SALT Developments in the Sale of Partnership Interests

Considering selling your investment in a partnership? It is worth noting the important factors that may impact the tax treatment for state income and franchise tax purposes. While many believe the gain derived from a sale of a partnership interest can only be sourced to the individual’s state of residency, that may not be the case. Factors such as states’ need for funds to offset rising deficits and court decisions finding in favor of the tax authorities have led to an uptick in state audits challenging the sourcing of a gain from the sale of partnership interests. Generally, taxpayers are required to recognize the gain as income in their state of residency. However, states may also attempt to tax non-residents on the gain from a sale of partnership interest when the partnership has engaged in business activities in such state.

California has successfully challenged taxpayers, requiring nonresidents to report a portion of gain resulting from a sale of partnership interest as California source income. Depending on the structure of the sale, sourcing rules may vary. For example, if a limited liability company (“LLC”) that is used as a holding company sells its investment in a partnership, and the LLC is owned by a mixed pool of corporate and non-corporate members, the sourcing rules for each member type may differ.

California Legal Ruling 2022-02

In July 2022, California released guidance^[1]in connection to sourcing federal Internal Revenue Code Sec. 751(a) gain from nonresident’s sale of California partnership interest. The guidance analyzed two scenarios (1) where all activities are conducted in California; and (2) where business is conducted partly within and partly outside the state. Under scenario 1, all income, gain or loss derived would be sourced to California. Under scenario 2, the gain or loss associated with the partnership’s Sec. 751 property (also known as “hot assets”) is sourced to California based upon the partnership’s California apportionment factors of the business conducting operations in the state. Because the gain or loss is calculated as if the partnership had sold the Sec. 751 property directly and distributed it pro rata to the partner, the income would be treated as income from a trade, business or profession and sourced according to the Uniform Division of Income for Tax Purposes Act (“UDITPA”) (RTC Sections 25120 to 25139).

California’s Taxation of Individual Members’ Disposition of an Intangible Property

Cal. Rev. & Tax. Cd. § 17952 ^[2]states that income of nonresidents from stocks, bonds, notes or other intangible personal property is not income from sources within this state unless the property has acquired a “business situs” in this state. An intangible has a business situs in the state if “it is employed as capital in the state or the possession and control of the property has been localized in connection with a business, trade or profession in this state so that its substantial use and value attach to and become an asset of the business, trade or profession in the state.^[3]” Unless the intangible property acquires a business situs in California, the concept of mobolia Sequuntur personam (moveable follows the law of the person) applies, and the income would not be taxed to the nonresident individual partner in California. Under these regulations, many taxpayers interpret this rule as the gain is not sourced to California. However, California has taken a more aggressive position applying Cal. Rev. & Tax. Cd. § 17951-4(d) ^[4]that if a nonresident is a partner in a partnership that carries on a unitary business, trade or profession within and without this state, the gain from such sale is sourced to the state.

An interesting result came out of the Metropoulos case in California. In the 2009 Metropoulos Family Trust v. Franchise Tax Board, the appellate court determined that a nonresident member of an S corporation was subject to California income tax on their distributive share of a sale of an intangible. The S corporation, Pabst Corporate Holdings, Inc. (“Pabst”), sold its interest in a wholly-owned subsidiary. Pabst is a Delaware S corporation domiciled in Connecticut doing business in various states. The shareholders were two non-grantor trusts Connecticut residents. The sale was deemed an asset sale, including goodwill for federal income tax purposes.

The Connecticut residents argued that the gain derived from an intangible asset should be sourced to their state of residency, not California. The Franchise Tax Board successfully argued that the gain resulted from the sale of goodwill and, thus, should be apportioned to California based on Pabst’s apportionment factor. Notably, the appellate court upheld the California taxing authority’s position and that regulations for apportioning business income within the S corporation applied, rather than the personal income tax rules for sourcing the gain of goodwill at the shareholder’s level. Additionally, it was noted that the sale of goodwill had partially acquired business situs in the state and should be subject to California personal income tax. The goodwill attributed to Pabst’ business income and was considered apportionable business income. 

California’s Taxation of Corporate Members’ Disposition of Intangible Property

In the context of a corporate partner selling their partnership interest, the first step is to determine which portion of the taxpayer's income and its distributive share of the partnership items constitute “business income” and “nonbusiness income” under Cal. Rev. & Tax. Cd.  §25120. ^[5]Once the gain generated from the sale of a partnership interest is classified as business income, the corporate partner must apportion the gain to California, applying the business apportionment of the disposed partnership and any apportionment factors at its level. In other words, the factors must be aggregated at the corporate level and income apportioned accordingly.

Conversely, if the gain is deemed non-business income, special rules apply under Cal. Rev. & Tax. Cd.  §25125(d)^[6]. Under these provisions, the gain or loss on the sale of a partnership interest is allocable to California in the ratio of the original cost of the partnership’s tangible personal property in the state to the cost of the partnership’s tangible personal property everywhere—determined at the time of sale. If more than 50% of the value of the partnership’s assets consist of intangibles (e.g., cash, goodwill,  certain investments) gain or loss from the sale of the partnership interest is allocated to this state in accordance with the sales factor of the partnership for its first full tax period immediately preceding the tax period of the partnership during which the partnership was sold. 

The Appeal of L. Smith

Many states have focused on the unitary relationship between a selling member, whether directly owned or through a holding company, and the disposed partnership. In the Appeal of L. Smith, the taxpayer, an individual, held an indirect ownership interest in the partnership, SOSC, LLC (“Holdco”), a holding company. Holdco did not have any tangible property, payroll or other operating activities of its own in California. Holdco held a 50.50% membership interest in Shell Vacations, LLC (“Shell”), an Arizona-based company, also treated as a partnership for federal purposes, which was in the business of owning and developing timeshares and vacation club memberships. Shell conducted part of its business in California. The gain in question was from Holdco’s sale of its ownership interest in Shell.

The taxpayer took the position that the sale of Holdco’s interest was a sale of an intangible asset with no business situs in the state. Thus, R&TC section 17952 applies, and the gain is sourced to the member’s state of residency. However, the OTA, agreeing with the California Franchise Tax Board, determined that R&TC section 17952 was not the applicable rule in this situation; instead, it was income from a unitary business, and R&TC section 17951-4 ^[7]applies. A key factor in this decision was that Holdco and Shell were unitary. This method views the gain as apportionable business income, flowing up Shell’s apportionment factors to Holdco to determine the portion of the gain taxable by California under its adoption of UDITPA rules. If the facts had been that Holdco and Shell were not unitary, conceivably, Holdco may have had a basis for treating the gain as a nonbusiness gain with a potentially more favorable result to Holdco.

New York State’s Treatment of a Nonresident’s Sale of Partnership Interest Owning Real Property

Chapter 57 of the Laws of 2009 discusses how nonresident individuals' New York source income is defined. Section 631(b)(1)(A)(1) expands the criteria for income, gain, loss and deduction to encompass specific gains or losses when a nonresident sells or exchanges ownership in an entity that possesses real property in New York State. This applies to partnerships, LLCs, S corporations, or closely held C corporations with up to 100 shareholders.

Effective May 7, 2009, if the entity owns significant New York real property (50%-plus of the fair market value of its assets owned for over two years), all or a portion of the gain or loss from the sale or exchange contributes to the individual's New York source income. To determine the portion sourced to New York, the numerator is the fair market value of real property located in New York, and the denominator is the fair market value of all assets, regardless of ownership duration. Section 631(b)(1)(A)(1) applies similarly to part-year residents with proper reporting. This statute does not affect taxes when the entity itself sells New York real property or when an interest in an entity contributes to another business in the state.

The law also applies to an individual's sale or exchange of an entity interest in a tiered structure of entities. Within a multi-tier setup, if any tier contains an entity owning New York State real property, the law applies. Likewise, if a partnership within this structure sells or exchanges its interest in another entity, the law applies. In this situation, the partnership assesses potential New York source income from the transaction, following Tax Law section 631(b)(1)(A)(1), as though it were a nonresident individual. 

VAS Holdings & Investments LLC v. Commissioner of Revenue 

Another decision involving the sourcing of a gain from the sale of partnership interest is VAS Holdings & Investments LLC (VASHI) v. Commissioner of Revenue. The Massachusetts Supreme Judicial Court ruled in favor of the taxpayer’s position citing that the commonwealth lacked statutory authority under the unitary business principle to impose corporate excise/nonresident composite taxes on gain of a foreign LLC treated as an S Corporation or its nonresident owners.

The case in question was connected to a gain derived from the sale of the LLC’s interest in a partnership. VASHI was a holding company organized in Illinois whose business operations were performed by a subsidiary that had a call center in Canada supporting the hospitality industry. In 2011, VASHI merged its Canadian and U.S operations with a Massachusetts-based company, an LLC operating in a similar industry. As a result of the transaction, VASHI held a 50% interest in a partnership, Cloud5, LLC. VASHI also changed its commercial domicile from Illinois to Florida, and its shareholders were non-Massachusetts residents. After the merger, all the business operations were managed and directed by Cloud5, LLC. VASHI was not involved with any of the decision making or day-to-day operations of the business conducted in Massachusetts. VASHI had no property, payroll or sales of its own in the state, other than a limited interest ownership in Cloud5, LLC. VASHI sold its entire 50% ownership in Cloud5, LLC, in 2013 that generated a capital gain of $37 million. None of the gain was sourced to Massachusetts by the nonresident shareholders or by the S corporation (VASHI).

The Massachusetts Department of Revenue challenged the taxpayer’s reporting, noting that the gain should be sourced to the state since the gain was related to business operations carried on partly in this state. VASHI appealed the case citing that the selling entity (Cloud5 LLC) was not part of a unitary business structure with VASHI. The court’s analysis and conclusion resulted in agreeing with the taxpayer that absent a unitary relationship there was no statutory authority to tax this gain. Pursuant to Massachusetts M.G.L c. 63 s. 32B rules, ^[8]taxes may apply to out-of-state businesses only on a unitary business principle, which was not established in this case.

Corrigan v. Testa, 149 Ohio St.3d 18, 2016-Ohio-2805

This decision involved a Connecticut resident who held a 79% interest in Mansfield Plumbing, LLC (“LLC”) an entity domiciled in Ohio that produced sanitary ware. The business had facilities in California and Texas and conducted business in all 50 states. The taxpayer, Corrigan, was an investor in the company who provided financing and strategic expertise with the purpose of growing the company for an exit strategy. Corrigan, while a member of the LLC’s board of managers, was not an active member nor participated in any of the decision making or day-to-day operations of the LLC.

During 2004, Corrigan sold his interest in the LLC, generating a capital gain and sourcing it to his home state, Connecticut. The Ohio Department of Taxation subsequently audited Corrigan and assessed tax on Corrigan’s sale of his partnership interest in the LLC. Notably, Ohio relied upon R.C. 5747.212^[9], apportioning gain recognized by a nonresident equity investor selling an investment in a closely held business (i.e., partnership interest). Pursuant to that rule, a taxpayer that directly or indirectly owned at any time during the three-year period ending on the last day of the taxpayer’s taxable year at least 20% of the equity voting rights shall apportion any income, including gain or loss realized from such sale. This specific statute overrides the general Ohio sourcing of a capital gain where such gain is sourced to the nonresident’s state of domicile.   

The case was appealed, and the court concluded that income from the sale of an ownership interest in a business is generally considered nonbusiness income for Ohio income tax purposes. Nonresidents generally do not incur Ohio tax on income from the sale of their ownership interests in Ohio businesses, because Ohio law allocates the nonbusiness income to the nonresident's state of domicile.[^10]

Key Takeaways

Because many states have limited guidance as to the treatment of a sale of partnership interest, this is an area that requires careful planning. Some principles to consider when selling a partnership interest include:

• Unitary versus non-unitary business relationship between selling member and the partnership.
• Participation of the selling members in the operating entity (active/limited investors).
• Whether the sale is a direct sale by an individual or indirectly through a holding company.
• Who are the investors (corporate versus noncorporate members)?
• Are there any 751 assets in place held by the partnership being sold?
• Type of assets held by the partnership being sold (real estate, goodwill).
• Sale structure (asset sale versus stock sale).

[1] California Legal Ruling 2022-02

[2] Cal. Rev. & Tax. Cd. § 17952

[3] Cal. Code Regs tit 18, Section 17952(c)

[4] Cal. Rev. & Tax. Cd. § 17951-4(d)

[5] Cal. Rev. & Tax. Cd.  §25120.

[6] Cal. Rev. & Tax. Cd.  §25125(d)

[7] R&TC section 17951-4

[8] M.G.L c. 63 s. 32B

[9] Ohio Rev. Code Ann.. § 5747.212

[10] Ohio Rev. Code Ann. § 5747.20(B)(2)(c)