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IOWA: TAX POLICY FOR A STAGNANT TOMORROW

January 24, 2008

There seems to be no end to the devotion of Iowa's political class to the ag industry. Let some administrative agency look cross-eyed at farmers, and a host of Iowa Senators and Represenatives rises up to smite the offending bureaucrat. Short of establishing the Cult of the Corn God as Iowa's state religion, there's not too much left for row crop lobbyists to ask from our elected representatives.

Other industries, not so much. And that's puzzling, when you consider what Iowa's biggest industries are, as a percentage of its economy (2006 figures, courtesy of the Federal Reserve Bank of Chicago):

  Finance, Insurance and Real Estate: 21.3%
  Manufacturing: 21%
  Services: 16.2%
  Wholesale and Retail: 13.9%
  ...
  Agriculture, Forestry, Fishing and Hunting: 3.3%

As the chart below shows, agriculture is much less of the Iowa economy than it was in 1980, while financial industries have become much more important.

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Source: Federal Reserve Bank of Chicago. Click chart for larger image.


While Iowa's economy has moved on, the Iowa Department of Revenue and Finance is still partying like it's 1979, at least when it comes to how it taxes investment partnerships.

Partnerships have become an everyday tool in the financial world. The entire hedge fund industry is built around investment partnerships. The private equity world loves partnerships. They allow ownership and allocation flexibility without incurring extra layers of tax.

Except in Iowa.

HOW IOWA TAXES INVESTMENT PARTNERSHIPS

The Iowa Department of Revenue takes the position that investment income of non-resident partners of Iowa investment partnerships is fully taxable in Iowa as "business income." That means a Florida investor in an Iowa investment partnership is expected to pay Iowa tax of up to 8.98% on his share of a dividends, interest and capital gains earned through an Iowa partnership - income that would be free of state income taxes if he earned the money directly.

State tax laws generally distinguish between "business" and "non-business" income. Iowa can tax Iowa business income earned by residents of other states, but non-business income is taxed only by the resident state. Iowa's tax regulations recognize this principle using an example of a farm operation that also has a savings account; the interest earned on the account is non-business because the account isn't used in the day-to-day operations of the business.

The Department of Revenue makes this regulation meaningless for partners by defining all partnership income as business. Their justification? They cite the non-tax definition of "partnership" in the Iowa statutes, which says a partnership is "an association of two or more persons to carry on as co-owners a business for profit." (their emphasis). So the same savings account that is "non-business" for the farmer becomes "business" once the farmer takes on a partner. This is all spelled out in a 1992 "Letter of Findings" ( Re Herman A. & Veneta L. Jensen).

This is absurd.

The Department's position doesn't even make sense on its own terms. While Iowa's partnership statute refers to operating "for profit," the parallel laws for limited liability companies and corporations merely refer to "any lawful purpose." By Iowa's logic, then, an LLC or S corporation should be able to have non-business income; even so, the Department of Revenue insists that investment LLCs and S corporations generate "business income," just like partnerships.

The Iowa Supreme Court has rejected the implication that a pass-through entity can't have non-business income in the Comacho case, though the taxpayers lost on the facts.

OTHER STATES DON'T TRY TO TAX NONRESENTS ON PARTNERSHIP INVESTMENT INCOME

New York state uses language identical to Iowa its tax law defining business and non-business income, but, tellingly, they don't try to tax non-resident partners on their investment income. Not coincidentally, there are hundreds of hedge funds based in New York. If there are any in Iowa, I haven't seen them.

Why does the Department do this? I'm guessing it's because the state needs the cash, and because they can get away with it. For most non-resident partners, the tax involved is too small to make it worth hiring a lawyer to fight. More importantly, anybody who has enough partnership income to fight over is staying out of Iowa altogether.

So in the pursuit of a few pennies from non-resident partners, the Department stifles a critical tool of the industry that provides 20% of the state's economy and much more than 20% of its growth. Meanwhile, Iowa's politicians, who should be all over the Department for this, instead look to beat up even more on non-resident taxpayers.

Many states, including California and Illinois, have laws that exempt non-resident partners of investment partnerships from their income tax; Iowa is one of the few states that even tries to tax nonresidents on investment partnership income. It's especially sad when Iowa's laws already exempt such income, but the Department of Revenue insists otherwise. But so far our Legislature is more interested in subsidizing Hollywood than in removing tax shackles from Iowa's most dynmamic economic sector.

Maybe it's just a branding issue. If partnerships were to call themselves, say, "corn heritage funds," the legislature might leap into action.

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