California Rules That Nonresident S Corporation Shareholders Owe Tax on Sale of Goodwill

By: Jeff Glickman, SALT Partner

At a glance

• The main takeaway: In California when a pass-through entity sells its business assets, the owners are likely to be taxed on the gain in the states where the entity does business and not their states of residence.
• Assess the impact: Pass-through entities and their owners need to be aware that different state income tax treatments can occur when a shareholder sells their pass-through entity ownership versus when the pass-through entity sells that business directly.  
• Take the next step: Aprio’s State and Local Tax (SALT) team has experience with issues that can arise from the sale of a pass-through entity and can assist you through the sale process to ensure that your state income tax liability is minimized. 

Schedule a free consultation today to learn more!

The full story: 

State income tax rules governing the taxation of pass-through entities (PTEs) and their nonresident owners are complicated and often lack sufficient and/or clear guidance. That complexity may cause PTE owners and their tax advisors to miscalculate the state income tax impact applicable to transactions effected by the PTE. Advance planning by both parties involved in the transaction may be able to mitigate any potential unfavorable consequences. This issue is illustrated by a recent California Court of Appeal decision addressing the sourcing of gain from the sale of goodwill by a PTE. _[1]

A closer look at the case

The taxpayers in this case were two non-grantor trusts that owned a combined 59.5% interest in an S corporation (Pabst). Pabst held, directly and indirectly, interest in several wholly-owned subsidiaries that engaged in business operations within and outside California. For Federal and California income tax purposes, the wholly-owned subsidiaries were treated as disregarded entities; therefore, all of the activities of these subsidiaries were reported directly on Pabst’s tax return.

In November 2014, Pabst sold all of its equity in those subsidiaries, which, for Federal and California income tax purposes was treated as an asset sale by Pabst, and 99% of the long-term capital gain was from the sale of goodwill. On Pabst’s California income tax return, 6.6% of the gain was apportioned to California, which was reflected in the K-1’s received by the trusts. Although the trusts initially reported and paid tax on their share of that gain to California, subsequently the trustee amended those returns to claim a refund of those amounts on the basis that as nonresidents the goodwill (i.e., intangible) gain should be sourced outside of California.

There are two separate rules at issue in this case.  

• First, when a nonresident is an owner of a PTE that carries on a business in the state, the amount of the nonresident’s share of PTE income is determined by applying California’s allocation and apportionment rules at the PTE level. _[2]
• Second, for purposes of computing the taxable income of nonresidents, “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.” _[3]

The ruling explained

The nonresident trusts argued that the rule for sourcing intangibles should apply, whereas the state claimed that as nonresident PTE owners, the trusts were required to treat the gain in the same manner in which it was passed-thought to them by the PTE. The court sided with the state, concluding that, “Because the gain from the asset sale of goodwill is undisputedly business income to Pabst, it remains business income for purposes of sourcing the trusts’ pro rata share of that income.”

This result can sometimes be frustrating for PTE owners who reside in states that impose income tax at a low rate or don’t impose an income tax at all. Those owners may anticipate that the sale of a business will be taxable in their state of residence, but then are surprised when they owe tax in the states where the PTE operates. Often, this disparate state tax treatment can be mitigated when identified early.

Let’s take an extreme example. Assume a Florida resident individual is the shareholder of an S corporation that operates solely in California. _[4] If the shareholder sells his stock in the S corporation, the gain from that sale does not flow-through from the S corporation, but instead is reported directly by the shareholder. In that case, and based on the first rule noted above, California would likely not tax the gain from the sale of stock since it is an intangible (assuming it didn’t otherwise acquire a business situs in the state). _[5]

However, from an income tax perspective, buyers often do not want to buy S corporation stock because they do not receive a step-up in the basis of the S corporation’s assets and therefore lose out on the corresponding depreciation and amortization deductions that would accompany that step-up. In order to structure these transactions in a way that provides buyers with a basis step-up, the parties would have to agree to make an IRC 338(h)(10) election or perform an “F-reorganization.” In those cases, the transaction is treated for income tax purposes as a sale of assets by the S corporation.

Based on the case summarized above, that means that the Florida shareholder will now have to pay California income tax on the gain recognized by the S corporation from its sale of assets. On a $10 million sale, that could mean a state income tax difference of $1.3 million. For tax advisors that recognize this issue, it will often be possible to negotiate with the buyer for an increase in the purchase price to compensate the Florida shareholder for the state tax cost associated with the buyer’s requirement of receiving a basis step-up. _[6]

The bottom line

This case and the example illustrates the different state income tax treatments that can occur when a shareholder sells his PTE ownership versus when the PTE sells that business directly. Aprio’s SALT team has experience addressing these issues and can assist you during the sale process to ensure that your state income tax liability is minimized. 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.

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[1] The 2009 Metropoulos Family Trust et al., v. Cal. Franchise Tax Board, Case No. D078790, Cal. Ct. App. 4^th App. Dist., Div. One (May 27, 2022). On August 24, 2022, the California Supreme Court declined to hear an appeal of this decision.

[2] Cal. Rev. & Tax Code § 17954; Cal. Code Regs. Tit. 18 § 17951-4(d), (f).

[3] Cal. Rev. & Tax Code § 17952.

[4] Florida does not impose an individual income tax, and California’s top marginal income tax rate is 13.3%.

[5] Generally, the Florida resident’s mere ownership of the S-corporation stock would not cause it to acquire a business situs in California.

[6] Typically, the present value of the income tax benefits of the basis step-up to the buyer exceed the additional income tax required to be paid by the shareholder, so the buyer should be willing to compensate for this.