Federal tax law is difficult enough to understand. But state tax law can be even more cumbersome, especially considering the variation from state to state. Upon closer examination though, there are some general themes that one can examine as it relates to state taxation. The goal herein is to examine a few of these differences.
First, let’s understand that most states have some form of individual income tax. However, below is a list of the seven states that do not have an individual income tax. Some states do impose other taxes and assessments:
- South Dakota
In addition, the following are states with limited income tax:
- New Hampshire (only taxes interest, dividends and business profits)
- Tennessee (only taxes income received from stocks and bonds)
For states with an individual income tax, the state of domicile will generally tax an individual based on worldwide income. However, that same state will generally only tax a nonresident based on in-state sources. To avoid double taxation, the state of residence will often provide a credit paid to the nonresident state.
Tangibles and Intangibles
Since states will typically tax a trade or business operating in the state (including a real estate holding), many states have determined that income from assets that are managed for long-term capital appreciation and income do not rise to the level of a trade or business, which is different from short term trading activities.
When we examine investment activities and try to understand how they are taxed at the individual level, we need to examine the differences between “tangibles” and “intangibles”. Tangibles are typically defined as real estate activities, tangible personal property, compensation for services and business activities (a CPA firm, a real estate brokerage, etc).
But intangibles are classified as something different. They represent a right or possession of a nonphysical or abstract nature that has value, or a financial asset that has no intrinsic value but that represents value. Intangible property includes but is not limited to patents, copyrights, licenses, trademarks, business goodwill, covenants not to compete, securities, bonds, notes, and insurance policies.
Now that we understand the difference between tangibles and intangibles let’s understand how they are taxed. Tangible assets are consider source income and are normally taxed by the state in which the property is located. However, intangibles (such as promissory notes) are often not taxed by a source state and taxed by taxpayer’s state of residence.
Partnership Tax Issues
Partners in partnerships have similar state tax questions. When individual taxpayers invest in partnerships that have operations in multiple states, there is always the question of whether the taxpayer is subject to tax in the states where the partnership has activities or generates income. If a partnership operates an active trade or business, the state will generally impose a tax on the partner based on their share of the income generated in the state.
Investment partnerships can be a different issue. If a partnership’s activities are limited to merely investing the capital of its partners and not actively engaging in business activities, there has been some debate as to whether the investment activity creates state filing responsibilities and related tax liabilities for the partners. This type of partnership is defined as an “investment” partnership.
There are many states that have initiated safe harbor provisions that protect certain types of investment partnerships and non-resident partners from state taxation. Each state will apply these rules differently, but the goal is generally to protect investors in partnerships that invest specifically in intangible assets. The list of states is as follows:
- New Jersey
- New Mexico
- New York
- North Carolina
Many states have used the term “qualifying investment securities” which is defined by a specific list of intangibles. Most statutes of course exclude real estate from the list of qualifying investments. Accordingly, if real estate is owned by a investment partnership it would typically disqualify it should income from the real estate or cost of the assets be 10% or more of the overall partnership income or assets, respectively.
Investors need to consider state taxation issues as it relates to tangibles and intangibles. Consideration should also be made when funding an investment partnership. Be careful because states can apply the issues discussed in this article differently. If properly structured and operated pursuant to state requirements, an investment partnership can limit exposure to multistate tax issues. However, state taxation is always subject to change, so make sure that you discuss any specific state tax issues with a qualified CPA or tax professional.