In February 2008, the Indiana Tax Court ruled that income received by a nondomiciliary S corporation received from its membership interest in an Indiana LLC did not constitute adjusted gross income from sources within Indiana. Hence, the S corporation was not required to withhold Indiana personal income tax for its nonresident shareholders.
The Court stated that "a member's economic rights in a limited liability company" constitutes intangible personal property, and income from intangible personal property is "adjusted gross income derived from sources within Indiana" if the taxpayer's commercial domicile is in Indiana.
In the case at hand, the taxpayer was not commercially domiciled in Indiana ("Commercial Domicile" means the principal place from which the trade or business of the taxpayer is directed or managed).
It should be noted that the Indiana Supreme Court denied a petition to review the Tax Court Case on August 28, 2008.
INDIANA'S RESPONSE TO COURT CASE
Indiana apparently disliked this court case's ruling, and amended its statutes to counteract the ruling.
IC 6-3-2-2 was amended by HEA 1001-2009(ss) effective retroactive to Jan. 1, 2009, for taxable years beginning after Dec. 31, 2008, to provide that income from a pass-through entity shall be characterized in a manner consistent with the income’s characterization for federal income tax purposes as provided in Section 1366(b) of the Internal Revenue Code for S corporations and Section 702(b) of the Internal Revenue Code for partnerships.
The income shall be considered Indiana source income as if the person, corporation, or pass-through entity that received the income had directly engaged in the income-producing activity in Indiana. Income that is derived from one pass-through entity and is passed through to another pass-through entity does not change the characteristics or attribution provisions of the income.
An LLC treated as a partnership for tax purposes and domiciled in Indiana is engaged in manufacturing automobile parts. All sales are to another Indiana manufacturer. A nonresident S corporation is a member of the Indiana LLC. The nonresident S corporation provides a distributive share of income to its nonresident individual shareholders.
The Indiana LLC’s income that passes to the S corporation and then to the shareholders is income derived from the sale of automobile parts to an Indiana manufacturer and is treated as such at the S corporation and individual shareholder levels.
The nonresident S corporation shall file a composite return for all of the nonresident shareholders and include the income attributable to the distributive shares from the Indiana LLC (and any other Indiana-source income of the S corporation) on the composite return with the amount of tax due being remitted by the nonresident S corporation.
Indiana recently issued Commissioner's Directive #38 which explains the impact of the amendment to the statutes and also provides a refund claim procedure for taxpayers to obtain refunds for tax years beginning before January 1, 2009.
IC 6-8.1-9-2 was amended by HEA 1001-2009(ss) to establish procedures to provide a refund to a pass-through entity’s nonresident partners, shareholders, or members if the overpayment arises from a determination by the Department or a court that the person’s pass-through income is not includible in the person’s adjusted gross income derived from sources within Indiana.
ARE YOU ELIGIBLE TO FILE A REFUND CLAIM?
To be eligible for a refund, the person must file a timely claim for refund with respect to the overpayment and the overpayment must:
- apply to a taxable year beginning before Jan. 1, 2009;
- be attributable to amounts paid to the Department by: a nonresident partner, shareholder, or member of a pass-through entity; a pass-through entity on behalf of a nonresident partner, shareholder, or member of the pass-through entity as part of a composite return required under IC 6-3-4-12 or IC 6-3-4-13; or a pass-through entity on behalf of a nonresident partner, shareholder, or member of another pass-through entity as part of a composite return required under IC 6-3-4-12 or IC 6-3-4-13;
- arise from a determination by the Department or a court that the person’s pass-through income is not includible in the person’s adjusted gross income derived from sources within Indiana as a result of the application of IC 6-3-2-2(a)(5) and IC 6-3-2-2.2(g); and
- be reported to the Department in a form specified by the Department that identifies under penalties of perjury the home state or jurisdiction where the income subject to the refund or credit was reported as income attributable to that state or jurisdiction.
If you own an interest in a pass-through entity operating in Indiana, you may want to review your Indiana returns for years prior to January 1, 2009 to see if you have any refund opportunities.
In addition, the state's amendment to their statutes may be unconstitutional or defeated if litigated.