A recent Supreme Court ruling just increased state’s rights to tax income made in other states.

In this case, the Court was looking at the ability of one state (Illinois) to tax the gain on the sale of an Illinois-based subsidiary, where the parent company was located in Ohio. The Illinois Tax Department considered the subsidiary to be an integral part of the parent company's operation. Under something called the "unitary business principle," (where interstate parts of a business together make up a whole business), taxing the Ohio company on the gain was okay. The Ohio company earned money from its Illinois subsidiary, which was taxable in Illinois, so the sale should also be taxable.

However, the parent company considered the subsidiary to be an investment, rather than a true subsidiary. They argued that there was no "unitary" business. The companies didn't share management, offices, resources ... heck, they didn't even offer each other discounts on services. As far as the parent company was concerned, the subsidiary was no different from a piece of real estate. And under current laws, states can't reach across state lines to tax passive income.

What made things even more complicated was a Supreme Court ruling back in 1992, where the Court made a passing reference to a tax liability created by assets that served "an operational rather than an investment function" for a business. Many states took this reference to mean that if an asset in another state earned money by providing a service (as opposed to real estate, which is passive), it became an "operational" asset -- and was taxable, even if the unitary business principle wasn't met. This was the approach that Illinois had taken to justify their tax bill to the Ohio company.

The Supreme Court clarified the situation by saying that there was no such alternative, and their earlier statement hadn't meant anything at all. However, what concerns me is what it could mean for LLCs that invest in real estate as their business, and invest across state lines.

According to the Supreme Court, some of the characteristics of a unitary business are "functional integration, centralized management, and economies of scale." If you are doing the property management for all of your properties, and everything is handled at your home office ... then it could be argued that you have a unitary business. And if so, the question then becomes, are your investment activities passive or not?

I'm not sure of the answer. Chances are, your real estate investments will be considered passive, and thus the gain will not be taxable in two states. On the other hand if you're doing fix-and-flips, the reverse is true, and you will be taxed on the income. I’m sure the lawyers will be fighting things out for some time to come, but I believe this case is one more reason to keep your LLC's assets contained on a state-by-state basis. And if you, or your clients are active in multiple states, it may be time to find a good advisor to make sure you stay current on this topic.

Published: May 15, 2008

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Diane Kennedy, the nation's pre-eminent tax strategist, is owner of Diane Kennedy & Associates, a leading tax strategy and accounting firm and founder of TaxLoopholes. She is the author of The Wall Street Journal and Business Week bestsellers, Loopholes of the Rich and Real Estate Loopholes, and co-author of The Insider's Guide to Real Estate Investing Loopholes, The Insider's Guide to Making Money in Real Estate, and TaxLoopholes for eBay Sellers. Register for free Tax Strategy updates and e-Newsletters delivered via email from TaxLoopholes.com. You will be updated on current tax law changes as well as proactive tax strategies the wealthy use plus news regarding Diane Kennedy.