California Denies Resident a Credit for Taxes Paid to Another State on Sale of Partnership Interest

By: Jeff Glickman, SALT Partner

At a glance

• The main takeaway: A recent California tax appeals decision illustrates that just because a resident pays income tax to another state does not automatically entitle the resident to a tax credit in his home state. 
• Assess the impact: While unfortunate, this case is an important reminder that double taxation does not always require the state to provide a remedy.  
• Take the next step: Aprio’s State and Local Tax (SALT) team can navigate you through the complex rules that come with individual state tax credits and can offer recommendations for structuring transactions to minimize your liabilities. 

Schedule a free consultation today to learn more!

The full story:

As a general rule, in order to avoid double taxation on income earned by a resident in another state and taxed by that other state, the state of residence will provide a tax credit against the resident’s individual income tax liability. That credit is typically limited to the lesser of the amount of tax paid to the other state or the tax that the state of residence would impose on the same amount of income.¹ However, it is not always the case that the resident state will provide a credit just because a resident pays income tax to another state. This situation is illustrated by a recent California Office of Tax Appeals (OTA) opinion.²

A closer look at the case

In that case, the taxpayer (husband) was a California resident and a partner in EIF Management LLC (EIF), a partnership with offices in California, Massachusetts and New York that provided portfolio management services for pooled investment vehicles in the energy sector. He owned 23.123% of EIF and was an active participant in the business, spending a substantial amount of time in Massachusetts to operate EIF. 

In 2015, the husband sold all of his equity interest in EIF. On his jointly-filed Massachusetts nonresident income tax return, he apportioned 50% of his gain from the sale of his EIF interest to Massachusetts.³ On his jointly-filed California resident income tax return, he claimed a credit of $391,032 for tax paid to Massachusetts on the gain from the sale of his EIF interest. California denied the credit, and this appeal followed.

The ruling explained

Under California law, a resident is allowed a credit for net income tax paid to another state on “income derived from sources within that state,” which is determined by “applying the nonresident sourcing rules for determining income from sources within this state.”⁴ In other words, California does not care that under Massachusetts’ rules, the income would be taxed by Massachusetts. Rather, California looks only to whether under its nonresident sourcing rules, the gain would be sourced to Massachusetts.

The taxpayers argued that there are two nonresident sourcing rules that entitle them to the credit because those rules would source the gain to Massachusetts. 

Nonresident Sourcing rule #1:

The first provides that a nonresident’s income from intangibles is not California-sourced unless the intangible property has acquired a business situs in the state.⁵ Under the regulations, intangible property has a business situs in California if “it is employed as capital in this 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 this State.”⁶

The taxpayers claimed that the husband’s activity in Massachusetts to perform services for EIF and his active participation in its daily operations established that his membership interest acquired a business situs in Massachusetts. The OTA disagreed, explaining that the husband’s activity in Massachusetts on behalf of EIF may connect him with the state, it does not establish that his membership interest was localized in the state (i.e., that the membership interest itself was in any way used in connection with the business of EIF).

Nonresident Sourcing rule #2:

The second nonresident sourcing rule provides that when the business activity of a partnership is part of a unitary business with another business activity conducted by one or more of its partners, then the income of the businesses is combined and apportioned at the partner level.⁷ The taxpayers argued that the husband’s involvement with EIF created a single unitary business between him and EIF. Again, the OTA disagreed, explaining that while the husband held his interest in EIF, that was not sufficient to establish that he carried on any kind of business activity that could be considered unitary with EIF.

Therefore, the OTA denied the taxpayers a credit. This case is an important reminder that double taxation, while unfortunate, does not always require the state to provide a remedy. Another way to think about this result is to analyze the reverse situation. For example, assume the taxpayer was a Massachusetts resident and partner in EIF, and spent substantial time in California to operate the business. Under those facts, California would not impose any tax on the nonresident in connection with the gain from the sale of his interest in EIF.

The bottom line

Aprio’s SALT team has experience with individual state tax credits and their complex rules, particularly as they may be applied to significant transactions. We work with our clients to help them understand the consequences of these transactions and may offer recommendations for structuring those transactions in an alternative manner to minimize their multistate income tax obligations based on the facts and circumstance of each situation. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

This article was featured in the June 2023 SALT newsletter.

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¹ This is to account for the differential in tax rates among states.

² In the Matter of J. Buehler (Deceased) and D. Buehler, OTA Case No. 21067960, 2023-OTA-215P, Feb. 28, 2023.

³ The opinion notes that it appears that the taxpayer applied Massachusetts regulation 830 CMR 62.5A.1(3)(c)(8.2).  However, whether or not the taxpayers properly applied Massachusetts’ tax rules is not at issue in this case.

⁴ Cal. Rev. & Tax Code §§ 18001(a)(1), (c).

⁵ Cal. Rev. & Tax Code § 17952.

⁶ Cal. Code Regs. tit. 18 § 17952(c). One common example of this is if the membership interest is pledged as security for a loan obtained by the business.

⁷ Cal. Code Regs. tit. 18 § 17951-4(d).