South Carolina Rules that Resident is Taxed on Apportioned Gain from Sale of Partnership Interest

At a glance

• The main takeaway: The South Carolina Department of Revenue issued a private letter ruling concluding that an individual resident taxpayer that sold his interest in a partnership was allowed to apportion the gain to the state, resulting in a significantly reduced state income tax liability.
• Assess the impact: There is no explicit mention in the ruling whether the resident taxpayer’s active participation in the partnership was an underlying factor in the decision, so it is possible that the state may apply this ruling to sales by nonresident passive investors.   
• Take the next step: Aprio’s State and Local Tax (SALT) team can assist with analyzing state income tax implications and recommend potential alternative transaction structures that may minimize liability.

Schedule a free consultation today to learn more!

The full story:

In a recently issued private letter ruling (PLR 24-1), the South Carolina Department of Revenue determined that a resident individual’s gain from the sale of a partnership interest was subject to apportionment and not fully allocable to South Carolina. Although the ruling was in favor of the resident taxpayer, nonresidents of South Carolina should take note of this decision, as the Department may also treat gain recognized by a nonresident of the state in a similar transaction as apportioned to and subject to tax in South Carolina.    

A closer look at the case

The South Carolina resident taxpayer (Taxpayer) was an active owner of a pass-through entity (PTE) that conducted business in multiple states, including South Carolina. In prior years, the Taxpayer was the president and executive officer of the PTE. In the year of the sale, the Taxpayer had been retired for several years, but he continued to take part in certain managerial functions in the business. In 2021, the Taxpayer sold his partnership interest and recognized approximately $2.6 million of long-term capital gain.

Before addressing the Department’s decision, it’s important to point out that South Carolina has a somewhat unique method for determining the taxable income of a resident owner of a PTE. Most states tax all of a resident’s income from a PTE, and then reduce that tax liability by permitting a credit for income tax paid to other states to avoid double taxation (subject to limitations). On the other hand, South Carolina residents are taxed on PTE income only to the extent that the income is derived from South Carolina sources, as determined by the state’s rules for allocating and apportioning income within and outside of the state.[1] Allocable income is generally assigned to one state, whereas apportionable income can be tax in more than one state based on the multistate nature of the property or activity from which the income is derived.

The ruling explained

In the ruling’s analysis as to whether the gain recognized by a taxpayer was allocable or apportionable income, the Department referred to South Carolina’s provisions addressing the treatment of income from intangibles, as a partnership interest is treated as intangible personal property.[2] Those rules reflect that gain from a sale of an intangible is treated as allocable income only when the intangible is “not connected with the business of the taxpayer.” Thus, if the taxpayer’s interest in the partnership was deemed to be connected with his business, then gain from the sale of that interest would be treated as income subject to apportionment and only subject to tax in South Carolina to the extent that the underlying business activity occurred in the state. 

As noted above, the Taxpayer was heavily involved in the partnership’s day-to-day business activities in prior years and continued to be involved in certain management aspects of the business up until the sale of his partnership interest. These facts would seem to suggest that the Taxpayer’s partnership interest was connected with his business.    

However, a somewhat troubling aspect of the ruling’s analysis suggests that these facts did not necessarily impact the ultimate conclusion that gain was subject to apportionment. Instead, in concluding that the Taxpayer’s partnership interest was connected with his business, the Department applied the “pass through principle” whereby the character of any item of income included in a partner’s distributive share of partnership income is the same as if the income was realized directly from the source from which the partnership derived the income. However, the Department did not perform any further analysis as to the character of the income at its source. Instead, the ruling simply concluded that the “partnership interest therefore was connected with the Taxpayer’s business.” 

The bottom line

For the Taxpayer in this ruling, this was a favorable decision because the portion of the gain that was subject to tax in South Carolina was based on the partnership’s apportionment percentage, which was only 2.4% in the year of the sale. Thus, instead of all the gain being subject to income tax by the state, the Taxpayer was only liable for South Carolina income on a very small portion the gain. 

As noted above, although the ruling summary of the facts makes note of the Taxpayer’s active participation in the underlaying business of the partnership, the Department’s analysis makes no explicit mention of this being a factor in why it reached its conclusion that the gain was subject to apportionment (i.e., that the partnership interest was connected with the Taxpayer’s business). Therefore, the Department may view the conclusion in this ruling as applicable to a nonresident passive investor. 

Aprio’s SALT team regularly advises taxpayers on the treatment of gain from transactions similar to the one addressed in the South Carolina ruling. If you are planning to dispose of a significant asset, we can assist with analyzing the potential state income tax implications and recommend alternative transaction structures that may minimize that 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.

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[1] S.C. Code Ann. § 12-6-560 and § 12-6-600.

[2] S.C. Code Ann. § 12-6-2220(5).