AICPA on MTC's reporting-options proposal.

One of the functions of the AICPA'S State and Local Tax Technical Resource Panel (TRP) is to monitor and comment on the activities and proposals of state organizations, including those of the Multistate Tax Commission (MTC), which represents states' interests on multistate matters, particularly on uniformity issues.

Over the past few months, the MTC has been considering a proposal ("Uniformity Proposal Concerning Reporting Options for Non-Resident Members of Pass-Through Entities") which, according to the TRP's understanding, intends to:

1. Reduce the cost of collecting tax on nonresident individuals by relieving the administrative burden on both taxpayers and state taxing authorities through a composite-filing process;

2. Respond to tax practitioners' requests to pursue composite-filing uniformity among the states; and

3. Eliminate a perceived loss of state revenue, based on anecdotal information that taxpayers are engaging in one-time transactions using flow-through entities that allow nonresidents to avoid state taxes on the transaction's profits or distributions.

While the proposal's title may imply a simple approach for improving uniformity in state composite-return filing, the draft's actual scope is much broader. After reviewing comments on, and opposition to, the first draft, the MTC concluded that mandatory withholding on cash distributions would address the three concerns stated above; thus, it issued a revised proposal, which essentially provides for composite filing for flowthrough entities. To the extent that nonresident members of flowthrough entities do not participate in the composite filing, the proposal provides for mandatory withholding at the flowthrough-entity level.

TRP's Comments

The TRP has submitted comments on the revised proposal and is awaiting the MTC's next draft. It raised several key issues that deserve separate consideration. First, the MTC has already reviewed and developed model statutory language on voluntary uniform-filing requirements in its Model S Corporation Income Tax Act (MoSCITA), to which the AICPA and other interested parties have previously provided input. If the proposal's objectives are administrative ease and uniformity, it makes sense to develop the composite-filing process beginning with the MoSCITA.

Second, withholding at the entity level will impose taxes on many nonresident members who have neither nexus nor a net tax liability with the state due to credits, deductions or losses from other sources. Further, the proposal began as an effort to provide filing options, but has become more like an entity-level tax proposal with withholding requirements. These are distinct issues that deserve separate review.

States already have the information needed to pursue nonfilers in their taxing jurisdiction and should make greater use of it, rather than imposing a heavy administrative burden on passthrough entities (which would require financial-system changes and complex tax payments).

Finally, the MTC's claim that states are suffering a revenue loss from nonresidents who do nor file state returns ignores the effect on the nonresidents' home states' tax revenue. One of the more significant effects is a home state's credit for taxes paid to another state. Accordingly, if a nonresident member pays tax in a state other than its home state, the home state's tax revenue from that individual decreases. On an overall net basis, the revenue pick-up under the proposal's scenario is neutral. The TKP strongly urges further study of the proposal's effect on revenue.

The TRP clearly supports voluntary, uniform composite-return filing for passthrough entities, because this would benefit taxpayers, tax practitioners and tax administrators. However, it is concerned that the MTC's current proposal does not appropriately achieve this goal. Based on AICPA members' extensive experience in the practical and logistical aspects of flowthrough-entity compliance with multiple state taxing jurisdictions, composite-filing options for passthrough entities must have five key characteristics:

1. Composite filing must be elective and voluntary;

2. A passthrough entity should not be liable for a member/owner's nonpayment of individual tax liabilities, nor treated as the taxpayer through this type of administrative process;

3. Eligibility requirements for using composite-return filing must emphasize administrative ease and uniformity;

4. There must be an exemption from payment of tax attributable to noncash or "phantom" income; and

5. Net operating losses must be considered in computing composite taxable income.

The proposal does not address several composite-filing logistical issues. It shifts a large part of a state's administrative burden to a passthrough entity. If the proposal is adopted, passthrough entities should be compensated for this burden in a manner similar to the discounts and allowances they currently receive for administering sales and use taxes (for example, a fixed credit amount based on the number of nonresident owners included in a composite return). Alternatively, a credit equal to the direct cost of composite-return preparation (e.g., the amount of a return preparer's invoice) is also viable. The TRP offered to assist the MTC in determining the average costs charged for preparing such returns.

Because nonresidents may have other business interests in a state that could offset income received from a flowthrough entity, the computations on a composite return could result in an overpayment. It is unrealistic for entities to track each nonresident's activities within the state and adjust for offsets from other ventures. Further, other sources of potential overpayment exist, created by use of the highest marginal rate and lack of uniformity in the tax base.

The proposal contains provisions not adoptable through regulations, requiring legislative action.

Other organizations (such as the Committee on State Taxation) have also commented on the proposal, expressing similar concerns.

Conclusion

At this writing, the MTC Uniformity Committee has not approved the proposal, but returned it to the Income and Franchise Tax Committee for further revision. Overall, states that participated in the MTC Annual Meeting in July 2002 expressed the continuing belief that revenue loss occurs as a result of nonresident members of passthrough entities not reporting income, and that mandatory withholding is the best option for overcoming this issue.

For further information on the MTC'S current activities and its hearing process, see www.mtc.gov.

RELATED ARTICLE: Tax division issues exposure draft.

On Oct. 29, 2002, the AICPA's Tax Executive Committee (TEC) voted to expose Interpretation No. 1-2, "Tax Planning," of Statement on Standards far Tax Services No. 1, Tax Return Positions.

Statements on Standards for Tax Services are enforceable standards that govern the conduct of AICPA members in tax practice. A significant area of many members' tax practices involves assisting taxpayers in tax planning. An area of recurring controversy has been the increase in transactions that are potentially abusive tax shelters. Taxing authorities, courts, the AICPA and other professional organizations have struggled with defining and regulating these transactions. Crucial in the debate about the appropriate means of addressing tax shelters has been the recognition that it may be difficult to clearly delineate the scope of transactions considered tax shelters in a way that will discourage abuse. At the same time, taxpayers have a legitimate interest in arranging their affairs so as to pay no more than their fair share of taxes; tax professionals, including AICPA members, have a role to play in advancing these efforts.

The TEC determined that there was a compelling need for a comprehensive interpretation of a member's responsibilities in connection with tax planning; such guidance would clarify how those standards would apply across the spectrum, including situations involving tax shelters (regardless of how that term is defined).

Members and other interested parties are encouraged to comment on this proposal, through April 30, 2003. For more information, see www.aicpo.org/members/div/tax/sslsint.asp.

Editor's note: Ms. Naghavi is chair of the AICPA Tax Division's State and Local Tax Technical Resource Panel (TRP). Ms. Warner is a member of the TRP, and Ms. Ferguson is AICPA staff liason. If you would like further information about this column, please contact Ms. Ferguson at [phone] or [e-mail], or Ms. Warner at [phone] or [e-mail].

Editor:
Faranak Naghavi
Principal
State and Local Tax Group
Ernst &Young LLP
Washington, DC

Authors:
Carol B. Ferguson, CPA
Technical Manager
AICPA
Washington, DC

Karen L. Warner, CPA
Multistate Tax Partner
Deloitte & Touche LLP
Dallas, TX