Earlier this year, the Idaho Supreme Court, in Noell Industries, Inc. v. Idaho State Tax Comm’n, --- P.3d ---- (2020), ruled that gain from the sale of membership interests in a limited liability company that had business operations in Idaho by a taxpayer domiciled outside of Idaho was not business income. As a result, the gain was not taxable in Idaho.
The court, in a 3-2 decision, upheld the district court’s reversal of the Idaho Tax Commission’s determination to tax the income. The sharks were circling the taxpayer, ready to attack, but the majority of the justices on the Idaho Supreme Court intervened, saving the taxpayer from a savage death (or at least a boatload of taxes).
Under IRC § 708(a), a partnership is considered as a continuing entity for income tax purposes unless it is terminated. Given the proliferation of state law entities taxed as partnerships today (e.g., limited liability companies and limited liability partnerships), a good understanding of the rules surrounding termination is ever important.
Prior to the Tax Cuts and Jobs Act (“TCJA”), IRC § 708(b)(1) provided that a partnership  was considered terminated if:
1. No part of any business, financial operation, or venture of the partnership continues to be carried on by any of the partners of the partnership; or
2. Within any 12-month period, there is a sale of exchange of 50% or more of the total interests of the partnership’s capital and profits.
As reported in my November 2013 blog post, for tax years beginning in 2015 or later, under ORS 316.043, applicable non-passive income attributable to certain partnerships and S corporations may be taxed using reduced tax rates. The reduced tax rates are as follows:
- 7 percent for taxable income of $250,000 or less;
- 7.2 percent for taxable income greater than $250,000 but less than or equal to $500,000;
- 7.6 percent for taxable income greater than $500,000 but less than or equal to $1,000,000;
- 8 percent for taxable income greater than $1,000,000 but less than or equal to $2,500,000;
- 9 percent for taxable income greater than $2,500,000 but less than or equal to $5,000,000; and
- 9.9 percent for taxable income greater than $5,000,000.
In accordance with ORS 316.037, the Oregon income tax rates that would otherwise apply to individual taxpayers are 9 percent on taxable income over $5,000 (up to $125,000), and 9.9 percent on taxable income over $125,000. At first blush, the reduced tax rates offered under ORS 316.043 look desirable. An understanding of the statute, however, is needed before jumping in head first.
- Election. To qualify for this reduced rate structure, which is subject to adjustment as provided by ORS 316.044, taxpayers must make an election on their original return by checking Box 22c and completing and attaching Oregon Department of Revenue Schedule OR-PTE, OR-PTE-PY or OR-PTE-NR. The election cannot be made on an amended return. Does the original return have to be timely filed? The statute is silent. Caution is advised!
- Material Participation. The reduced rate structure is only available to taxpayers who materially participate in day-to-day operations of a partnership or an S corporation that constitutes a trade or business.
- Non-Passive Income Only. The reduced rate structure only applies to “non-passive” income that flows through to the taxpayer from the partnership or S corporation.
- One or More Non-Owner Employees. The S corporation or partnership must employ at least one non-owner and an aggregate of at least 1,200 hours of work must be performed in Oregon during the taxable year by the non-owner employee(s). For the purpose of computing the number of hours worked in Oregon during the taxable year, only hours during weeks in which the non-owner worker(s) performed 30 hours or more of services may be counted.
- Irrevocable. Per the statute, once made, the election is irrevocable—it cannot be amended or revoked. Does this mean that once an election is made, the taxpayer is required to use the reduced rate structure for all future tax years, or does it simply mean that the taxpayer cannot revoke the election for the particular tax year the election is made? Logic dictates that the election is made for each tax year, so the later should be true. The statute, however, does not provide a clear answer to this question. Caution is advised! The Oregon Department of Revenue has not yet written administrative rules to accompany ORS 316.043. I suspect, it will address this question in any rules it drafts.
- No Disregarded Entities. The owner of a disregarded entity (e.g., a single-member limited liability company or a sole proprietorship) is not eligible for the reduced tax rates.
- Limited Deductions. For purposes of computing the taxpayer’s income, which is subject to the regular income tax rates, the taxpayer is allowed to use all subtractions, deductions or additions otherwise allowable under the Oregon tax laws set forth in ORS Chapter 316. For purposes of computing the non-passive income to which the reduced tax rates apply, however, the taxpayer is only allowed to take into consideration depreciation deductions or adjustments directly related to the partnership or S corporation. Consequently, before making the election to use the reduced tax rates, an analysis of the impact of the limited use of subtractions, deductions and additions against the non-passive income needs to be undertaken.
- Composite Returns. A taxpayer who uses the reduced income tax rates may not join in the filing of a composite return under ORS 314.778.
Until the Oregon Department of Revenue drafts administrative rules to accompany ORS 316.043, the questions discussed above will remain unanswered. Consequently, caution is advised. Careful review and consideration is required before tax practitioners jump into an election under this alternative tax rate regime. Unfortunately, traps exist for the unwary.
Larry J. Brant
Larry J. Brant is a Shareholder in Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "A Good Look At The Limitations to Code Section 1031 and Other Possible Deferral Alternatives," OSCPA 2021 Annual Real Estate ConferenceVirtual Event, 6.9.21
- To be rescheduled