New York City Rules That Tax Gain from Sale of Partnership Interest is Subject to Corporate Tax

When a taxpayer sells an equity interest in a business, the gain from that sale may be taxable in the jurisdictions where the business is being conducted as opposed to the principal place of business of the taxpayer.

By Jess Johannesen, SALT Manager

Many of us are familiar with the general rule that as individuals, when we sell assets such as stock in a corporation, any gain is taxable to our state of domicile.  However, the rules get more complicated if the asset sold is an interest in a pass-through entity or if the seller is a corporation instead of an individual.

A number of factors must be considered when determining the state income tax treatment of such gains, as the treatment may differ from state to state which may lead to the gain being taxed in multiple states.  A recent New York City Tax Appeals Tribunal (“Tribunal”) decision illustrates this concept, as the Tribunal ruled that a nondomiciliary corporation with no direct business activities in the city owed New York City General Corporation Tax (“GCT”) on a portion of its capital gain realized from selling its minority interest in a New York City-based business.[1]

In the ruling, the Petitioner was a Delaware corporation that indirectly owned a minority interest in an LLC that engaged in business activities in New York City.  The Petitioner owned this minority LLC interest through its interest in a limited partnership (the “Fund”).  Neither the Petitioner nor the Fund owned any real or tangible personal property in New York, had any employees in New York, and did not conduct any business activities in New York.  Furthermore, neither the Petitioner nor the Fund participated in the management, control or operation of the day-to-day operations of the LLC.  Lastly, it was agreed that neither the Petitioner nor the Fund were part of a unitary business with the LLC.

In 2010, the Fund sold its interest in the LLC which generated a capital gain of almost $55 million for federal income tax purposes.  This gain flowed through from the Fund to the Petitioner, and the Petitioner included the gain in computing its federal taxable income for 2010.  When the Petitioner filed its 2010 New York City GCT return, however, the gain was excluded from its city entire net income.  New York City then audited the 2010 GCT return and concluded that the Petitioner should have included a portion of the gain in its city entire net income based on the Petitioner’s proportionate share of the LLC’s City apportionment factors.  This resulted in an audit assessment of $4 million plus interest.

The Petitioner argued that, in the absence of a unitary business, its passive interest in the LLC did not create sufficient nexus between the Petitioner and New York City to establish that the gain should be included as apportionable business income.  New York City, on the other hand, argued that the nonexistence of a unitary business was irrelevant because the gain itself possessed sufficient nexus to the city.  New York City explained that, “the City conferred protection, opportunities and other benefits upon [the LLC], which led to the increase in the value of Petitioner’s interest in [the LLC], and, ultimately, resulted in the gain realization.”  In short, “[the City] …has given [the taxpayer] something ‘for which it can ask return.’”[2]  The Tribunal agreed with the City, concluding that in order for the City to tax gain from the sale of an interest in an entity operating within the City, nexus must exist between the City and the entity whose interest is sold.

The Petitioner also argued that New York City lacked personal jurisdiction over the nonresident owners of the LLC.  New York City cited a U.S. Supreme Court ruling which rejected the proposition that a state’s taxing power must be premised on a taxpayer’s own activities within the state.

In summary, the Supreme Court explained that the personal presence of stockholder-taxpayers is not essential to the constitutional levy of a tax when the stockholders ultimately benefit from the corporation’s state activities.[3]  However, this argument seems to be negated by the fact that the Petitioner filed GCT returns due to its indirect ownership in the LLC.  New York City also addressed the recent U.S. Supreme Court ruling in South Dakota v. Wayfair, Inc. as a reference to the constitutional state taxation of nondomiciliary taxpayers in certain circumstances.[4]  New York City noted that the constitutional taxation held in Wayfair arises from the privileges and opportunities that the state afforded to remote business entities operating in that state.

Accordingly, the Tribunal concluded that the gain was subject to GCT through its inclusion in Petitioner’s business income to which the LLC’s business allocation percentage should be applied, stating:

A jurisdiction’s ability to tax turns on whether nexus exists between that jurisdiction and the taxpayer’s business being sold. This inquiry does not call for the consideration of other factors, such as unitary business between the owner entity and the sold business, for taxation to be constitutional. Nexus is sufficient. . . .  Through its nexus with the City, [the LLC] appreciated in value and enjoyed the protection, opportunities and benefits that the City conferred to it. The City provided [the LLC] with a successful environment, which resulted in [the LLC’s] appreciation in value, and this created the City’s right to receive something in return.  Clearly, the benefits that the City provided to [the LLC] had a rational relationship to the gain that Petitioner realized on its sale of [the LLC].

This ruling emphasizes the need to evaluate the specific facts and circumstances that factor into whether such gains from the sale of pass-through entity interests are subject to tax in the states in which the pass-through entity conducts business.  Each state has its own rules and interpretations that factor into such a determination.  Aprio’s SALT team has experience assisting taxpayers with the state income tax consequences of gains from the sale of businesses to ensure that multi-state income tax liabilities are minimized to the maximum extent possible. 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.

Contact Jess Johannesen, SALT manager, at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the February 2019 SALT Newsletter.

[1] In the Matter of the Petition of Goldman Sachs Petershill Fund Offshore Holdings (Delaware) Corp., N.Y. City Tax App. Trib., Adm. Law Judge Deter., TAT(H)16-9(GC), 12/06/2018.

[2] Allied-Signal, Inc. v. Commr. Of Fin., 79 NY2d 73, 1991.

[3] International Harvester Co. v. Wisconsin Dept. of Taxation, 322 U.S. 435, 05/29/1944.

[4] It is worth noting that South Dakota v. Wayfair, Inc. is a sales tax case which is being referenced here for corporate income tax purposes.  While the Supreme Court held that sales tax nexus based on economic nexus (as opposed to physical presence) did not violate the constitution, this concept is specifically cited by New York City as being applicable to the GCT along the same rationale.  It will be interesting to monitor the impact of Wayfair beyond sales tax.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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