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Montana Administrative Register Notice 42-2-869 No. 23   12/08/2011    
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                                                    BEFORE THE DEPARTMENT OF REVENUE

OF THE STATE OF MONTANA

 

In the matter of the adoption of New Rule I (42.9.110), New Rule II (42.9.111), New Rule III (42.9.502), and New Rule IV (42.9.107), and the amendment of ARM 42.9.102, 42.9.106, 42.9.203, and 42.15.120 relating to pass-through entities

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NOTICE OF ADOPTION AND AMENDMENT

TO:  All Concerned Persons

 

1.  On September 22, 2011, the department published MAR Notice No. 42-2-869 regarding the proposed adoption and amendment of the above-stated rules at page 1992 of the 2011 Montana Administrative Register, issue no. 18.

 

2.  A public hearing was held on October 17, 2011, to consider the proposed adoption and amendment of the above-stated rules.  Leo Berry, Attorney representing the National Association of Publicly Traded Partnerships (NAPTP), appeared and testified at the hearing.  Subsequent to the hearing, the department also received written comments from Lindsay Sander, of NAPTP, William Gregory Turner, Attorney for the Council On State Taxation (COST), Jane Egan, of the Montana Society of Certified Public Accountants (MSCPA), and Nancy Schlepp, of the Montana Taxpayers Association (MonTax).  Oral and written comments received are summarized as follows along with the responses of the department.

 

COMMENT NO. 1:  Leo Berry, NAPTP, appeared and testified at the hearing stating that there is a lack of statutory authority for enactment of the rules.  He also questioned what changes were made to the statute that prompted the rule proposals.

Lindsay Sander, NAPTP, also provided written comments stating that she does not believe the cited statutes provide clear and specific authority to adopt the rules as required by 2-4-305, MCA, nor do the statements of reasonable necessity provide adequate reasons for their adoption as required by law.

 

RESPONSE NO. 1:  The department appreciates Mr. Berry's and Ms. Sander's questions regarding the proper citations for the proposed rules and rule amendments.  However, the department respectfully disagrees about the lack of statutory authority.  Sections 15-1-201 and 15-30-2620, MCA, provide direct statutory authority for the department to adopt administrative rules and rule amendments to administer revenue laws.

These statutes are included in each proposed new rule and rule amendment in the published proposal notice; however, when preparing the responses to the comments it was noticed that that all of the applicable statutes for every rule were not included.  The statutes that were inadvertently omitted are added to the rules as shown below.  These omissions may have led to the need for clarification as evidenced by some of the comments.  The department apologizes for any confusion that was caused by these omissions.

All of the cited statutes were effective prior to the 2011 legislative session, and were not amended in that session.  The department believes that the reasonable necessities for each proposed new rule and rule amendment clearly describe the purpose for the proposal and, if problems or circumstances arose that prompted the rule proposals, they were identified in the reasonable necessities for each rule contained in the proposal notice.

COMMENT NO. 2:  Mr. Berry asked which legislative sponsors were notified of the proposed rulemaking action, as was indicated in the opening statement of the rule hearing.

RESPONSE NO. 2:  Cleo Anderson, the department's administrative rule hearings officer, responded to Mr. Berry's comment during the hearing, apologizing for the confusion and explaining that the department is required, under 2-4-302(a), MCA, to notify legislative sponsors and interested parties regarding a proposed rulemaking action within 3 days of publication of the proposal notice.  As part of the standard introduction to each hearing, the hearings officer informs the attendees that the department has complied with this requirement.  Ms. Anderson further explained that, in this particular rulemaking action, the department determined that sponsor notification did not apply.  This determination was also noted on page 2004, of proposal notice 42-2-869 in the 2011 Montana Administrative Register, No. 18.

COMMENT NO. 3:  Mr. Berry and Ms. Sander, requested a meeting with the department prior to the adoption and amendment of these rules in order to discuss the problems that NAPTP and the publicly traded partnership (PTP) industry foresees with the adoption of the proposed rules.  Nancy Schlepp, MonTax, also requested that the department host a meeting with MonTax and other interested parties before the rules are implemented.

 

RESPONSE NO. 3:  The Montana Administrative Procedure Act does not provide for additional or ad hoc means for public input during the rulemaking proceeding.  Consequently, the department respectfully declines to afford the representatives of these two entities more input than other members of the public have been or will be given.

 

COMMENT NO. 4:  Mr. Berry commented that it's unclear how the proposed rules impact PTPs and other pass-through entities in multi-tier pass-through entity structures.  Ms. Sander and Mr. Berry further explained that the industry and the department have different understandings of what is a second-tier or a lower-tier pass-through entity versus a higher tier pass-through entity.  Mr. Berry and Ms. Sander also commented that several other states extend the withholding exemption for PTPs to the lower-tier owners as well.

 

RESPONSE NO. 4:  The department thanks Mr. Berry and Ms. Sander for the opportunity to clarify how the proposed rules apply to PTPs and lower-tier pass-through entities in which these entities have direct and indirect ownership interests.

Because a PTP is a pass-through entity, the applicable statutes and rules that affect pass-through entities also generally affect PTPs.  However, PTPs are exempt from the requirement under 15-30-3313(1), MCA, to elect composite tax or remittance of tax if the PTP complies with 15-30-3302(4) and 15-30-3313(7), MCA.  The responses to Comment No. 15 and Comment No. 20, explain in further detail, the exceptions for PTPs in regard to the proposed new rules and rule amendments.

The department confirms that the rules consistently use the same order and diagram form used in Securities and Exchange Commission reports, tax treatises, and professional publications in describing tiered entities – that is the PTP (and other owners) are at the top of the ownership pyramid and the owned entities are below.

The responsibility of a first-tier pass-through entity to remit tax or file a composite return on behalf of a second-tier pass-through entity (which does not establish that its share of Montana source income is fully accounted for on Montana returns) is statutory.  According to the department's information, no other state has this particular requirement.

Some states that adopted pass-through reporting and remittance statutes in years after Montana's enactment require that all pass-through entities withhold for all owners.  The Montana provision was crafted in 2003 with the help of MSCPA to address the fact that the first-tier pass-through entity usually knows only its own owners and that there is no effective means of tracing Montana source income through higher tiers.  The provision was intended to impose a tax liability on the second-tier pass-through entity (if a composite return was not filed) except in the instance, usually involving small entities above which there was no further tiering, when the second-tier pass-through entity could identify all owners to which its share of income was ultimately passed and establish that Montana tax was being paid.

A refundable credit for the second-tier pass-through entity's paid tax was provided so that, like any other Montana tax credit available to owners of pass-through entities, it would be reflected in the owners' distributable share of tax items that are passed through and could be claimed by the ultimate owner when they file a Montana return reporting the Montana income.  The credit was made refundable so that even if the ultimate owner owed a lesser amount (or no) Montana tax, the owner's share of the amount paid would be recoverable by that recipient of Montana source income.

 

COMMENT NO. 5:  Jane Egan, MSCPA, provided an overall comment that the administrative rules process is in place to clarify existing law, stating "however this new rule appears to be expanding or changing existing law and circumventing the legislative process."  Ms. Egan also commented that it is similar to SB 396, L. 2011, which did not pass the 2011 Legislature.

Nancy Schlepp, MonTax, also commented that the language for proposed New Rule III actually originated from possible substitute language to SB 396 of the 2011 Legislative Session.  Senate Bill 396 did not make it through the process and thus substitute language was not considered.

 

RESPONSE NO. 5:  The department appreciates Ms. Egan's and Ms. Schlepp's comments and participation in this rulemaking process.  While Ms. Egan presented this as an overall comment, only one of the proposed new rules, New Rule III, relates to SB 396.  Ms. Egan's only specific comment on proposed New Rule III is that it provides clarity.

In regard to Ms. Schlepp's comment, SB 396 was related to the sale of an interest in a pass-through entity (partnerships, S corporations, and disregarded entities).  In the course of the department's work and through the SB 396 hearings, the department is aware that some taxpayers drop assets into single member LLCs and then sell the interest in the LLC, rather than the assets, to avoid reporting the sale of the assets as Montana source income.

For both federal and Montana purposes, a disregarded entity is disregarded for all tax purposes.  If parties formulate a sale, as a sale of the member interest in a disregarded entity rather than a sale of the assets of the disregarded entity, the disregarded entity is disregarded and the transaction is treated as a sale of assets by the owner.

The department included the section that describes this treatment of disregarded entities in SB 396, only to clarify the appropriate treatment under existing state law, not to expand the existing law.  New Rule III simply reflects the department's interpretation of current statute and is included to inform the public of this interpretation.

 

COMMENT NO. 6:  Ms. Egan commented that wherever the phrase "audit adjustments" are referenced in proposed New Rule I, the phrase should be changed to "agreed upon audit adjustments," and that if audit adjustments affect allocation, the pass-through entity must be notified.  She suggested the following language be added regarding the notification:  "Once the adjustments are agreed upon by DOR and entity partners, the pass-through entity will prepare revised schedule(s) K-1 and distribute them.  If DOR assesses the pass-through without agreement, DOR will schedule out adjustments and provide them to the pass-through entity."

Ms. Schlepp asked whether the audit adjustments discussed in proposed New Rule I are agreed upon adjustments or unilateral adjustments by the department, how the audit adjustments would be handled if there is no taxpayer agreement between the department and the taxpayer about the adjustments, and whether the department would send out a new schedule(s) K-1 once changes are agreed upon.

 

RESPONSE NO. 6:  The department appreciates Ms. Egan's and Ms. Schlepp's comments on proposed New Rule I.  There is no statutory provision for agreed upon audit adjustments.  As proposed New Rule I(1) explains, the details of an audit adjustment of a pass-through entity's information return will also be reported to the pass-through entity and owners of the pass-through entity.  The department reports details of audit adjustments in audit reports that describe the adjustments and, if applicable, any increase or decrease in tax as a result of the audit adjustments.  If the department adjusts a pass-through entity return, the department does not send out new schedule(s) K-1.

Because Montana's legislature has not adopted the Tax Equity and Fiscal Responsibility Act (TEFRA) -like unified partnership audit procedures, the department must assess any additional tax liability to the owner (regardless of the status of any proceeding by the pass-through entity contesting the audit adjustment) before the owner's statute of limitations expires.  For example, the owners of partnerships may be individuals, corporations, or other pass-through entities; the ultimate taxpayer to which a pass-through entity's items of income, deduction, or credit pass, may be either an individual, with a five-year statute of limitations or a corporation, with a three-year statute of limitations.

TEFRA-like unified partnership audit procedures would require a pass-through entity's tax matters partner to be responsible for all partnership level issues.  In addition, the unified partnership audit procedures would bind other partners to proceedings that involve that tax matters partner and statutes of limitation would be extended to impose any additional tax that is attributable to final TEFRA-like partnership audit adjustments.

In the absence of these procedures, the department must determine the tax liability and adjust the ultimate owner's tax return.  The pass-through entities themselves, who file only information returns and do not have a tax liability (except for composite tax), are sent the audit adjustments only so they may appear and be part of resolving the department's audit adjustments that result in changes to the ultimate owners' Montana tax liability.  The audit adjustment may be appealed as provided for in 15-1-211, MCA.  The department added additional implementing statutes for this rule proposal as described in the response to Comment No. 1.

COMMENT NO. 7:  Ms. Schlepp also asked how proposed New Rule I would affect individual partners of a pass-through entity.

RESPONSE NO. 7:  If the department sends an audit adjustment to a pass-through entity, under the provisions of proposed New Rule I, the department would also send the details of the audit adjustment to an individual owner of the pass-through entity as provided in proposed New Rule I(1).  In addition, if the audit adjustment affects an individual owner's distributive share of items that were passed through during the audit period, the department may, if necessary, adjust the individual's tax return to reflect the audit adjustments to the owner's distributive share of pass-through items.

If this occurs, the department will also notify the individual owner of these adjustments as provided in proposed New Rule I(3).  If the individual owner has not filed a tax return for the audit period, and it is necessary that the individual owner file a return to report Montana source income, then the department may request that the individual owner file a tax return.  If the individual owner does not file a tax return after being requested to do so, the department may estimate the owner's tax liability as provided in proposed New Rule I(4).

COMMENT NO. 8:  Ms. Schlepp commented that proposed New Rule I places the responsibility on the taxpayer for appealing an estimated assessment or adjustment with no clear guidance or authority.

RESPONSE NO. 8:  The department has attempted to provide the necessary clarity for appealing an audit adjustment or an estimated assessment that originated with a pass-through entity in the response to Comment No. 6.  The purpose of proposed New Rule I is to explain the circumstances under which the department can provide information to owners of pass-through entities and also to explain the type of information that the department can provide.  Proposed New Rule I does not address appeals of audit adjustments or estimated assessments.

COMMENT NO. 9:  For proposed New Rule I, Ms. Schlepp asked if the department could provide data regarding the increased number of pass-through entities over the past 10 years.

RESPONSE NO. 9:  The following chart summarizes the number of Montana returns filed by C corporations, S corporations, and partnerships since fiscal year 2000.  

Returns Filed in Fiscal Year

Corporation License Returns

S-Corporation Returns

Partnership Returns

2000

16,972

14,249

10,398

2001

16,250

15,060

10,905

2002

16,706

16,471

11,548

2003

16,383

17,828

11,717

2004

16,296

19,328

12,475

2005

16,200

21,591

13,500

2006

16,193

21,670

15,719

2007

17,492

25,063

17,683

2008

17,997

26,452

19,200

2009

17,276

27,445

20,290

2010

17,673

27,713

21,286

COMMENT NO. 10:  In regard to proposed New Rule I, Ms. Schlepp requested more information about the confidentiality issues that have been identified by the department.

RESPONSE NO. 10:  The department regularly encounters tiered entity structures that have multiple layers.  For example, a 95 percent interest in the first-tier pass-through entity is owned by a partnership (the second-tier entity); a 60 percent interest in the second-tier entity is owned by another partnership (the third-tier entity); a 35 percent interest in the third-tier entity is owned by another partnership (the fourth-tier entity); an 80 percent interest in the fourth-tier entity is owned by another partnership (the fifth-tier entity); the fifth-tier entity is owned 50 percent by a C corporation and 50 percent by an S corporation (the sixth-tier entity); the S corporation is owned 80 percent by individual A, and 20 percent by individual B.  Sections 15-30-2618 and 15-31-511, MCA, limit what tax information can be disclosed and to whom.  These disclosure restrictions make no exceptions for the tiered entity structures.

The department interprets the statutes as restricting the disclosure of information about the first-tier entity's items of income, deduction, credit, or the identity of its partners to the owners of the second, third, fourth, fifth, or sixth-tier entities, or other owners, without the first-tier entity's consent, or to permit the department to disclose adjustments it makes to the returns of individuals A or B resulting, in whole or in part, from adjustments made to the first-tier entity's information return without the consent of individuals A and B.

Corporations that file combined reports, as provided in ARM 42.26.204, are not affected by this rule and do not present similar confidentiality concerns.  There are no equivalent provisions for combined reports by controlled pass-through entities.

COMMENT NO. 11:  Ms. Schlepp further commented that there is concern about how New Rule I(7) fits with the apportionment principles for multi-state, multi-tier structures.

RESPONSE NO. 11:  Proposed New Rule I(7) does not address or affect the apportionment of income by entities engaged in multi-state business.  The department's responses to Comments No. 6, 7, and 10 provide a necessary explanation of the purpose and function of proposed New Rule I.

COMMENT NO. 12:  Ms. Sander, Ms. Egan, and Ms. Schlepp objected to the language in (1) of proposed New Rule II, which states that the department may revise any return of an entity if, in the opinion of the department, it is incorrect in any essential respect.

Ms. Sander stated that this provision grants the department broad and excessive jurisdiction to change facts and figures without audit or other due processes and requests this provision be removed or amended.  Ms. Egan requests the sentence be changed to add the words "with cause" and to strike the opinion language, and Ms. Schlepp stated that the department should not have opinions, but should follow statute explicitly.  Ms. Schlepp further stated that the term "essential respect" is not defined anywhere and should not be used in the rules, and added that MonTax opposes legislating through rulemaking and requests that the department not adopt New Rule II.

William Gregory Turner, COST, stated the language was not supported by the authority cited by the department and is causing taxpayer confusion because it suggests the department has authority to revise returns whenever the department concludes that a return is "incorrect in any essential respect."

Mr. Berry commented that the rule proposal allows the department to modify filed returns, and he expressed concern that the ability to modify filed returns was an overreach in the department's statutory authority.

 

RESPONSE NO. 12:  The department appreciates the comments to proposed New Rule II, but the listed statutory authority, 15-30-2605(1), MCA, specifically states "If, in the opinion of the department, any return of a taxpayer is in any essential respect incorrect, it may revise the return."  The beginning of proposed New Rule II merely states existing statutory audit authority to provide context for the subsequent language in the proposed rule.

Proposed New Rule II relates to audit adjustments.  Section (1) identifies why the department would revise a return.  Sections (2) through (6) describe the period of time within which the department will make those revisions.  Partnerships may have a partner that is a corporation (subject to a 3-year statute of limitations on audit adjustments) and a partner that is an individual (subject to a 5-year statute of limitations on audit adjustments).  The rule simply addresses the department's procedure for handling the different time limits.

To clarify the scope of proposed New Rule II, the department will amend the title of the rule to read "Pass-through Entities – Statute of Limitations for Audit Adjustments" as shown below.

 

COMMENT NO. 13:  Ms. Egan asked for clarification of how the department would treat a composite tax return assessment if a C corporation was an eligible participating owner and the assessment took place outside of the corporate statute of limitations under the provisions of proposed New Rule II.

 

RESPONSE NO. 13:  Proposed New Rule II(3) explains that, regardless of the entity type of the eligible participating taxpayer, the statute of limitations is 5 years for the composite tax return.  A foreign C corporation can be an eligible participating taxpayer in a composite return, but if it elects for the pass-through entity to file a composite tax return on its behalf, then the applicable statute of limitations for the composite tax return is 5 years instead of 3 years.  Composite tax returns and corporation license tax returns are two separate tax returns with separately applicable statutory provisions.

 

COMMENT NO. 14:  Mr. Turner and Ms. Sander further commented that in proposed New Rule IV the department makes a distinction between operations income and flow-through income without the statutory authority to do so.  Mr. Turner also commented that the reasonable necessity does not provide an explanation for the distinction.

 

RESPONSE NO. 14:  The department respectfully disagrees that there is a lack of statutory authority for making a distinction between operations income and flow-through income.  Section 15-1-201, MCA, provides direct statutory authority for the department to adopt administrative rules and rule amendments to administer revenue laws.  In the course of developing rules, the department must often identify the meaning of certain terms as they apply to specific circumstances.

In pass-through entity structures with many tiers through which more than one entity's distributable shares of income pass, it is often difficult to clearly explain how rules may or may not apply.  This rule uses the term 'operational income' to identify the income an entity in the tiered structure generates itself and the term 'flow-through income' to identify the income it receives from lower-tier pass-through entities.  The department chose to use these descriptive terms because there are no terms in existing parlance that draw this distinction - a distinction that is important to achieve a proper tax result under Montana law and to assist taxpayers in preparing returns to comply with the law.

In the course of administering the tax reporting requirements of pass-through entities, the department has found that entities in tiered structures are not consistently categorizing or reporting business and nonbusiness income, and that some upper-tier entities are simply lumping the flow-through income they receive with their own operations income.  In proposed New Rule IV, the meanings of the terms 'operations income' and 'flow-through income' are limited to the rule itself in (1).

 

COMMENT NO. 15:  Ms. Sander and Mr. Berry questioned how proposed New Rule IV applies to multi-tier structures that include one or more PTP.

 

RESPONSE NO. 15:  Proposed New Rule IV, which addresses the reporting requirements of multi-tier pass-through entity structures, may affect how PTPs will report their Montana source income when filing their Montana pass-through entity information returns.

As is the case with any other business entity or individual, a PTP may own an interest in a pass-through entity (a "lower-tier" pass-through entity).  Every pass-through entity with Montana source income is required to file an information return with the Montana Department of Revenue, as provided in 15-30-3303, MCA, which requires that pass-through entities report their income from all sources as well as the part of that total income that is Montana source income.  A pass-through entity is also required to report this information to its owners on Montana Schedule(s) K-1, so the owners may appropriately report that income when filing their Montana tax returns.

If a pass-through entity's owner is another pass-through entity, the owner may or may not also be engaged in business producing its own Montana source income.  If the owner does not have its own Montana source income, it will report its distributive share of Montana source income when it files its Montana information return.  It will also report this Montana source income to its owner(s) when it sends them Montana Schedule(s) K-1.

The Montana Schedule(s) K-1 is provided to owner(s) so that they may appropriately report Montana source income when filing their Montana tax returns.  The PTP, as an owner of one or more pass-through entities, should receive Montana Schedule(s) K-1 that report the total amount of Montana source income that is being passed through to the PTP.  The PTP would then add the amount of any Montana source income it generates from its own activities or investments to the amount passed through to it and report that amount on its Montana pass-through entity information return, and on the Montana Schedule(s) K-1 that it provides to its partners.

Section 15-30-3313(7), MCA, provides that, unlike other pass-through entities, certain PTPs are not required to remit tax or file a composite return on behalf of its owners.  Nothing about proposed New Rule IV affects this statutory provision.

 

COMMENT NO. 16:  In regard to proposed New Rule IV, the department received several comments concerning the determination of business and nonbusiness income as well as concerns that the proposal required additional allocation and apportionment provisions.

Mr. Turner commented that the requirement to separately identify income as business or nonbusiness was an "added complication to taxpayer filings."

Ms. Sander commented that the statement "the entity must then determine what part of this business and/or nonbusiness income is Montana source," in proposed New Rule IV(2), was not necessary because it restated statute.

Ms. Egan commented that they expect the department to follow federal definitions for business income and nonbusiness income per 15-31-501, MCA.

Ms. Schlepp also questioned why an entity would have to further separate its sources of income between the business or nonbusiness character of its income.

Mr. Berry, Ms. Sander, and Ms. Schlepp questioned the need for additional allocation and apportionment provisions.

 

RESPONSE NO. 16:  The department thanks Mr. Turner, Mr. Sander, Ms. Egan, Ms. Schlepp, and Mr. Berry, for their comments, and welcomes this opportunity to further explain the purpose of the rule proposal.

Many partnerships and S corporations are now engaged in business in more than one state.  Multi-state businesses that are subject to the reporting requirements of 15-30-3302, MCA, and in Title 15, chapter 31, part 3, MCA, need to separately identify business income and nonbusiness income so they may properly apportion a part of the business income to Montana (using Montana's three factor apportionment formula) and appropriately allocate any nonbusiness income to Montana or another state.

While the department may agree with Ms. Sander's comments that the rule appears to be saying what the law already requires, the department has found that pass-through entities in tiered structures are not consistently doing what the statute requires, which is why the department is providing additional and specific guidance for pass-through entities that are a part of a multi-tier structure.

The definitions of business income and nonbusiness income are provided in 15-1-601 (the Multistate Tax Compact), and 15-31-302, MCA.  The federal definitions for business and nonbusiness income are not applicable to this rule under 15-31-501, or 15-30-2620, MCA, (which provide that if a term is not defined in the chapter, it has the same meaning as it does when used in a comparable context in the IRC).  The terms "business" and "nonbusiness income" as used in the Multistate Tax Compact and in these rules are applicable only to state taxes and are the basis for apportioning multi-state income.  There are no comparable terms or concepts in the federal tax system, which has no limits based on state boundaries.  The Internal Revenue Code does use the same terms but in a completely different context.  The federal definitions for these terms are limited to the calculation of net operating losses (IRC section 172) and have a completely different meaning.

The department included additional implementing statutes for this rule proposal as described in the response to Comment No. 1

COMMENT NO. 17:  Ms. Schlepp and Ms. Sander commented in regard to proposed New Rule IV(6), that it gives the department "additional power to determine the business or nonbusiness character of an entity's operations or the Montana source character of an entity's flow-through income."

RESPONSE  NO. 17:  The department provided a detailed explanation for the definitions of business income and nonbusiness income in its response to Comment No. 16.  The character of an entity's income is either business or nonbusiness income.  The department and taxpayers also must follow statutory provisions for the determination of Montana source income, and the rule proposal does not grant the department additional authority in regard to this determination.

The department must be able to determine if a taxpayer has correctly identified its income as business income and nonbusiness income, as well as whether or not the income is sourced to Montana, to confirm that the taxpayer correctly reported its income.  The purpose of (6) is to ensure that the new rule does not limit the department's ability to perform this review as it is required to under 15-30-2605, MCA.

 

COMMENT NO. 18:  For the proposed amendments to ARM 42.9.102, Ms. Egan asked what needs to be filed under the rule and what is an explanation for an event.  She also requested examples.

 

RESPONSE NO. 18:  No substantive amendments to ARM 42.9.102 are being proposed.  ARM 42.9.102, needs to be followed in conjunction with the other rules that are part of the same chapter.  Details about each type of information return that a pass-through entity is required to file are located in a separate subchapter for each type of entity. Partnership rules are in subchapter 3, S corporations rules are in subchapter 4, and disregarded entity rules are in subchapter 5.

ARM 42.9.510, which describes the filing requirements of a partnership that has elected under Section 761 of the IRC to be excluded from some or all of the partnership tax rules, is an example of an information return that is required to be filed only on the happening of an event.  The rule provides that the partnership has to file the Montana disregarded entity return form, DER-1, within 90 days after making that federal election.

 

COMMENT NO. 19:  The department received various related comments about the proposed amendments to ARM 42.9.106.

Ms. Egan commented that very few states have similar reporting requirements and this process is not business friendly.  Ms. Sander, Mr. Turner, Ms. Schlepp, and Ms. Egan all commented that the requirement of the second-tier pass-through entity to establish that all taxes will be paid adds another level of compliance that places businesses in the position to enforce compliance, when this is the department's responsibility.  They also commented that the statements "establishes to the satisfaction of the department" and "fully accounted for" create ambiguity for the taxpayer.

Ms. Egan asked why the extra compliance is needed when by filing Form PT-AGR, the agreement is in place to ensure that proper reporting is taking place, and Ms. Schlepp inquired about how many states require a PT-STM Form.

 

RESPONSE NO. 19:  The department appreciates the comments on the proposed amendments and agrees that the reporting procedures that are currently established for the Form PT-STM are unnecessarily complex.  To reduce this complexity, the department will further amend the rule so that the first-tier, instead of the second-tier, pass-through entity completes and files the Form PT-STM with the department.

The department acknowledges the observation that most states do not have similar reporting requirements, but respectfully disagrees that the reporting requirements are not business friendly.  Currently, the waiver of the first-tier pass-through entity's requirement to file a composite return or remit tax on behalf of a second-tier pass-through entity is an annual request.

The proposed amendments provide first-tier pass-through entities with an opportunity to receive a multiple year waiver if the owners who report their share of the second-tier pass-through entity's Montana source income are compliant with tax filings and payments.

The multiple year waiver was requested by MSCPA for taxpayer convenience and simplification, and the department agreed that this provision would further reduce the complexity of filing the Form PT-STM while not violating the statutory reporting requirements of first-tier pass-through entities in regard to their second-tier pass-through owners.

The department respectfully disagrees that the statements "establishes to the satisfaction of the department" and "fully accounted for" will create ambiguity and place entities in a position of enforcing revenue laws.  Section 15-30-3313(1)(c)(ii), MCA, clearly establishes the role of a first-tier pass-through entity with regard to tax compliance.  This section of law states that if a first-tier pass-through entity does not file a composite return or remit tax on behalf of a second-tier pass-through entity, then a statement must be filed setting forth the name, address, and social security or federal identification number of each of that entity's partners, shareholders, members, or other owners and information that establishes that its share of Montana source income will be fully accounted for on individual income or corporation license or income tax returns filed with the state.

The proposed amendments do not require additional forms to be filed with the department.  The Form PT-AGR is not addressed in ARM 42.9.106 because the rule addresses the filing requirements of second-tier pass-through entities and the Form PT-AGR is filed by individuals, corporations, estates and trusts.  Second-tier pass-through entities do not file the Form PT-AGR.

The department did not conduct an analysis of other states to determine if they have an equivalent form to Montana's Form PT-STM.  Most states do have reporting requirements for pass-through entities.  However, the governing statutes and regulations, as well as the resulting filing requirements, differ among the states.

 

COMMENT NO. 20: The department received several related comments in regard to the proposed amendments to ARM 42.9.106.

Ms. Sander requested clarification of several provisions relating to lower-tier partnerships that impact not only NAPTP members, but potentially all pass-through entities.  Ms. Sander also commented that NAPTP would like the department to confirm that nothing within the proposed rulemaking will impact the current exemption.

Mr. Berry, Ms. Sander, and Mr. Turner commented that the proposed rule amendments do not address how pass-through entities that are owned by PTPs should apply the reporting provisions in the rule.

 

RESPONSE NO. 20:  ARM 42.9.106, which addresses how first-tier pass-through entities must remit tax or file composite returns on behalf of their owners who are themselves pass-through entities (second- or "upper-" tier pass-through entities), does not directly affect PTPs.  As noted, these entities are subject to the special provision under 15-30-3313(7), MCA, that prevents PTPs from having to remit or file composite returns.

The rule may, however, affect them indirectly, in that PTPs may receive a refundable Montana tax credit attributable to a lower-tier pass-through entity through which Montana source income has been passed.  This will occur when a lower-tier pass-through entity must either remit tax or file a composite return on behalf of an owner that is also a pass-through entity (an upper-tier pass-through entity) because that upper-tier pass-through entity cannot establish that its share of Montana source income from the lower-tier entity is fully accounted for on Montana tax returns.

If a PTP, as second-tier pass-through entity, could not establish that its share of income from one or more first-tier pass-through entities would be reported in Montana tax returns, the first-tier pass-through entity would be required to remit tax or file a composite return on behalf of the PTP.

 

COMMENT NO. 21:  Ms. Egan and Ms. Schlepp commented in regard to the proposed amendments for ARM 42.9.106, that not all taxpayers are eligible to file composite tax returns and requiring them to do so will not improve compliance.  Ms. Schlepp also asked if all returns will have to be composite.

 

RESPONSE NO. 21:  The proposed amendments to ARM 42.9.106, do not require taxpayers to elect composite tax returns.  A taxpayer can only elect composite tax treatment if it is a nonresident or domiciled outside of Montana and has no other Montana source income unless other Montana source income is also reported on composite income tax returns.

Under 15-30-3313, MCA, first-tier pass-through entities are not required to include second-tier pass-through entities in a composite return.  It is one of three methods that a first-tier pass-through entity has for reporting the Montana source income that it distributes to second-tier pass-through entities.  The first-tier pass-through entity may also choose to remit tax on behalf of the second-tier pass-through entity or file a statement (Form PT-STM) with the department that identifies all higher-tier owners and establishes that all Montana source income is accounted for on income tax or corporation license tax returns.

COMMENT NO. 22:  Mr. Berry, Mr. Turner, and Ms. Sander commented that allowing higher-tier owners in a multi-tier pass-through entity structure to claim a refundable credit equal to their distributive share of the remittance that the first-tier pass-through entity pays on behalf of the second-tier pass-through entity, as provided in the proposed amendment to ARM 42.9.106, would create confusion among taxpayers and be burdensome for the department to administer.

RESPONSE NO. 22:  The department appreciates the opportunity to further explain the history of the refundable credit provision in 15-30-3313(4), MCA.  Allowing the ultimate taxpayers to claim their share of the taxes paid by the first-tier pass-through entity as a refundable tax credit was a 2003 legislative action.  The legislation was crafted with the help of MSCPA to ensure that the ultimate taxpayer paid no more tax than they owed on their share of Montana source income.  In addition, the legislation assured that taxes would be paid on Montana source income and that this income would not lose its identity as it passes through multi-tier entity structures.

The department administers the credit similarly to any other Montana tax credit that may be claimed by the owners of a pass-through entity.  The department included an additional implementing statute for this rule as described in the response to Comment No. 1.

 

COMMENT NO. 23:  Ms. Sander, Mr. Turner, and Ms. Schlepp commented that the amendment to ARM 42.9.106, requiring the Form PT-STM to be filed 45 days before the filing deadline of the first-tier pass-through entity, was an unnecessary complication and would be impossible for many taxpayers to fulfill.

 

RESPONSE NO. 23:  The department thanks Ms. Sander, Mr. Turner, and Ms. Schlepp for the opportunity to further explain why the Form PT-STM must be filed in advance of the due date of the first-tier pass-through entity's information return.

The form is required to be filed sufficiently in advance of the first-tier pass-through entity's tax filing deadline so that the department has adequate time to review it and notify the first-tier pass-through entity of whether the entity is relieved of the obligation to remit tax, or file a composite return, on behalf of the second-tier pass-through entity.  The filing deadline is set at 45 days to allow the department 30 days to review and respond to the first-tier pass-through entity and still allow the first-tier pass-through entity enough time to file its return accordingly.

 

COMMENT NO. 24:  In reference to a statement within the department's reasonable necessity for the proposed amendments to ARM 42.9.106, that the department's current practices were not sufficient to ensure proper tax collection because the national growth of complex pass-through entity structures with nonresident owners, Ms. Schlepp questions what quantifiable measurement of this quote has been assessed.  Ms. Schlepp further stated that MonTax disagrees with creating and changing rules if there are not good data points as reference.

 

RESPONSE NO. 24:  The following chart summarizes the number of federal returns filed by C corporations, S corporations, and partnerships from tax year 1997 to 2008 (most recent year available) as provided by the Internal Revenue Service (http://www.irs.gov/taxstats/bustaxstats/article/0,,id=152029,00.html).

As evidenced by the chart, the number of returns filed by pass-through entities for federal purposes has increased significantly.

 

 

Tax Year

Corporation License Returns

S-Corporation Returns

Partnership Returns 

(GL, LP, LLP and LLC)

1997

2,248,065

2,452,254

1,758,627

1998

2,249,970

2,588,088

1,855,348

1999

2,198,740

2,725,775

1,936,919

2000

2,172,705

2,860,478

2,057,500

2001

2,136,756

2,986,486

2,132,117

2002

2,100,074

3,154,377

2,242,169

2003

2,047,593

3,341,606

2,375,374

2004

2,027,613

3,518,334

2,546,877

2005

1,974,961

3,684,086

2,763,625

2006

1,955,147

3,872,776

2,947,116

2007

1,865,232

3,989,893

3,096,334

2008

1,782,478

4,049,944

3,146,006

 

The department findings concerning the increase of complexity in pass-through entity structures and the challenges that trend poses for the compliance by non-resident owners are based on its substantial compliance work with regard to pass-through entities and nonresident owners.  The department's knowledge of complexity in this area is also informed by its participation, along with a small number of other states, in a special Internal Revenue Service pass-through entity project.  The department has provided information to the Revenue and Transportation Interim Committee in past years on the complexity of pass-through and entity structures and nonresident owner tax compliance issues.

 

COMMENT NO. 25:  Ms. Schlepp also commented that if the proposed amendments to ARM 42.9.106, were adopted, it would subject taxpayers to double taxation.  She further explained that taxpayers could be required "to pay a Montana tax without getting a corresponding state credit in their own state either because the taxpayer lives in a state without an income tax or the state does not allow a full credit against a Montana tax paid."

 

RESPONSE NO. 25:  The department respectfully disagrees that the proposed amendments create a double taxation effect.  If a taxpayer lives in a state without an income tax, there is no potential for double taxation.  All states with an income tax allow a credit against a resident's tax liability for income taxes paid to another state which prevents double taxation.

 

COMMENT NO. 26:  In regard to ARM 42.9.106, Mr. Turner commented that the requirement that a taxpayer establishes to the satisfaction of the department that its distributive share of income will be fully accounted for on Montana tax returns lacks an objective test that taxpayers can rely upon to know whether they will be entitled to a waiver.

He also commented that the proposed rule language that allows the department to generally waive the requirements to pay or file a composite return if it can determine that all income for the three most recent tax years has been reported on timely filed returns and all tax due under those returns has been paid is confusing, leaving him to wonder when the department would not issue a waiver or if taxpayers are subject to the whims of the department.

 

RESPONSE NO. 26:  The department appreciates the opportunity to further explain the statutory basis for the proposed amendments to ARM 42.9.106, and how the department is implementing the statutory language.  Section 15-30-3313(1)(c)(ii), MCA, requires a taxpayer to establish that a second-tier pass-through entity's share of Montana income will be fully accounted for on Montana tax returns.

The department disagrees that the conditions for obtaining a waiver are not guided by objective standards.  As provided in Montana's Administrative Procedure Act, 2-4-102(11)(a), MCA, a rule is a statement of general applicability that implements, interprets, or prescribes law or policy of the agency.  A rule cannot, and is not required to, state or anticipate every possible fact, situation, or exception.  It will be the policy of the department, generally, to waive the requirement to pay or file composite in the described circumstances, just as the rule explains.  There may be circumstances, however, when the department would not waive the requirement even if, for the past three years, the second-tier pass-through entity's share of Montana income was accounted for on returns and the taxes were paid.

For example, if an interest in the partnership had been transferred to someone who has never filed a return or is delinquent in paying Montana taxes.  A taxpayer is not entitled to unilaterally determine that they have established that the conditions for waiver have been met, or to demand a waiver regardless of changes in circumstances.  A taxpayer who disagrees with a department's decision may contest it under the uniform dispute resolution procedures adopted under 15-1-211, MCA, including review by the independent State Tax Appeal Board.

 

COMMENT NO. 27:  Ms. Egan and Ms. Schlepp requested that the department provide an example for ARM 42.9.203(2).  Ms. Schlepp also requested an example for ARM 42.9.203(5).

 

RESPONSE NO. 27:  The department thanks Ms. Egan and Ms. Schlepp for the suggestion to provide more examples, and agrees that an example for (2) may help clarify the intent of the proposed amendments.  The department will add the example provided below to the rule as part of its adoption notice:

Example 1a. composite tax ratio:  Assume a partnership's federal income from all sources (as reported on Form PR-1, line 15) is $60,000 and the partnership's Montana source income (as reported on Form PR-1, line 21) is $20,000.  The composite tax ratio is $20,000/$60,000 = 33.3333%

 

Example 1b. composite tax liability:  Assume that the partnership in Example 1a. has one electing eligible participant in the composite tax return, an individual. To determine the electing partner's share of federal taxable income, multiply the partner's ownership percentage (as reported on the Montana Schedule III) by federal income from all sources (as reported on Form PR-1, line 15).

 

Electing partner's ownership percentage                                                            50%

Partnership's federal income from all sources                                                   $60,000

Electing partner's distributive share of federal income from all sources       $30,000

 

Reduce the electing partner's distributive share of federal income from all sources by the allowable standard deduction for a single individual and one exemption allowance.

 

Electing partner's distributive share of federal income from all sources       $30,000

Standard deduction                                                                                                 ($4,110)

Exemption allowance                                                                                             ($2,190)

                                                                                                                                    $23,700

 

Using the tax rates as set forth in 15-30-2103, MCA, assume the tax is $1,123.  Multiply the resulting tax by the composite tax ratio determined in Example 1a.

 

Tax on the distributive share of federal income                                     $1,123

Composite tax ratio (from Example 1.a.)                                                 33.3333%

Total composite tax                                                                                      $374  

The department respectfully disagrees that an example for (5) would help taxpayers determine the amount of their quarterly estimated payments of composite tax.  The rule specifically refers to statute for the calculation of quarterly estimated tax payments and the department believes that (1) clearly explains that the composite tax that an entity owes is the sum of each electing eligible participant's composite tax liability.

COMMENT NO. 28:  Ms. Sander and Ms. Schlepp also commented about the proposed amendments to ARM 42.15.120, which cross-reference the corporation license administrative rules applicable to apportionment and allocation of business and nonbusiness income, and which add a section to specify that a taxpayer may request or the department may require an alternative method of reporting multi-state income.  They stated that this section should be deleted because it is giving the department authority and is not supported by statute.  Ms. Schlepp also asked what alternative method is being considered, and how it is fair to treat certain taxpayers different than others.

RESPONSE NO. 28:  The department respectfully declines to delete this added section because it accurately describes the taxpayer's right to request, and the department's power to require, alternative reporting for multi-state business activity and because deleting the section would not change this right or power.

The amendment clearly states that the taxpayer may petition for, or the department may require, an alternative method of reporting activity as provided in the Multistate Tax Compact, adopted in 15-1-601, MCA.  The compact in Article IV, section (18) describes when the alternative reporting method can be requested or imposed and what the alternative reporting methods can include.

If allocation and apportionment provisions of this article do not fairly represent the extent of the taxpayer's business activity in this state, the taxpayer may petition for, or the tax administrator may require, in respect to all or any part of the taxpayer's business activity, if reasonable:

(a) separate accounting;

(b) the exclusion of any one or more of the factors;

(c) the inclusion of one or more additional factors which will fairly represent the taxpayer's business activity in this state; or

(d) the employment of any other method to accomplish an equitable allocation and apportionment of the taxpayer's income.  

These alternative reporting methods are provided for in 15-1-601(18), MCA.

COMMENT NO. 29:  Ms. Egan asked that the department provide a more specific reference in 15-1-601, MCA, in the proposed amendments for ARM 42.15.120.

RESPONSE NO. 29:  To comply with the rule formatting standards, the department is not able to provide a more specific subpart statutory reference within the rule language.  However, for the purposes of being responsive to the question, a more specific reference is 15-1-601(18), MCA.

 

3.  Based on the comments received, the department adopts New Rule I (42.9.110), New Rule II (42.9.111), and New Rule IV (42.9.107), and further amends ARM 42. 9.106, and 42.9.203, as follows, stricken matter interlined, new matter underlined:

 

NEW RULE I (42.9.110)  PASS-THROUGH ENTITIES – AUDIT ADJUSTMENTS  (1) through (7)(b) remain as proposed.

 

AUTH:  15-1-201, 15-30-3312, MCA

IMP:  15-30-2512, 15-30-2605, 15-30-2618, 15-30-3302, 15-30-3311, 15-30-3312, 15-31-511, 35-1-1107, 35-8-405, 35-10-103, 35-10-402, 35-12-508, MCA

 

NEW RULE II (42.9.111)  PASS-THROUGH ENTITIES – STATUTE OF LIMITATIONS FOR AUDIT ADJUSTMENTS  (1) through (6) remain as proposed.

 

AUTH:  15-1-201, MCA

IMP:  15-30-2605, 15-30-2606, 15-30-2607, 15-30-3302, 15-31-509, MCA

 

NEW RULE IV (42.9.107)  MULTI-TIERED PASS-THROUGH ENTITY STRUCTURES WITH MONTANA SOURCE INCOME – REPORTING REQUIREMENTS  (1) through (6) remain as proposed.

 

AUTH:  15-1-201, MCA

IMP:  15-1-601, 15-30-3302, 15-30-3311, 15-31-301, MCA

 

42.9.106  COMPOSITE RETURN, WITHHOLDING, OR WAIVER FOR PARTNERS, SHAREHOLDERS, MANAGERS, AND MEMBERS THAT ARE SECOND-TIER PASS-THROUGH ENTITIES  (1) remains as proposed. 

(2)  The department may waive the requirements to remit tax or pay composite tax on behalf of the second-tier pass-through entity for the current tax year as set forth in (1) if the second first-tier pass-through entity:

(a)  completes and submits the Form PT-STM for the year to the department at least 45 days before the original due date of the first-tier pass-through entity's tax return; and

(b)  establishes to the satisfaction of the department that its the second-tier pass-through entity's distributive share of Montana source income for the current year will be fully accounted for in individual income, corporation license, or other income tax returns filed with the state.

(3)  The department will notify the first and second-tier pass-through entities entity of its decision to waive or not waive the requirement to file a composite return or remit within 30 days after receipt of the completed Form PT-STM.  The department will generally waive the requirement if it can determine that all of the income for the three most recent tax years has been reported on timely filed tax returns and that all tax due under those returns has been paid.

(4)  The department may grant a conditional waiver that lasts longer than one year on written request included with the Form PT-STM if, in addition to the conditions provided in (3), the second first-tier pass-through entity:

(a)  agrees to notify the department if the ownership of the second-tier pass-through entity and, if applicable, the ownership of any higher-tier pass-through entities changes;

(b)  agrees to remit the amount provided under (1) within 60 days after notice from the department that its the second-tier pass-through entity's distributive share was not fully accounted for on corporation license, individual income, or other tax returns filed with the department; and

(c)  agrees to be subject to the personal jurisdiction of the state for the collection of the remittance.

(5) through (8) remain as proposed.

 

AUTH:  15-1-201, 15-30-2620, MCA

IMP:  15-1-201, 15-30-2620, 15-30-3302, 15-30-3312, 15-30-3313, MCA

 

42.9.203  COMPUTATION OF COMPOSITE TAX  (1) remains as proposed.

(2)  The composite return liability of each eligible consenting participant is calculated as follows:

(a)  compute the entity's composite tax ratio by:

(i)  calculating the entity's federal income from all sources as determined for federal income tax purposes;

(ii)  calculating the entity's Montana source income;

(A)  if the entity is only doing business in Montana, the entity's Montana source income is the net taxable income after Montana additions and deductions to income as allowed in 15-30-3302, MCA; or

(B)  if the entity is engaged in multistate business, the entity's Montana source income is determined as provided in [NEW RULE IV] ARM 42.9.107; and

(iii)  dividing the entity's Montana source income by the entity's federal income from all sources;

(b)  subtract the allowable standard deduction for a single individual and one exemption allowance from each participant's share of the entity's federal taxable income as determined for federal income tax purposes.  Determine the tax that would be imposed on the result using the rates specified in 15-31-121, MCA, for C corporations and the rates specified in 15-30-2103, MCA, for all other eligible participants; and

(c)  multiply the amount determined in (b) by the composite tax ratio computed in (a).

(i)  Example 1a. composite tax ratio:  Assume a partnership's federal income from all sources (as reported on Form PR-1, line 15) is $60,000 and the partnership's Montana source income (as reported on Form PR-1, line 21) is $20,000. The composite tax ratio is $20,000/$60,000 = 33.3333%.

(ii)  Example 1b. composite tax liability: Assume that the partnership in Example 1a. has one electing eligible participant in the composite tax return, an individual. To determine the electing partner's share of federal taxable income, multiply the partner's ownership percentage (as reported on the Montana Schedule III) by federal income from all sources (as reported on Form PR-1, line 15).

 

Electing partner's ownership percentage                                                            50%

Partnership's federal income from all sources                                                   $60,000

Electing partner's distributive share of federal income from all sources       $30,000

 

Reduce the electing partner's distributive share of federal income from all sources by the allowable standard deduction for a single individual and one exemption allowance.

 

Electing partner's distributive share of federal income from all sources       $30,000

Standard deduction                                                                                                 ($4,110)

Exemption allowance                                                                                             ($2,190)

                                                                                                                                    $23,700

 

Using the tax rates as set forth in 15-30-2103, MCA, assume the tax is $1,123.  Multiply the resulting tax by the composite tax ratio determined in Example 1a.

 

Tax on the distributive share of federal income                                     $1,123

Composite tax ratio (from Example 1.a.)                                                 33.3333%

Total composite tax                                                                                      $374

 

(3)  through (5) remain as proposed.

 

AUTH:  15-1-201, 15-30-2620, 15-30-3312, MCA

IMP:  15-30-2103, 15-30-2512, 15-30-3302, 15-30-3312, 15-31-121, MCA

 

4.  Therefore, the department adopts New Rule I (42.9.110), New Rule II (42.9.111), New Rule IV (42.9.107), and amends 42.9.106, and 42.9.203 with the amendments shown above, and adopts New Rule III (42.9.502), and amends ARM 42.9.102, and 42.15.120 as proposed.

 

5.  An electronic copy of this notice is available on the department's web site at www.revenue.mt.gov.  Locate "Legal Resources" in the left hand column, select the "Rules" link and view the options under the "Notice of Proposed Rulemaking" heading.  The department strives to make the electronic copy of this notice conform to the official version of the notice, as printed in the Montana Administrative Register, but advises all concerned persons that in the event of a discrepancy between the official printed text of the notice and the electronic version of the notice, only the official printed text will be considered.  In addition, although the department strives to keep its web site accessible at all times, concerned persons should be aware that the web site may be unavailable during some periods, due to system maintenance or technical problems.

 

 

/s/ Cleo Anderson                                        /s/ Dan R. Bucks

CLEO ANDERSON                                     DAN R. BUCKS

Rule Reviewer                                               Director of Revenue

 

Certified to Secretary of State November 28, 2011

 

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