State & Local Tax Bulletin (March 2006)
DC Court Strikes Down Unincorporated
Tax on Nonresident
Individuals in Bender v. District of
By James M. Grosser,
a tax partner in
the Washington, D.C. office of Pillsbury Winthrop
Shaw Pittman LLP.
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In a significant taxpayer victory, the Superior Court of the District of Columbia ruled that applying the Unincorporated Business Franchise Tax to income distributable to individuals residing outside the District violates the so-called "commuter tax ban" in the District of Columbia Home Rule Act.
Impact on Taxpayers
- The Bender decision benefits any nonresident individual who owns an interest in an unincorporated business operating in the District of Columbia, regardless of the type of activity conducted by the unincorporated business. Resident individuals and corporations who own interests in unincorporated businesses operating in the District continue to be subject to the unincorporated business franchise tax (the "UB Tax").
- In cases of unincorporated businesses structured with multiple tiers of partnerships and limited liability companies ("LLCs"), the Bender exemption should be applied by looking through all of the tiers to identify the distributable shares of all nonresident individual owners.
- While the exemption established in Bender is applied at the owner level, the payment obligation falls at the entity level. Therefore, partnerships and LLCs with taxable and tax-exempt owners will need to address the allocation of the UB Tax burden in their operative documents, taking into account such factors as the availability of credits for the tax in other states.
- The decision does not address the impact of the commuter tax ban on the taxation of S corporations owning interests in unincorporated businesses operating in the District. While the court's "economic burden" rationale could be applied to S corporations and their shareholders, this seems unlikely to occur given that District tax law draws no distinction between S corporations and C corporations. Consequently, individuals operating unincorporated businesses in the District through multi-tier structures will be disadvantaged if their structures include S corporations.
- The District of Columbia has not acquiesced in the result in Bender, and has stated that it plans to appeal. Until the appeals process is complete, taxpayers who follow Bender may face assessment for underpayment of tax, along with penalties and interest. Therefore, taxpayers should consider whether it is preferable to continue complying with the tax until the appeals process is exhausted. Protective refund claims can be submitted to preserve taxpayer rights.
The District of Columbia, unlike many state and local jurisdictions, imposes an entity-level income tax on partnerships, LLCs, and other non-corporate entities doing business in the District, even if such entities receive pass-through treatment for federal income tax purposes. This tax, often referred to as the UB Tax,[fn. 1] is a 9.975% annual tax on net income. Except for a few types of businesses specified in the statute, the UB Tax applies to any trade or business conducted in the District by a partnership, LLC, other non-corporate entity or individual.[fn. 2] For example, an LLC developing a residential condominium project in the District would be an unincorporated business under the statute. The UB Tax often comes as an unwelcome surprise to real estate investors and developers and others who are used to receiving pass-through treatment at the federal, state and local levels for their business ventures conducted through partnerships and LLCs.
In Bender, the Superior Court addressed an issue arising at the intersection of the UB Tax and the provision in the District's Home Rule Act[fn. 3] commonly known as the "commuter tax ban." The commuter tax ban is a provision in the Home Rule Act barring the taxation of "personal income" of nonresident individuals. (Note that the commuter tax ban does not apply to the taxation of corporations, including S corporations.) The District of Columbia Court of Appeals previously determined in Bishop[fn. 4] that, while the filing and payment obligations for the UB Tax fall on the unincorporated business, the economic burden of the UB Tax falls on the owners of the unincorporated business. Consequently, the court concluded that the application of the UB Tax to a professional services partnership constituted an impermissible tax on the personal income of the owners of the unincorporated business, who were individuals residing outside the District.[fn. 5]
The principal issue in Bender was whether the holding in Bishop should be extended to encompass income from business activities other than professional services. In answering this question in the affirmative, the court reached the sweeping conclusion that all of the net income of a unincorporated business that is distributable to an individual is personal income:
"the Court holds that the [commuter tax ban] does effectively limit the Council's exercise of its [unincorporated business] regulatory authority to impose upon any [unincorporated business] net income to the extent that the [unincorporated business] distributes directly to nonresident individuals, whether professionals or otherwise."
The breadth of this conclusion is extremely favorable to taxpayers, with the minor caveat that the reference to income that the unincorporated business "distributes" is ambiguous and could be read to refer either to actual distributions or to distributable shares. In our view, however, the better reading is that "distributes" should be read to refer to distributable shares rather than actual distributions.
- DC Code § 47-1808.01, et seq. [return to text]
- Examples of businesses carved out from the definition of "unincorporated business" include certain personal service businesses and
businesses that by law, customs or ethics cannot be incorporated. [return to text]
- DC Code § 1-201.01, et seq. [return to text]
- 401 A.2d 955 (1979). [return to text]
- Bishop, which involved a law partnership, was decided during a period in which the statutory definition of "unincorporated business" did not include the present carve out for personal services businesses. Under current law, the law
partnership in Bishop would not be an
unincorporated business. [return to text]
This material is not intended to constitute a complete analysis of all
tax considerations. Internal Revenue Service regulations generally
provide that, for the purpose of avoiding United States federal tax
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