Undivided Interest Structures

Undivided Interest Structures

February 01, 2005

Undivided interest structures may be taxed differently by US states than by the federal government.

Municipal utilities and tax-exempt electric cooperatives who are approached about buying electricity from independent power companies sometimes ask to own an interest in the project and take a share of electricity in kind rather than buy the electricity under a power contract. One reason is the municipal utility or coop usually tap cheaper sources of money than the private developer can to finance its share of the project. The developer retains an interest in the project. It and the municipal utility or coop own the project as “tenants in common,” meaning that each has an interest in the whole plant but the plant cannot be easily separated or divided. If two parties owned a chair this way, then each could sit in the whole chair, but they must share its use.

In order for such an arrangement to work, the parties must file a “section 761 election” with the Internal Revenue Service. The election ensures that the arrangement will not be treated as a partnership for federal income tax purposes.

A Louisiana appeals court said in late December that such an arrangement was still a partnership for some state tax purposes. A Louisiana taxpayer, Unocal, owned a 2% interest in the trans-Alaska pipeline. The pipeline is owned by an “unincorporated association”; the owners opted out of partnership treatment at the federal level.

Louisiana allocates income earned from a partnership to the state where the partnership has its business operations. Thus, in this case, none of Unocal’s income from the Alaska pipeline could have been taxed in Louisiana. However, if the pipeline project was not a partnership, then the income would be apportioned among all the states where Unocal does business, and part of it would be taxed in Louisiana.

The state argued that the pipeline project was not a partnership. It said it would follow the federal treatment. Unocal wanted the project treated as a partnership, at least for purposes of determining to which state to attribute its share of the pipeline income.

A Louisiana appeals court sided with Unocal. It said that even the federal tax code says that a joint undertaking among several parties to do a project remains a partnership for some federal tax purposes notwithstanding an election to opt out of such treatment. The court said this venture remained a partnership when it came to deciding where Unocal’s share of income should be taxed. The case is Unocal Pipeline Co. v. Kennedy.

Keith Martin