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Montana source income includes but is not limited to any income, gains, losses, or credits from:
- Work or services performed in Montana
- Products sold to Montana customers
- Selling, renting, or leasing property in Montana
If a business receives income from another pass-through entity, any Montana source income that entity passes-through counts as Montana source income.
Montana Source Income from Activities in Montana
An entity may earn Montana source income from activities carried out inside or outside Montana.
- Only in Montana
- If you are doing business only in Montana, all your income is Montana source income.
- In and Out of Montana
If you do business both inside and outside Montana, your Montana source income includes:
- The apportionable income apportioned to Montana
- The non-apportionable income allocated to Montana
- All Montana source income passed through from another entity
With some exceptions, states are prohibited from imposing income tax on businesses whose only activity in that state is the sale of tangible personal products. Please refer to ARM 42.26.501 and Public Law 86-272 for more information on what business activities are taxable versus non-taxable.
If a business is required to file a return in Montana, the business is said to have nexus in Montana.
The Nexus Questionnaire (Form NEXUS) can be used to help determine if a business has nexus in Montana.
Allocating and Appropriating Income to Montana
Apportionable income is determined using a transactional test and a functional test. These tests do not depend on the type of income, but if the income is derived by the entity’s trade or business.
This determination is done at the entity level and ignores how the income is treated on on the owner’s return. As a result, dividend and interest income used to apply the passive loss limitation rules under IRC § 469 on the owner’s return has not effect on classification:
- Interest income is apportionable if the source of the interest came from, or was created by, the regular course of the taxpayer’s trade or business operations.
- Dividends are apportionable income if derived from stocks acquired in the regular course of the taxpayer’s trade or business operations.
If the entity regularly engages in the ownership, sale, or other disposition of investments and as part of the ordinary course of business, then the income arising from such transactions is presumptively apportionable income.
- Property Sales
- Gain or loss from the sale, exchange, or other disposition of real, tangible, or intangible personal property is apportionable income if it was used in the taxpayer’s trade or business while owned by the taxpayer or was included in the apportionment factor.
- Rental Income
- Rental income from real and tangible property is apportionable if the property the entity rents and receives income on is used in the entity’s trade or business, is incidental to the trade or business, or includable in the property factor.
Income is apportioned to the state using three equally weighted factors.
The property factor is a fraction determined by the average values of real and tangible property owned, leased, or rented by the entity.
Find the factor by dividing the average value of property in Montana used to produce apportionable income during the tax period by the average value of all property used to produce apportionable income during the tax period.
Property owned by the pass-through entity is valued at its original cost.
Real and tangible personal property used in the course of business includes:
- stocks of goods,
- inventories, or
- any other tangible property actually used in connection with the production of apportionable income.
It does not include money, accounts receivable, other intangible property, real property that is held for investment or nonbusiness purposes or idle property of any nature.
Migratory or mobile property used in Montana must be included in both average property values.
Unless otherwise required, the average value of owned property is determined by averaging the values at the beginning and end of the tax period.
Rented property is valued at eight times the net annual rental rate. Rental expense cannot be averaged and the current year’s rental expense must be used in the property factor.
The payroll factor is determined by the amount paid for compensation attributable to the production of apportionable income during the tax period.
Find the factor by dividing the compensation paid in Montana by the total compensation.
Payroll is considered paid in Montana if:
- the base of operations is in Motnana;
- there is no base of operations and the place from which the service is controlled is in Montana; or
- the base of operations or place of controll is not in Montana, but the person providing the service is in Montana.
The receipts factor is determined by the income from selling tangible personal property during the tax period.
Find the factor by dividing the total gross receipts received in Montana by the total of all gross receipts received by the entity.
- Receipts from selling tangible personal property are in Montana if the property is delivered or shipped to a purchaser in Montana other than the United States government, or the property is shipped from Montana and the pass-through entity is not taxable in the purchaser’s state.
- Beginning January 1, 2018, receipts other than from the sale of tangible personal property must be assigned based on the entity’s market. (ARM 42.26.245 through 42.26.250)
Allocation of Nonapportionable Income
Nonapportionable income means all income other than apportionable income.
More specifically nonapportionable income is income for which both the transactional test and the functional test failed.
Nonapportionable income is allocated to Montana depending on its character and the facts attached to the income.
For income determined to be nonapportionable, the following are examples of items that must be allocated to Montana:
- Net rents and royalties from real property located in Montana.
- Net rents and royalties from tangible personal property if and to the extent the property is utilized in Montana, or the entire net rent or royalty if the entity’s commercial domicile is in Montana and the entity is not organized under the laws of the state in which the property is utilized, and the net rents or royalties are not taxable in that state.
- Capital gains and losses from sales of real property located in Montana.
- Capital gains and losses from sales of tangible personal property are allocable to Montana if the property had a situs in Montana at the time of the sale, or the entity’s commercial domicile is in Montana and the capital gains or loss is not taxable in the state in which the property had a situs.
- Capital gains and losses from sales of intangible personal property if the entity’s commercial domicile is in Montana.
- Interest and dividends if the entity’s commercial domicile is in Montana.
- Patent and copyright royalties to the extent that the patent or copyright is utilized by the payer in Montana, or to the extent that the patent or copyright is utilized by the payer in a state in which the patent and copyright dividend is not taxable and the entity’s commercial domicile is in Montana.
A patent is utilized in Montana to the extent that it is employed in production, fabrication, manufacturing, or other processing in Montana or to the extent that a patented product is produced in Montana.
A copyright is utilized in Montana to the extent that printing or other publication originates in Montana.
If the basis of receipts from copyright or patent royalties does not permit allocation to states or if the accounting procedures do not reflect states of utilization, the copyright or patent is utilized in the state in which the taxpayer’s commercial domicile is located.
The original entity that generates income determines the state sourcing and characteristic of the income. The type of income and state sourcing stays the same when passed on to another entity.
Montana source income received from another pass-through entity is not included in apportionment and cannot be re-characterized.
The practical consequence is that flow-through income received on Schedules K-1 issued by a first-tier must be separated from the trade or business of a second-tier before this second-tier classifies its items of income from its own trade or business into apportionable income and nonapportionable income. In a second step, the flow-through Montana source income from the first-tier must be added to the Montana source income derived from the second-tier trade or business activities.
See ARM 42.9.107 for more information on how to report income received from another pass-through entity.
Items of Montana source income that are aggregated on the second-tier return determine the basis used for the calculation of withholding or composite tax if required. Thus, income may be offset by a loss derived from activities occurring at another tier.
This does not apply to partnerships and S corporations computing Montana source income in a tiered structure.
However, if one of the direct or indirect owners of a partnership is a C corporation, the operations of the partnership may be unitary with the C corporation.
Guaranteed payments representing a return of capital are apportionable.
If the guaranteed payment stems from an item of nonapportionable income per the partnership agreement, and this income is allocated to Montana, then the guaranteed payment is Montana source income.
Payments for Services
Payments made to a partner for services are considered nonapportionable income allocable to the state where the services were performed. Guaranteed payments must be included in the calculation of the federal self-employment taxes of the owner to qualify as guaranteed payments made for services rendered.
If any part of the guaranteed payment is compensation a nonresident partner for services performed in Montana, then that portion of guaranteed payment is Montana source income and must be reported on Column II of Montana Schedule K-1. If the guaranteed payment is paid to a resident of Montana for services rendered, the entire guaranteed payment is Montana source income and must be reported on Column I.
See ARM 42.9.303 for more information about sourcing guaranteed payments.
In general, disregarded entities must follow the same sourcing rules used by partnership and S corporations. However, because of the disregarded entities unique relation with their owner, specific rules apply based on the type of their owner.
Disregarded entities owned by a partnership or an S corporation
There can be two types of disregarded entities owned by a partnership or an S corporation:
- disregarded entities that carry on a trade or business, and
- disregarded entities that are segments of the trade or business of their owner.
Disregarded Entities Carrying on a Trade or Business
These entities determine their amount of gross income and Montana source income the same way partnerships or S corporations calculate their income.
This determination must be made before the pass-through owner determines the amount of Montana source income from its own trade or business.
A disregarded entity with Montana source income from activity in Montana must be included on List of Disregarded Entities (Form PTE, Schedule VII) of the owner’s Form PTE.
A disregarded entity is a segment if:
- the owner segregated a trade or business into functions or assets; and
- contributed a function, asset, or both to the disregarded entities so the determination of Montana source income at the disregarded entity level does not represent the activities carried on in Montana.
Segments remain disregarded for the determination of Montana source income.
All their items or income, loss, deduction and credit remain in the apportionable income of their owner and their items of property, compensation or receipts are used in the determination of the apportionment factor.
If the partnership or the S corporation remains at risk based on a recourse debt related to a trade or business held in a disregarded entity holding functions or assets of such trade or business, the disregarded entity would still be considered a segment. If the debt is nonrecourse, such debt and its related expenses are automatically allocated to the entity holding the collateral.
If the disregarded entity is a segment and it carries on its own activities constituting a fully functioning and independent trade or business, the disregarded entity must complete the List of Disregarded Entities (Form PTE, Schedule VII) to determine the amount of Montana source income stemming from its own trade or business activities.
Items of income, (loss), deduction, credit or apportionment included in the segment are not reported on Schedule DE.
Disregarded Entities Owned by a C Corporation
Disregarded entities owned by a C corporation are deemed unitary and must report their items of income, loss, deduction, credit, and apportionment on their owner’s Corporate Income Tax Return.
Disregarded Entities Owned by a Resident Individual
Disregarded entities owned by resident individuals must report their items of income, loss, deduction and credit on their owner’s federal Schedule C.
Disregarded Entities Owned by a Nonresident Individual, Estate or Trust
Disregarded Entities Owned by a nonresident individual, an estate or a trust must file Form DER-1 to report their Montana source income.
Form DER-1 includes Worksheet DE, that the disregarded entity may use to determine their Montana source income.
Income Sourced to Montana Based on the Residency Status of the Owner
Pass-through income received by resident owners is Montana source income whether the entity carries on a trade or business in Montana.
Income sourced to Montana based on the residency status of the owner does not create a filing requirement for the pass-through entity. However, pass-through entities, including investment clubs, may still file an information return if they deem it necessary to provide Montana adjustments information to their Montana resident owners.
Partnerships formed by individual owners exclusively for the purpose of holding stock and securities, the so-called investment clubs, do not have a filing requirement.
The income is always sourced to the state of residence of owners because the income derived from such holding never relates to a trade or business.
This exemption to file does not extend to investment clubs that are corporations or trusts.
Guaranteed payments made to a retired partner are sourced to the state of residence of this partner.