Sale of Partnership Interest by Another Partnership Creates California Income for Nonresident
May 31, 2023
By: Nicole McClintock, SALT Director
At a glance
- The main takeaway: A pass-through entity sold its ownership interest in another pass-through entity, and its owners are required to pay income tax on the gain in the states where the sold entity engaged in business.
- Assess the impact: Determining the state tax consequences that come from a sale of a partnership interest is complex and the guidance is not always clear.
- Take the next step: Aprio’s State and Local Tax (SALT) team can help you address and analyze the state tax consequences when selling a partnership interest.
The full story:
When a taxpayer sells an interest in a partnership it can be unclear, especially for nonresidents, how the gain should be treated for state income tax purposes. This is especially the case when the nonresident is not directly selling his or her interest, but instead a partnership owned by such nonresident is selling an interest in another partnership. A recent California Office of Tax Appeals (OTA) opinion addressed this issue.1
There are many nuances to consider when a partnership interest is sold, such as the unitary relationship between the seller and the partnership that was sold, and whether corporate or personal income tax sourcing rules apply.2 This case provides some clarity, but also reveals the complexity of the state tax analysis for these types of transactions.
A closer look at the case
In this particular case, L. Smith, a nonresident of California, owned an indirect membership interest in SOSV, LLC (Holdco), which was taxed as a partnership for federal and California income tax purposes. Holdco’s sole function was to hold its 50.50% interest in Shell Vacations, LLC (Shell) and its principal office was in Illinois along with its sole manager (an individual). Shell conducted its business from Arizona and was taxed as a partnership for federal and California income tax purposes. The business activity of Shell consisted of acquiring, selling and developing timeshare ownership interests and vacation club memberships. Shell’s business activities were conducted in and outside of California.
Holdco did not have any activity or apportionment factors of its own, so in 2012, when Holdco sold its entire interest in Shell it did not source any of the gain to California. As a result, the taxpayer did not source any of the gain that was passed through to California.
Upon audit, the California Franchise Tax Board (FTB) held that Holdco and Shell constituted a unitary business, resulting in the treatment of the gain on the sale of the partnership interest as apportionable business income. Under this position, California held that Holdco’s gain should be apportioned based upon its share of Shell’s apportionment factors resulting in California sourced income for the taxpayer from Holdco. California issued a Notice of Proposed Assessment that the taxpayer protested, the FTB affirmed the decision and the taxpayer appealed to the OTA.
On the appeal, one of the issues raised was whether the personal or corporate income tax sourcing rules should apply. Under the personal income tax rules, the taxpayer argued that the sale of a partnership interest was the sale of an intangible, thus the aggregate theory approach should be applied. This would result in the gain being sourced to the taxpayer’s out-of-state residence. Under California Revenue & Taxation Code section 17952 the “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…”
The ruling explained
On the flip side, the FTB took the entity approach by treating the partnership as a separate entity and applying the corporate income tax sourcing rules. Due to management oversight, financial oversight and a noncompete agreement, the FTB held that Holdco and Shell were unitary, meaning Holdco’s gain should be apportioned to California based upon its share of Shell’s apportionment factors. This resulted in the taxpayer having California sourced income from Holdco’s disposition of its entire interest in Shell.
Despite the taxpayer’s argument, the OTA agreed with the FTB and concluded that the corporate income tax sourcing rules applied, thus the taxpayer was liable for the tax on the California sourced gain from the sale of the partnership interest. The lynchpin in this decision rests upon the unitary determination. To read more on California’s position regarding the unitary treatment of holding companies refer to Legal Ruling 2021-01. A unitary determination is highly fact specific and needs to be analyzed with care. If the entities had been non-unitary, even if the gain was business income, Holdco’s own apportionment factors would have been used resulting in no California apportionable income. This draws out the importance of carefully analyzing the facts when making a unitary determination.
The bottom line
Determining the state tax consequences resulting from the sale of a partnership interest requires a complex analysis that is based on the specific factual situation and by applying rules and guidance that are not always clear. Aprio’s SALT team has experience addressing these issues, and we can analyze the state tax consequences of these transactions and recommend alternative transaction structure(s) that could minimize multistate tax liability. 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 May 2023 SALT newsletter.
1 In the Matter of the Appeal of L. Smith, OTA Case No. 20036033, Dec. 7, 2022.
2 We refer to the “corporate” sourcing rules since partnerships generally apportion income under the same apportionment rules applicable to corporations. Cal. Code Regs. 17951-4(d).