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State Tax Liability for all Alternative Investments

What can you can do if you did not pay state taxes

By Laura Kalick, JD, LLM in Tax

Nonprofit organizations that have adopted Accounting Standards Codification (ASC) 740-10 (FIN 48) have gone through the exercise of determining whether there are any material uncertain tax positions. This analysis should have been performed for all income tax positions at the federal, international, and state and local levels. The identification of tax positions should have taken into account all the open tax years, i.e., those years that would be subject to assessment by the taxing authorities. In general, for federal income tax purposes, the government has three years from the date a tax return is filed to go back to assess taxes. Otherwise, there is a statute of limitations on going back further unless there is a material understatement of tax liability, i.e., greater than a 25% understatement.

Most organizations have filed Forms 990 and 990-T and information and tax returns in their state of domicile. Also, most organizations are in compliance with state filings in states where they have a physical location and employees and it is clear that there is nexus in the state, i.e., that there are enough points of contact with the state that the state can claim jurisdiction over taxing the entity. On the other hand, organizations may not have been aware of state filing requirements that have arisen because of an ownership interest in a partnership or alternative investment that has activities and property in another state. If an organization never filed a state tax return where one was required there is no statute of limitations on how many years the state can go back to assess taxes. Also, if the state were to pursue the organization, in addition to the back taxes, there could also be significant interest and penalties.

Whether or not there is nexus through a partnership interest is not always clear cut and different states have different rules. If an alternative investment reports on a K-1 that there is unrelated trade or business income or loss in a particular state, an exempt organization should look into its reporting responsibilities. This is true both when there is net income and if there is a net loss. If an organization never files a tax return, then a loss in one year cannot be used to offset income in another year.

An organization that has not filed a tax return that it should have filed may have to establish a reserve to take into account the liability. The reserve should take into account all the income earned when the organization held the investment and the interest and penalties associated with that liability. If the organization continues to not file returns, the reserve will keep growing. If the organization decides to rectify the situation by just filing returns in the future or even files returns for the last three years, this may be a serious “red flag” because now the state knows of the organization’s existence and may pursue previous years and the related interest and penalties.

If there is potential liability in just one state, an organization could consider contacting that state in order to determine what the state will find acceptable. Their representative could even contact the state on a no-name basis. However, the potential problem is that unless the state has a written procedure indicating how many years’ returns will be required, the amount of interest and whether penalties will be imposed, the organization is at the mercy of the state. Also, if there are multiple states where there is potential liability, contacting the states and getting an agreement can be a full-time job.
Fortunately, there is an alternative to continually carrying a reserve or revealing yourself to the taxing authorities and begging for mercy.

Multistate Voluntary Disclosure Program

The Multistate Tax Commission (MTC), an intergovernmental state tax agency working on behalf of states and taxpayers to administer the tax laws equitably and efficiently, has established a Multistate Voluntary Disclosure (MVD) Program that allows a tax non-filer with potential liability in multiple states (including DC) to negotiate a settlement agreement regarding back liability on favorable terms through a single point of contact and a single, uniform procedure. The procedure does not determine whether nexus exists with respect to an organization, but the parties set that issue aside and come to an agreement for past non-filing and agree that filing will occur in the future.

The MTC does not charge for their services. An organization or its representative can have the MTC approach all the participating states on a no-name basis to reach an agreement. The agreement usually includes that the organization files and pays back tax and interest with respect to the prior periods or “lookback period;” the state(s) waives all penalty and tax prior to the lookback period and the organization will continue to file with the state(s) unless its nexus status changes. The identity of the organization is only revealed to the state(s) after a legally binding voluntary disclosure contract has come into force. The program is not available if the organization has already made “contact” with a state. “Contact” includes filing a return, paying a tax, and receiving an inquiry from the state regarding the type of tax at issue. So this means that an organization must come forward before it is too late.
All but six states participate in the MVD Program. For a full list of the states, see http://www.mtc.gov/Default.aspx.

BDO has assisted organizations in navigating through the MVD Program.