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Matthew A. Stevens
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Jamie C. Yesnowitz
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On Nov. 7, 2019,1
the California Office of Tax Appeals (OTA) held that nonresident shareholders’ California source income from an S corporation’s sale of goodwill in a transaction generating business income should be determined using the S corporation’s California apportionment percentage, and not based on the nonresidents’ state of domicile.2
Because the income was apportionable business income, its apportionment by the S corporation was held to be determinative of its source in the hands of the S corporation’s nonresident owners. A concurring opinion reached the same conclusion on the alternative theory that the intangible property (in this case, goodwill) had partially acquired a business situs in California.
The 2009 Metropoulos Family Trust and the Evan D. Metropoulos 2009 Trust owned a 39.5% interest and a 20% interest, respectively, in Pabst Corporate Holdings, Inc., an S corporation domiciled in Delaware (“Pabst Corporate Holdings”). During the year at issue, each of these trusts was beneficially owned by individual taxpayers residing outside California. Pabst Corporate Holdings owned a 100% interest in a qualified subchapter S subsidiary, Pabst Holdings, Inc., that operated throughout the United States, including in California.
In 2014, Pabst Corporate Holdings sold its 100% interest in Pabst Holdings, Inc. in a transaction treated as an asset sale for federal income tax purposes. The primary asset sold was goodwill, and this transaction resulted in a long-term gain that exceeded $607 million. The gain was reported as apportionable business income by Pabst Corporate Holdings on its 2014 California S corporation return, and apportioned using the S corporation’s 6.6% California apportionment percentage. This apportioned gain was, in turn, reported as California sourced income to the trusts to be passed through to their nonresident beneficiaries.
The trusts subsequently filed amended California returns that treated all income attributable to the sale of Pabst Holdings, Inc. as not being subject to California taxation. Because the gains arose from the sale of intangible property, the trusts argued that the gains lacked a California source and should have been sourced to the trusts’ domicile outside California. The FTB denied these refund claims, and the trusts filed a timely appeal with the OTA.
California sourcing of income from S corporations
California generally adopts federal tax law concerning the treatment of S corporations.3
The character of a shareholder’s share of S corporation income is determined as if the income were realized directly from the source from which realized by the corporation.4
This principle is referred to as the “conduit rule.” Under Cal. Rev. & Tax. Code Sec. 17952, “income of nonresidents from stocks, bonds, notes, or other intangible property is not income from sources within [California] unless the property has acquired a business situs” in the state. For purposes of sourcing the share of a nonresident’s income from a partnership conducting a unitary business both within and outside California, Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1) provides that the total business income of the partnership must be apportioned at the partnership level, and Cal. Code Regs. tit. 18, Sec. 17951-4(d)(3) provides that the source of a partner’s share of items that do not constitute business income must be determined under the sourcing rules of Cal. Rev. & Tax. Code Secs. 17951 through 17955.5
These same rules expressly apply to sourcing income from S corporations.6
Majority holds business income sourced at S corporation level
The OTA was asked to determine whether the gain passed through to the nonresident individuals should be sourced to the nonresidents’ state of domicile (under Cal. Rev. & Tax. Code Sec. 17952) or sourced using the S corporation’s California apportionment percentage (under Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1)). The majority’s opinion concluded that following Cal. Code Regs. tit. 18, Sec. 17951-4 both: (i) comports with the California Court of Appeal’s decision in Valentino v. Franchise Tax Board;7
and (ii) is consistent with the “conduit rule.”
As background, in Valentino
, the Court of Appeal was required to determine whether all S corporation income passing through to its shareholders should be treated as income from intangibles sourced under Cal. Rev. & Tax. Code Sec. 17952. On this issue, the Court determined that “the Legislature intended the source of S corporation pass through income be determined by reference to corporate-income-producing activities.”8
The Court went on to say that, separate from sourcing pass-through S corporation income, Cal. Rev. & Tax. Code Sec. 17952 “continues to apply in those situations it did before the enactment of the S corporation provisions—that is, to determine the source of stock dividends and income from the sale of stock.”9
Addressing the scope of Valentino
, the OTA called it “an incomplete guide” on how to treat the type of income at issue in the instant case, and sought to distinguish Valentino
because Cal. Code Regs. tit. 18, Sec. 17951-4(d) was amended after the Valentino
decision to provide additional clarity on the treatment of S corporations.
The OTA’s majority opinion based its conclusion on the initial treatment of the gain as business income, which was uncontested on appeal. In part, the majority explained that:
To focus instead on the classification of the income as originally being from the sale of intangibles and to apply the general rules of R&TC section 17952 would be to completely bypass the more explicit rules of Regulation 17951-4 (and thereby bypassing R&TC sections 17951 and 17041), which would be an incorrect application of the law. The application of R&TC section 17952 as it applies to shareholder income from an S corporation’s nonbusiness income on the sale of intangibles is supported by Regulation 17951-4(d)(3). Here, however, the income at issue was business income, and Regulation 17951-4(d)(3) does not apply.
Under the logic of the majority’s opinion, it appears that Cal. Code Regs. tit. 18, Sec. 17951-4(d)(3), and by extension Cal. Rev. & Tax. Code Sec. 17952, cannot apply to determine the sourcing of income from intangibles to a nonresident unless dealing with a distributive share of net income which is not characterized as business income to the S corporation.10
One Administrative Law Judge (ALJ) issued a concurring opinion agreeing with the majority’s final sourcing of the gain, but disagreeing on the underlying rationale. In contrast with the majority, the concurring opinion agreed with the trusts’ application of Cal. Rev. & Tax. Code Sec. 17952 over Cal. Code Regs. tit. 18, Sec. 17951-4(d) because the income at issue related to intangible property. However, when applying Cal. Rev. & Tax. Code Sec. 17952 to the facts of the case, the concurring opinion concluded that the intangible property had partially acquired a business situs in California. Under that rationale, the gain should be sourced to California using the same apportionment percentage the S corporation used on its original 2014 return.
The sourcing of gains to the nonresident owners of a pass-through entity that sells some or all of its interest in an operating company in a transaction treated as an asset sale for federal income tax purposes has been a hot FTB audit issue for many years. Frequently, the buyer’s desire to acquire business assets with a stepped-up basis causes the transaction to be structured as an asset sale for federal purposes, which in turn creates the issue of how gain from the sale is sourced for California purposes. Under several variations of this fact pattern, the FTB frequently takes the position that the gain is treated as apportionable business income to the pass-through entity, and that this characterization dictates the treatment in the hands of the pass-through entity’s nonresident owners.
Under the majority’s analysis in the instant case, the determination of whether Cal. Rev. & Tax. Code Sec. 17952 applies to source pass-through gain from a partnership’s or S corporation’s sale of an interest in an operating company appears to be dictated by whether the underlying transaction generates business or nonbusiness income to the partnership or S corporation. The majority concluded that Cal. Rev. & Tax. Code 17952 does not apply to the sourcing of business income. Thus, it appears the initial classification of the gain as business income (which does not appear to have been contested) resulted in the nonapplication of Cal. Rev. & Tax. Code Sec. 17952 in the eyes of the ALJs joining the majority opinion. Although goodwill is intangible property, under the majority’s analysis, gain from the sale of goodwill is not subject to sourcing under Cal. Rev. & Tax. Code Sec. 17952 unless the underlying transaction generates nonbusiness income to the S corporation.
It is worth noting that the majority opinion did not address the potential asymmetrical results that may occur between the nonresident individuals in the instant case, and a similarly situated nonresident individual that directly sells an interest in a business entity. If a nonresident has gain from the direct sale of an interest in a partnership or S corporation (i.e
., that is not passing through from the partnership’s sale in an operating company and is not subject to Cal. Code Regs. tit. 18, Sec. 17951-4(d)), directly applying Cal. Rev. & Tax. Code 17952 to the nonresident’s sale of intangible property may potentially cause divergent results for such nonresident.
The majority opinion also did not address whether its approach to applying Cal. Code Regs. tit. 18, Sec. 17951-4(d), which is an interpretive administrative regulation, may elevate this regulation above a conflicting statute, Cal. Rev. & Tax. Code Sec. 17952. From an administrative law perspective, an interpretive regulation generally should not alter or enlarge the statute under which it is promulgated, and the majority’s opinion did not address related issues regarding the interplay of Cal. Code Regs. tit. 18, Sec. 17951-4 and Cal. Rev. & Tax. Code Sec. 17952.
This decision may potentially embolden the FTB in seeking to assess nonresident owners of pass-through entities that have sold an interest in an operating business through an asset sale. Taxpayers and tax practitioners will be watching to see if the taxpayers in this case decide to seek judicial review of this OTA decision.
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