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IOWA TAXES AND THE TYRANNY OF SMALL NUMBERS

February 17, 2006

Some battles just aren't worth the money to fight. A rational client will concede an incorrect but small assessment because the professional fees required to prevail would exceed the tax. This can let state revenue authorities get away with a goofy reading of the tax law for an amazing length of time.

IT'S NONE OF YOUR NON-BUSINESS

State tax laws make a distinction between "business income" and "non-business" income. If a non-resident has business income in a state, it's fair game for the revenuers. Non-business income, in contrast, is only taxed in the state where the taxpayer lives.

Enormous amounts of professional fees have been consumed debating the precise difference between business and nonbusiness income, but in general terms, "business" income arises from, well, business. If you live in Illinois but farm in Iowa, the farm income will be Iowa business income. Interest earned on an Iowa bank account used for farm business is also Iowa income. In contrast, an Illinois retiree who earns interest from CD at a bank in Bettendorf will earn "non-business" income; that interest will be taxed in only Illinois and not Iowa.

IOWA: EVERYTHING IS BUSINESS, IF ITS IN AN LLC?

A tax professional of our acquaintance has an Iowa limited liability set up to hold investment assets as part of an estate plan. The LLC, which is taxed as a partnership, has never had an actual business; it has only owned cash and securities since it was formed. As a partnership, it reports its items of income and loss to its members on a schedule K-1; the items are then taxed on the returns of the members.

This LLC has a Missouri member. The state of Iowa has asserted on examination that the Missouri member must pay Iowa tax on the interest and dividends earned by the LLC. Why? Because, says the Iowa Department of Revenue, anything earned in an LLC is by definition, business income.

The technical term to describe this position is "bogus." Unfortunately for the taxpayer, its cheaper to file an Iowa return and pay the tax than it is to pay to fight the improper assessment.

WHY BOGUS?

The Iowa Supreme Court addressed the taxation of non-resident owners of pass-through entities (S corporations and partnerships) in a 2003 case, Camacho v. Iowa Department of Revenue and Finance. The Department in that case explicitly argued that all pass-through income was taxable to non-residents, business or not. The court rejected the Department's argument, saying that each item of income of the entity must be evaluated as business or non-business. The Court held that, from the evidence in the case, the interest from the S corporation happened to be business income because it was used for farming operations in the S corporation. The court said a different result "would be warranted... if the income at issue was nonbusiness income."

An investment LLC normally has no "trade or business" under well-established law, so all of its income should normally be non-business. Non-resident members should only pick up their share of such an LLC's interest or dividends on their home state returns.

WHERE THINGS STAND

If our acquaintance's experience is any indication, the Department intends to continue to try to tax non-residents on interest income earned by investment LLCs. Many LLC members will find it cheaper to pay the tax than to fight. Residents of other states with income taxes, in particular, will be likely to settle because they will claim a credit for the Iowa taxes against their home state taxes.

If Iowa persists, it will get away with this position until either they find somebody ornery enough to fight them on principle, or they run up against somebody with enough money at stake to make it worth litigating. Then Iowa will lose. But by then Iowa will have a new Governor and a new Director of the Department of Revenue, and they will get to figure out how to pay the refunds that will be due.

Related: IOWA SUPREMES: NONRESIDENT S CORPORATION SHAREHOLDER NOT TAXED IN IOWA ON "NONBUSINESS" INCOME

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