Recent cases from New York and New Jersey illustrate the continuing confusion surrounding the taxability of nonresident owners of passthrough entities. In the New York case, the Division of Tax Appeals analyzed whether out-of-state corporate members of a limited liability company were taxable in New York by looking only to whether the income that was being taxed was earned by the LLC in the state and ignoring whether the corporate members themselves had nexus with the state (Shell Gas Gathering Corp. #2 & Shell Gas Pipeline Corp. #2, DTA Nos. 821569 and 821570 (N.Y.S. Div. of Tax Appeals, June 11, 2009); for the decision, see Doc 2009-14036 or 2009 STT 117-17). In New Jersey, the New Jersey Tax Court found that a nonresident limited partner in a partnership was not doing business in New Jersey because it was not engaged in a unitary business with the partnership (BIS LP, Inc. v. Director, Division of Taxation, No. 007847-2007 (N.J.T.C. July 30, 2009); for the decision, see Doc 2009-17760 or 2009 STT 149-19).
 
Even though the ownership rights of the nonresident members of the LLC in the New York case were similar to the limited partner's ownership rights in the limited partnership in the New Jersey case, the cases took divergent paths getting to their respective answers.

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The analysis of whether a corporate owner of an interest in a partnership or LLC is subject to tax in a state based solely on that ownership interest is a seemingly straightforward inquiry. However, few state courts have been willing to squarely address the nexus issues and have focused instead solely on the fact that the passthrough entity was earning income in the state and did not pay tax. Some states have even enacted regulations saying that corporate owners of passthrough entities that operate in the state are subject to tax based solely on the ownership of the passthrough entity.

Regardless of whether states dislike the ramifications of the result, questions regarding jurisdiction over foreign corporate owners of passthrough entities should be decided based on the corporate owners' presence in the state and an analysis of the corporation's ownership rights in the passthrough entity and not on the fact that the passthrough entity itself is not subject to tax. While states may not like the idea of companies being able to elect to treat an entity as a partnership or disregarded entity, neither of which is generally taxed, and then asserting that the state does not have jurisdiction over the corporate owner, there are other ways to address the issue that may not involve overstepping constitutional boundaries.

There is nothing to prohibit a state from imposing an entity-level tax on LLCs and partnerships, as some states have done, thus obviating the need to attempt to tax the income when it is paid to the corporate owner. Alternatively, states may be able to require withholding on payments to nonresident owners of LLCs and partnerships. However, that a state has chosen not to tax some entities does not automatically give the state the right to tax the owners of those entities when they are not present in the state.

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