income tax would be even better. This result potentially can be achieved by employing New Jersey Reg. Sec. 18:7-7.6 in conjunction with a company incorporated under the laws of a state that does not levy a corporate income tax.
Specifically, Reg. Sec. 18:7-7.6(a) provides that a foreign corporation (not incorporated under New Jersey laws) that is a general partner of a general or limited partnership or is deemed to be a general partner in an LP doing business in New Jersey is subject to filing a corporation business tax return in New Jersey and paying the applicable tax under the terms of the corporation business tax to New Jersey.
However, Reg. Sec. 18:7-7.6(b) provides an exception to the general rule. It states that the general rule does not apply to out-of-state corporations whose only connection to the state is owning one or more LP interests in one or more LPs doing business in New Jersey, unless the following conditions exist: the corporate limited partner also is a general partner of the LP; the out-of-state corporation limited partner — in addition to exercising its rights and powers as a limited partner — takes an active part in control of the partnership business; or the out-of-state corporate limited partner itself directly is doing business in New Jersey pursuant to state regulations.
If complied with, Reg. Sec. 18:7-7.6 will not subject out-of-state corporate limited partners to New Jersey state income or franchise taxes. This conformation, coupled with various state court decisions, has laid to ruin New Jersey's corporate income tax on out-of-state corporations with New Jersey source income from LPs, thus paving the way for a unique state tax-planning opportunity.
Multistate Taxation Reprieve?
For instance, assume a Delaware corporation holds income-producing property through a New Jersey LP. In the proposed structure, income generated by the property that flows to its Delaware corporate partners is taxed neither by Delaware, by virtue of being incorporated in that state, nor by New Jersey, by virtue of Reg. Sec. 18:7-7.6.
The accompanying chart illustrates the potential state tax savings of a proposed transaction. For the sake of simplicity, assume that the corporation's distributable share of income generated by the property of the partnership is $1 million and that the $1 million is the corporation's only income. The state income tax liabilities vary considerably, from nothing to $130,000 when using for comparison the states of Maryland and Virginia, where the corporate income tax rates are 7 percent and 6 percent respectively.
Issues to Consider
Corporations holding an interest in a New Jersey LP will not be subject to New Jersey corporate state income tax on New Jersey-sourced income, provided that the limited partner also is not a general partner of the LP; the out-of-state corporate limited partner, in addition to the exercise of its rights and powers as a limited partner, does not take an active part in the control of the partnership business; or the out-of-state corporate limited partner itself directly is not doing business in New Jersey pursuant to state regulations.
As demonstrated above, with a proper structure that employs the rules outlined by New Jersey Reg. Sec. 18:7-7.6., corporate limited partners can realize significant corporate state income tax savings. It is important to note, however, that while limited liability corporations generally are treated like partnerships for federal income tax purposes, they are not treated as LPs for purposes of applying this regulation. Accordingly, the proposed structure employing a Delaware corporation and a New Jersey LP would not create the same result using a New Jersey LLC instead of a New Jersey LP.
In light of the many complexities of multistate taxation, it is imperative that taxpayers contemplating using any type of state tax-planning structure, including those discussed above, consult with their tax adviser.