Can a partnership's guaranteed payments to partners (salary-type payments and interest on capital accounts) be sourced to each partner's state of residency and excluded from the income apportioned to Utah on a composite nonresident return, and can nonresident partners in a composite filing get a personal deduction the way an individual nonresident filer would?

Plain-English summary

A professional partnership with nonresident partners asked the Utah Tax Commission to change how it treated "guaranteed payments" — fixed salary-type payments and interest on capital accounts that a partnership agreement pays to partners regardless of the partnership's actual profit or loss — on its composite nonresident Utah return. The partnership's position: since a recently-issued regulation (R865-9-13I) denied composite filers any deductions and taxed them at the maximum rate, the partnership wanted its guaranteed payments for services and its capital-account interest sourced to each nonresident partner's home state (and excluded from the Utah apportionment base) rather than allocated to Utah, arguing this was more equitable and that other states (it cited Maine) allowed comparable exclusions.

The Commission's Auditing Division rejected the sourcing argument. Utah Code Ann. § 59-10-303(2) says that in determining where a nonresident partner's income comes from, no effect is given to language in the partnership agreement that characterizes a payment as being "for services" or "for the use of capital" — the statute looks at the payment's real economic substance, not its label. Because the payments here were "guaranteed payments" under IRC § 707(c) — amounts paid without regard to the partnership's income, taxed to the recipient as ordinary income under IRC § 736(a)(4), and reported as part of the partner's distributive share for other tax purposes — the Division found they were paid out of the partnership's gross income earned from carrying on its multi-state business, and so had to be allocated to Utah just like the rest of the distributive share. The Division also noted, separately, that composite-return filers don't get the standard deduction, itemized deductions, personal exemptions, or a deduction for federal tax paid the way an individual nonresident filer could; the Division mentioned it was proposing (not yet adopted, as of this ruling) a flat 15% deduction against Utah taxable income for composite filers, to apply for a future tax year, in place of those individual-style deductions. Partners who wanted the fuller individual deduction menu could instead file individual nonresident Utah returns.

What this means for you

Multi-state partnerships (law firms, accounting firms, and similar professional partnerships) with nonresident partners

Don't assume guaranteed payments (fixed salary-equivalent payments, interest on capital accounts) escape Utah apportionment just because the partnership agreement calls them "salary" or "interest" rather than a distributive share of profit. This ruling treats the substance of the payment — was it really compensation for services performed, or interest on capital, sourced from the partnership's overall multi-state business income? — as controlling, and Utah Code Ann. § 59-10-303(2) expressly disregards the partnership agreement's own label.

Nonresident partners deciding between a composite filing and an individual nonresident return

If your individual deductions (standard/itemized deductions, personal exemptions, credit for federal tax) matter to your bottom line, this ruling is a reminder that composite-return treatment historically gave up those individual-style deductions in exchange for filing convenience. Compare the numbers — an individual nonresident return may produce a better result depending on your situation, even though it requires separate filing.

Accountants preparing composite Utah returns for multi-state partnerships

Verify how any guaranteed payments in the partnership agreement are structured and reported for federal purposes (IRC § 707(c)/§ 736(a)(2)) before excluding them from the Utah apportionment base — this ruling's reasoning suggests they generally can't be excluded just by relabeling them, and the composite-filer deduction landscape (flat percentage vs. no deduction vs. individual-return deductions) may have changed since 1993, so confirm current Rule R865-9-13I mechanics before filing.

Common questions

Q: Our partnership agreement calls certain payments to partners "salary" — does that mean they're sourced to the partner's home state rather than Utah?
A: Not under this ruling. Utah Code Ann. § 59-10-303(2) disregards the agreement's characterization of a payment as being for services or capital; the Commission looks at whether the payment is, in substance, a guaranteed payment drawn from the partnership's multi-state business income, in which case it's allocated to Utah.

Q: Are interest payments on partners' capital accounts treated any differently than salary-type guaranteed payments?
A: No — this ruling treated interest on capital accounts the same way as guaranteed payments for services: both were required to be allocated to Utah as part of the partnership's Utah-source distributive income, despite the taxpayer's request to source them to each partner's residency state.

Q: Do partners in a composite Utah filing get the same deductions as an individual nonresident filer?
A: Under this ruling's facts, no — composite filers did not get the standard deduction, itemized deductions, personal exemptions, or a federal-tax deduction. The Auditing Division was, at the time, proposing a flat 15% deduction against Utah taxable income for composite filers in lieu of those items, but had not yet adopted it. A partner wanting the individual deduction menu could file an individual nonresident return instead.

Citations and references

Statutes (Utah Code Annotated, 1953, as in effect at the time of this 1993 ruling):

• § 59-10-301 — partners carrying on business are liable for Utah income tax only in their separate/individual capacities (the statutory basis the Commission cited for why a partnership-level composite return isn't automatically authorized, absent an agreement)
• § 59-10-302(1) — incorporates federal taxable income (including IRC § 707 treatment of guaranteed payments) as the partnership's apportionment base
• § 59-10-303(2) — in sourcing a nonresident partner's income, no effect is given to partnership-agreement language characterizing a payment as being for services or for the use of capital
• § 59-10-303(4) — gives the Commission authority to make equitable adjustments to sourcing as appropriate

Rules:

• Utah Administrative Rule R865-9-13I — governs composite-return treatment of nonresident partners; at the time of this ruling, denied composite filers a deduction and required tax at the maximum rate, with a proposed (not-yet-adopted) flat 15% deduction floated for future tax years

Federal law incorporated by reference:

• IRC § 707(c) — guaranteed payments to a partner for services or capital, made without regard to partnership income, are treated as made to a nonpartner for certain purposes
• IRC § 736(a)(2)/(a)(4) — payments to (often retired) partners considered guaranteed payments are taxable as ordinary income to the recipient

Source

• Landing page: https://tax.utah.gov/commission/rulings/
• Original PDF: https://files.tax.utah.gov/tax/commission/ruling/93-006.htm

Original ruling text

Response
March 22, 1993

Request

March 1, 1990

XXXXX

Dear XXXXX:

I appreciated very much your meeting with me to discuss the composite filing to be completed for XXXXX for the XXXXX calendar year. As you recall, our discussion centered on the recently issued Regulation R865-9-131. This Regulation deals with the treatment of nonresident partners included in composite returns. The Regulation takes the position that no deduction shall be allowed to a composite filer and additionally requires tax to be paid at the maximum rate. This is a departure from the past filings which have been made by our Firm which have been approved by the Tax Commission. We as a Firm have been forthright in discussing with the Tax Commission positions that have been taken in previous filings. Accordingly, a question arises as to the effective date of the Regulation and how this Regulation should apply to our Firm given our past agreements with the Tax Commission.

I believe that it is inequitable to deny deductions to a composite filer that would be afforded to any nonresident who files a return in Utah. This position seems out of line with what is afforded under the Utah Law. Accordingly, I would propose the XXXXX composite return be allowed a federal income tax deduction equal to 14 percent of Utah income. Fourteen percent is derived by taking 50 percent of the 28 percent federal rate. It is recognized that the maximum federal rate is 33 percent. As such, a 14 percent deduction rate represents an amount that should be less than the amount actually being paid by our partners. This position could be supported if the Tax Commission would clarify the effective date of the Regulation to be prospective for composite filers who have disclosed in the past their filing methodology for the federal tax deduction and received State approval. This is the circumstance for our Firm.

Additionally, we hereby request that guaranteed "payments salary and interest" and certain payments made pursuant to IRC § 736(a)(2) be sourced to the state of residency and excluded from the income subject to the apportionment formula. We make this request pursuant to Utah Code Annotated 59-10-303(4) which gives the Tax Commission authority to make equitable adjustments as may be appropriate.

The foregoing request results in a more equitable allocation to the State of Utah for the following reasons. The XXXXX partnership agreement provides that each partner will receive a $$$$$ guaranteed payment as part of his compensation. Such services are rendered by partners in various states throughout the country and this $$$$$ amount represents a minimal amount of compensation for service rendered in the State of residence. It would seem appropriate to source this income to the state of residency rather than requiring it to be included in apportionable income.

Payments made pursuant to Internal Revenue Code Section (IRC §) 736(a)(2) which are also guaranteed payments are made primarily to retired partners and similarly should be sourced to their state of residency. These payments are fixed and determinable payments calculated without reference to partnership income. Such payments are made pursuant to deferred compensation formulas the partnership utilizes. These items are in the nature of an expense to active partners.

The partnership also pays partners interest on their respective capital and drawing account balances. This interest, by equity, should be sourced to the partners' state of residency rather than being includible in apportionable income. Utah and other states tax interest and also dividend income received by individuals to their state of residency (Utah Code Annotated 59-10-118(6)). As such, it would be appropriate to exclude such amounts from income subject to apportionment for Utah purposes.

Should you require further detailed information regarding the guaranteed payments, I would be happy to provide this information to you.

I would appreciate your consideration of these matters at the earliest possible time as they are of some urgency for our Firm. I thank you in advance for your consideration.

Very truly yours,

XXXXX

cc: XXXXX

Your letter of XXXXX has been reviewed and discussed with the Auditing Division. Utah Code Annotated 59-10-301 states, ". . . Persons carrying on business as partners are liable for the tax imposed by this chapter only in their separate or individual capacities." As the Tax Commission interpreted the law, a composite return for a partnership was not allowed. However, for the convenience of the taxpayers, agreements were made with certain partnerships in the past to allow composite returns to be filed. These agreements varied from partnership to partnership. The intent behind Rule R865-9-13I was to formally allow partnerships with hundreds or thousands of non-resident partners with negligible amounts of income attributable to Utah to file a composite Utah return on behalf of those partners and to standardize what would be allowed in a composite return. It was never our intention that composite returns would take the place of all non-resident partners' individual returns, regardless of the amount of their income or complexity of their situation.

Utah Code Annotated 59-10-303 (2) indicates that "In determining the sources of a nonresident partner's income, no effect shall be given to a provision in the partnership agreement which: (a) characterizes payments to the partner as being for services or for the use of capital . . ." As you discuss in your letter, the $$$$$ guaranteed payment is for services rendered by partners and those payments need to be allocated to Utah.

Section 736(a)(4) of the IRC indicates that payments, to the extent considered as guaranteed payments under 736(a)(2), are taxable as ordinary income to the recipient and therefore should be allocated to Utah.

The Auditing Division has proposed a change to Rule R865-9-13I which would allow a deduction equal to 15 percent of the Utah taxable income attributable to non-resident partners included in the composite filing. The deduction would be allowed in place of a standard deduction, itemized deductions, personal exemptions, federal tax determined for the same period, or any other deductions. The proposed effective date for this rule change would be for tax years beginning during XXXXX. These rule changes have not yet been issued for public comment.

The original changes to Rule R865-9-13I were effective for tax years beginning in XXXXX. If the non-resident partners of your firm wish to have all applicable deductions, they can file an individual non-resident return for XXXXX.

Sincerely,

XXXXX

The XXXXX statute is located in the Tax Commission files.

The XXXXX Form is located in the Tax Commission files.

Utah State Tax Commission

Heber M. Wells Building

160 East Third South

Salt Lake City, Utah 84134-0300

Dear Chairman Hansen:

We are writing to request an advisory opinion on behalf of XXXXX as to the treatment of certain guaranteed payments.

XXXXX presently files a composite return for nonresident partners pursuant to Utah State Regulation R865-9-13I. In filings prior to XXXXX, guaranteed payments for services or for the use of capital have not been deducted in determining "adjusted income" of nonresident partners under the regulation. We are writing to request an advisory opinion that XXXXX be allowed a deduction for certain services and for interest for the use of capital which we believe to be consistent with Utah provisions as explained below.

The intent of Utah Tax Code (UTC) Section 59-10-303(2) is to treat a guaranteed payment in the context of what it actually is, rather than permit the partnership agreement to determine the characterization of the payment. To the extent that such payments represent in substance and without regard to the partnership agreement, compensation and interest on capital accounts, the source of such payments would follow the situs of the service and domicile of the nonresident partner respectively. Specifically, UTC 59-10-303(2) provides in pertinent part, "In determining the sources of a nonresident partner's income, no effect shall be given to a provision in the partnership agreement which: (a) characterizes payments to the partner as being for services or for use of capital. . ." . This language does not deny a partnership a deduction for such payments, nor does it deny a nonresident partner the right to treat such payments based on their merit for purposes of applying the sourcing methodology required of nonresidents generally.

The relevant language in the XXXXX partnership agreement reads as follows: "Notwithstanding the profits (or losses) of the Firm, each partner shall receive a salary at the annual rate of $$$$$ ($$$$$)...." Under UTC 59-10-303(2) no effect is given to the term "salary", a term which characterizes the payment made to the partner. Instead, the XXXXX provision is interpreted as requiring the payment (a noncharacterization word) to each partner without regard to the partnerships' profits or losses.

Under IRC § 707(c), payments made to partners "without regard to the income of the partnership" are considered as made to nonpartners, provided such payments are for services or the use of capital. This Section 707 provided treatment is specifically incorporated into the Utah law by UTC 59-10-302(1). Accordingly, even though UTC 59-10-303(2) ignores the characterization of these payments by the partnership agreement as salary, IRC § 707 and UTC 59-10-302(1) provide for such treatment to the extent the payments are in substance salary.

Therefore, we would conclude these payments are deductible by the partnership. Since UTC 59-10-303(2) does not deny the partnership a deduction for true guaranteed payments, it is not inconsistent with the utilization of federal taxable income as characterized in UTC 59-10-302(1) as the partnership's apportionment base pursuant to Reg. R865-9-13I. Accordingly, we respectfully request XXXXX be allowed a deduction for salary and interest on capital accounts in determining the Utah apportionable base for purposes of filing its composite return. We propose that this change be prospective for calendar years subsequent to XXXXX.

In further support of our request, we would like to point out that despite statutory language identical to that of Utah's, the State of Maine, in its forms, (a copy attached) uses ordinary income as its apportionment base after deduction of guaranteed payments as shown on Federal Form 1065. (A copy of the Maine statute is attached for your reference). As computed on the Federal Form, this would be after deductions for salary and interest on partner capital accounts.

I submit the following comments in summary. UTC 59-10-303(2) operates only to ignore partnership agreement language which characterizes payments as compensation for services. It does not deny the right to treat the payment as such if the substance of the payment reflects a guaranteed payment for services. UTC 59-10-302(1), IRC § 707 and Treas. Reg. 1.707-1(c) all require that XXXXX deduct all payments which are in substance payments for services. The deduction for compensation for services and interest on capital accounts in arriving at partnership apportionable income (adjusted income pursuant to R865-9-13I) is consistent with all Federal/Utah statutes and regulations as cited above. Your prompt consideration of this matter will be very much appreciated.

Very truly yours,

XXXXX

TO: XXXXX, Director

FROM: XXXXX, Secretary

DATE: XXXXX

SUBJECT: Request for Advisory Opinion - No. 93-006DJ

Attached is a request for an advisory opinion from XXXXX of XXXXX. Will you please review the request of XXXXX concerning the treatment of certain guaranteed payments.

Please prepare the response for signature by the Commission as per the guidelines established by them.

Thank you.

cc: Joe Pacheco

XXXXX

XXXXX

RE: Treatment of Certain Guaranteed Payments

Your request for an advisory opinion regarding XXXXX allowance for salary (guaranteed payments) and interest on capital accounts in determining the Utah apportionable base for purposes of filing its nonresident composite partnership return was referred to the Auditing Division for their analysis.

It is the division staff recommendation that:

IRC Section 707 provides that any fixed or guaranteed amounts paid by a partnership to its partners for services or for the use of capital (loans made to the partnership by the partner), without regard to the income of the partnership, are treated as though they were paid to an outsider for only two purposes. These "guaranteed payments" are taxed as salary or interest to the partners and allowed as ordinary and necessary business deductions to the partnership. However, the partner must report the salary or interest as though it were a part of his distributive share of the partnership income.

For purposes other than determining the ordinary income (loss) of the partnership, guaranteed payments are regarded as a partner's distributive share of ordinary income.

Utah Code 59-10-303 indicates that in determining the sources of a nonresident partner's income, no effect shall be given to a provision in the partnership agreement which characterizes payments to the partner as being for services or for the use of capital or allocates to the partner, as income or gain from sources outside this state, a greater proportion of his distributive share of partnership income or gain than the ratio of partnership income or gain from all sources.

Although XXXXX indicates guaranteed amounts paid by the partnership to its partners for services or interest for the use of capital are made without regard to the income (loss) of the partnership, it does not change the fact that such payments would be made from gross income of the partnership that was derived from carrying on the business of the partnership in the different states.

Therefore, guaranteed payments from the partnership should be allocated to Utah.

If you do not agree with this determination, you may appeal to the Tax Commission for a formal hearing. The results of that hearing would constitute a declaratory judgment and be appealable to the Utah State Supreme Court. A Notice of Appeal Rights and copy of the Utah Taxpayer Bill of Rights are attached.

For the Commission,

Joe B. Pacheco

Commissioner