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A Review of Taxability on the Sale of Passthrough Entity Interests

Posted on Oct. 17, 2022
Colleen M. Redden
Colleen M. Redden
Breen M. Schiller
Breen M. Schiller

Breen M. Schiller is a principal in EY’s National Tax and Indirect Tax group, and Colleen M. Redden is a manager in EY’s Indirect Tax group.

In this inaugural installment of A SALT-EY Perspective, Schiller and Redden argue that the unitary business principle is still necessary for finding apportionable income and provide a discussion of federal passthrough entity tax theories.

Copyright 2022 EY LLP.
All rights reserved.

Market changes in the way business is conducted continue to alter the state income tax landscape. At the turn of the 20th century, the use of railways spurred multistate businesses and created our modern unitary business principles.1 Today, the use of passthrough entities presents new challenges for state income tax. A number of state courts and administrative agencies have issued opinions on the taxability of the gain on the sale of an interest in a passthrough entity — with differing results.2 This article does not cover the multitude of issues in this area; instead, it analyzes recent opinions in terms of U.S. constitutional principles, arguing that the unitary business principle is still necessary for finding apportionable income, and discusses the application of federal passthrough entity tax theories.

Background

There are varying facts between each of the cases and issues presented in this article that may change the answer as to taxability of gain from the sale of an interest in a passthrough entity. However, the starting point for examining a state’s imposition of income tax is whether the owner of the passthrough entity has sufficient nexus to the taxing state.3 Current Supreme Court jurisprudence evaluates the question of nexus under both the due process and commerce clauses, which impose distinct but parallel limitations on a state’s power to tax out-of-state activities.4 The due process clause demands that there exist “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax,” and a rational relationship between the tax and the “values connected with the taxing state.”5 On the other hand, the commerce clause restricts states from levying taxes that discriminate against interstate commerce or that burden it by subjecting activities to multiple or unfairly apportioned taxation.6 However, the test presented under both clauses ultimately asks “whether the state has given anything for which it can ask in return.”7

When the taxpayer is found to have contacts with the taxing jurisdiction establishing a taxable connection, the inquiry shifts to “what the state may tax.”8 The Court has developed the unitary business principle as a test to determine what income falls under the state’s taxing authority by examining what activities generated the income at issue.9 If the unitary business exists, income from the unitary business is subject to tax. However, if a nonresident taxpayer or multistate taxpayer earns income from an unrelated business activity not conducted in the state, the activity is considered a “discrete business enterprise,” and the income is not subject to the state’s taxation.10

Applying the Constitutional Tests

One issue demonstrated in the various state decisions finding taxability or nontaxability on the sale of an interest in a passthrough entity is determining which business activity to apply the constitutional tests to — the activities of the partnership or the activity of the owner? Further, are the activities of the partnership ascribed to the owner? In other words, is the test applied to the partners individually as an aggregate of the partnership, or is the test applied at the entity level to the partnership itself? When the state seeks to tax an activity, it must have a connection to the activity, rather than only to the actor.11 In the context of the sale of an interest of a passthrough entity, arguably the activity generating the income at issue is the sale of the passthrough entity interest. The question is how to determine the connection between the state, the sale activity, and the partners.

Application of Federal Partnership Tax Principles: Entity vs. Aggregate Theory

Federal tax principles may prove instructive on how to view the gain on sale of an interest in a passthrough entity. The Internal Revenue Code approaches partnership taxation with two distinct, and at times competing, concepts — the entity concept and the aggregate concept. While the entity concept views the partnership as an entity separate from its partners, the aggregate concept views the partnership as an aggregation of the individual partners, with the partnership serving as a conduit to distribute income to the partners. For assets owned by the partnership, under the aggregate approach, each partner is treated as having a direct interest in each asset of the partnership.12 Other sections of the IRC apply a commingled approach, with the entity approach as the general rule and the aggregate approach being the exception.13 One IRC section concerns the federal treatment of the gain on the sale of a partnership interest. Under section 741, the gain from the sale of a partnership interest is treated as a capital gain. However, section 751 provides an exception to the general rule of section 741, treating gain on the sale of a partnership interest as ordinary income if the partnership owns “hot assets,” which include inventory, unrealized receivables, and service contracts. Section 751, viewed as an antiabuse provision, uses the aggregate approach to create a deemed sale of assets by the partnership, with a corresponding distributive share of ordinary income and any remaining gain treated as capital gain.

Examples of Federal Partnership Tax Principles at the State Level

Against the backdrop of these federal principles, one could argue that state taxation should follow federal treatment. Use of the entity approach would suggest that the activities of the passthrough entity are considered separately from passthrough entity owners.14 Conversely, the aggregate approach — treating the sale of an interest in a passthrough entity as a sale of that owner’s share of assets held by the passthrough entity — has been used by a handful of states in analyzing these transactions to attribute in-state presence of a passthrough entity to the out-of-state partner, member, or shareholder.

For instance, the New York City Tax Appeals Tribunal has expressly adopted the aggregate approach for the computation of New York City general corporation tax (GCT) on the sale of an interest in a partnership doing business in the city.15 For GCT purposes, doing business in New York City includes ownership in a limited partnership that does business in the city. In Mars Holdings Inc., the tribunal rejected the petitioner’s argument that federal conformity required gain on the sale of partnership interest to be treated as capital gain in line with section 741. Most recently, citing several cases, the tribunal stated that the aggregate approach for nexus purposes has been upheld by the New York Court of Appeals and is appropriate for entire net income computation under the GCT.16

Under Supreme Court jurisprudence, one arguable shortcoming of the aggregate approach is that it does not incorporate the due process and commerce clause inquiries required to find taxation.17 Ownership of assets alone is insufficient to determine if due process has been satisfied to allow taxation of a nonresident. In the corporate context, a nonresident shareholder is not generally subject to tax on gain from the sale of stock. Does the sale of an interest in a passthrough entity deserve a different result? Absent evidence of the partner or member’s engagement in the operation of the passthrough entity, the result, arguably, should not differ between ownership in a partnership or corporation.

Application of Aggregate and Entity Concepts to State Taxability

As demonstrated, the entity and aggregate theories have made their way into not only state nexus considerations but, more importantly, state taxability considerations for taxing the sale of partnership interests. For instance, investor apportionment looks to the owner of the passthrough entity for taxability determination, while investee apportionment ascribes activities of the passthrough entity to the owner for purposes of finding apportionable income.

Investor Apportionment

The Ohio Supreme Court in Corrigan described the activity that generated the nonresident individual’s gain at issue as a “transfer of intangible property by a nonresident.”18 In Corrigan, the nonresident taxpayer reported a capital gain on the sale of an interest in an LLC that operated as a multistate sanitary supplies business. The court described the taxpayer’s connection to Ohio as “indirect,” finding that while the taxpayer availed himself of the benefits of Ohio through income earned by the LLC, the taxpayer did not avail himself of the protections of Ohio regarding the sale of the LLC interest.19 Under the investor apportionment approach, the nonresident passthrough entity owner’s gain on the sale of its interest is subject to tax when a unitary business relationship exists between the nonresident owner and the passthrough entity.20

This appears to be the default treatment at the state level and, when implemented, has required a unitary business analysis. For instance, Illinois recently reaffirmed its treatment of income from the sale of an interest in a non-unitary partnership as capital gain from the sale of intangible personal property and allocated to the taxpayer’s commercial domicile.21

Investee Apportionment

While the Ohio Supreme Court rejected investee apportionment, the Supreme Judicial Court of Massachusetts accepted the method, stating, in dicta, that the taxation of the nondomiciliary corporation’s gain on the sale of its in-state LLC was constitutional.22 The Massachusetts court found that the protections and benefits afforded to the in-state LLC provided sufficient constitutional nexus for the state to tax the nondomiciliary corporation’s gain on the sale of its interest in the LLC. The court stated that a unitary business between the nonresident owner and the in-state LLC was not required to find in favor of taxation.23 Rather, the in-state LLC, as the source of the capital gain, had benefited from the state’s protections, benefits, and opportunities, which was sufficient to pass constitutional thresholds required for the state to tax the nonresident shareholder’s gain on the sale of its interest in the in-state LLC.

The two courts varied in their reliance on U.S. Supreme Court opinions: Ohio following MeadWestvaco and Allied-Signal, and Massachusetts following J.C. Penney Co. and International Harvester.24 In Allied-Signal, the Court, rejecting New Jersey’s plea to abandon the unitary business principle, stated that apportionment does not require a unitary relationship between the payor and the payee.25 However, in the absence of a unitary relationship, the asset or transaction at issue must be part of the unitary business or, as the Court described, serve an operational function rather than an investment function.26 The Court stated that mere corporate presence in the state is insufficient to subject the entirety of a multistate taxpayer’s income to state taxation. Later, the Court reinforced the necessity of the unitary business principle in MeadWestvaco, stating that its prior decisions in Allied-Signal and Container Corp. did not announce new ground for constitutional apportionment in the absence of a unitary business.27 Rather, when a unitary relationship between the payor and payee does not exist, an asset may be part of the taxpayer’s unitary business and therefore generate apportionable income.

However, in both International Harvester and J.C. Penney Co., the Court upheld a Wisconsin privilege tax on a nondomiciliary corporation’s payment of dividends to its shareholders.28 The tax at issue was imposed for the “privilege of declaring and receiving dividends out of income from property located and business transacted in Wisconsin.”29 In J.C. Penney Co., which preceded International Harvester, the Court characterized the issue as one of semantics because of the language of the imposition statute triggering the tax on the privilege of declaring a dividend rather than describing the tax as a supplementary income tax.30 The Court, reversing the Wisconsin Supreme Court, upheld the tax because the income subject to the tax was earned from business transacted in the state, thus satisfying the constitutional requirements for taxation.31 The Court, pointing to its decision in J.C. Penney Co., upheld the tax again in International Harvester, finding that Wisconsin had afforded sufficient benefits to the corporation’s activities in the state, which in turn generated the dividends subject to tax.32

California also recognizes the conduit approach in determining the gain on sale of an interest in a passthrough entity by the same character and form as the income was realized directly by the passthrough entity. In 2009 Metropoulos Family Trust, the California Court of Appeals denied the nonresident trust shareholder’s claim for refund of California income tax paid on its distributive share of income from gain on the sale of assets sold by its S corporation.33 The taxpayers, which were nonresident trusts, were shareholders of an S corporation that sold its wholly owned holding company. The sale was treated as an asset sale for federal tax purposes.34 Treating the S corporation as an aggregate of all its members, here the court of appeals reasoned that the gain realized by the S corporation passes through to the nonresident shareholder trust in the same form as realized by the S corporation. Thus, the gain sourced as business income to the S corporation retains that same treatment when sourcing the distributive share of said income to the nonresident trust shareholders.35

In Legal Ruling 2022-02 (July 14, 2022), the California Franchise Tax Board announced that a nonresident individual should use a bifurcated approach to source the gain from the sale of its interest in a partnership holding IRC section 751 assets. The general rule treats the gain on the sale of a partnership interest as gain from the sale of an intangible and, in the case of a nonresident individual, is sourced to California if the interest has acquired a business situs in the state.36 In the case of a partnership holding section 751 assets, the nonresident individual would follow two sets of sourcing rules: California Code of Regulations (CCR) section 17951-4, to source the gain from the deemed sale of section 751 assets as receipts from a trade or business; and CCR section 17952, to source the gain from the sale of the partnership interest as receipts from the sale of an intangible.

The Investor Apportionment Approach Correctly Applies the Unitary Business Principle

States favoring the investee apportionment method argue that the gain realized on the sale of a partnership interest is directly attributable to the partnership’s in-state business operations and assets. However, there are arguably numerous activities critical to the successful sale of an interest in a passthrough entity separate and apart from general business operations, and in some circumstances these can be more valuable than the general business operations. For instance, on contemplation of a sale, owners of the passthrough entity engage in negotiations, due diligence, and legal and financing activities.37 The activities may take place outside of the state, and even without participation of the passthrough entity. In other words, the activity of advancing the sale of an interest in a passthrough entity is a discrete business enterprise or unrelated business activity relative to that which takes place in the state. Moreover, one could argue that the value of the passthrough entity is relatively fixed, and the state has captured this value through its imposition of annual income tax paid through nonresident withholding imposed on state-source income. Thus, the activities conducted in anticipation of sale are the true drivers of gain or loss recognized on the sale activity.38 Further, unlike the investee apportionment method, the investor approach correctly applies the unitary business test to the passthrough entity owner and examines the owner’s activities in the state to determine constitutionality of an imposed income tax. Failure to account for the activities and associated value of those activities conducted in furtherance of the sale of the passthrough entity interest may result in the state taxing extraterritorial value.

However, if a state successfully finds the investee apportionment theory applicable, alternative apportionment may be necessary to capture value from those activities described above that take place outside the general business of the passthrough entity.

Conclusion

As demonstrated, competing applications of constitutional law and partnership taxation theories yield different results of taxability. What remains consistent is that Supreme Court jurisprudence dictates the need for a unitary relationship to justify the state’s taxation of a nonresident taxpayer, in terms of whether the minimum connections have been met to satisfy due process and commerce clause concerns. The open question on finding apportionable income in the passthrough entity context is this: Are we required to examine the relationship between the passthrough entity and the passthrough entity owner, or are the activities of the passthrough entity sufficiently ascribed to the passthrough entity owner to determine taxability?

FOOTNOTES

1 State Railroad Tax Cases, 92 U.S. 575 (1875).

2 When referring to an interest in the passthrough entity, this article contemplates an ownership interest in partnerships, S corporations, limited liability companies, and similar entities.

3 This article does not provide in-depth coverage of U.S. constitutional principles.

4 MeadWestvaco Corp. v. Illinois Department of Revenue, 553 U.S. 16, 24 (2008).

5 Id. at 24 (quoting Miller Brothers Co. v. Maryland, 347 U.S. 340, 344-345 (1954)).

6 Id.

7 The “broad inquiry” subsumed in both constitutional requirements is “whether the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state” — that is, “whether the state has given anything for which it can ask return.” ASARCO Inc. v. Idaho State Tax Commission, 458 U.S. 307, 315 (1982) (quoting Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444 (1940)).

8 MeadWestvaco Corp., 553 U.S. at 16.

9 Id.

10 As discussed herein, some courts and state tax administrators have questioned the necessity of the unitary business test. However, the last statement regarding the unitary business principle from the U.S. Supreme Court clarified that its decisions finding a lack of unitary relationships between payor and payee did not abolish the unitary relationship test, stating that its previous decisions “did not announce a new ground for constitutional apportionment of extrastate values in the absence of a unitary business.” Thus, for purposes of this article, the authors argue that the unitary business relationship is still vital to the analysis.

11 Allied-Signal Inc. v. Director, Division of Taxation, 504 U.S. 768, 778 (1992).

12 Concepts regarding entity can be found in section 706 (partnership has its own tax year), section 708 (partnership terminates on specific events), or section 707 (partner can engage in transactions with the partnership). Aggregate concepts can be found in section 702 (income and credits to the partner) and section 751 (gain on sale of interest in partnership holding hot assets). See Arthur B. Willis, Philip F. Postlewaite, and Jennifer H. Alexander, Partnership Taxation para. 1.03(2) (2022).

13 Id. at para. 1.03(2)(c).

14 In response to the Tax Cuts and Jobs Act’s limitation on the deduction for state taxes paid, a number of states have enacted an election for taxes to be paid at the passthrough entity level rather than withheld on the nonresident taxpayer’s distributive share of income. A question for later debate may be whether the election, explicitly recognizing the entity approach, would extend to gain on the sale of an electing entity treating the gain on the sale of an interest as a nontaxable capital gain.

15 In the Matter of the Petition of Mars Holdings Inc. (f/k/a Mars Associates Inc.), TAT(H) 16-14(GC) (N.Y.C. Tax. App. Trib. June 26, 2020) (citing In the Matter of National Bulk Carriers Inc. and Affiliates, TAT(E) 04-33 (GC) (N.Y.C. Tax. App. Trib. Nov. 30, 2007), for the premise that the aggregate approach applies in the “entire net income” calculation for GCT purposes).

16 See also, In the Matter of Goldman Sachs Petershill Fund Offshore Holdings, TAT(E) 16-9(GC), at para. 7 (N.Y.C. Tax App. Trib. Mar. 12, 2021) (describing that, under federal income tax and GCT, partners of the partnership are treated as carrying on the business of the partnership), aff’d, In the Matter of Goldman Sachs Petershill Fund Offshore Holdings (Delaware) Corp. v. New York City Tax Appeals Tribunal, 204 A.D.3d 469 (N.Y. App. Div. 2022).

17 MeadWestvaco Corp., 553 U.S. at 24-25.

18 Corrigan v. Testa, 73 N.E.3d 381, 390 (Ohio 2016).

19 Id. Post-Corrigan, Ohio adopted a mixed approach using both aggregate theories and the unitary business relationship. Effective September 23, gain on the sale of an interest in a passthrough entity will be treated as business income when the sale is treated as a sale of assets for federal tax purposes or the taxpayer materially participates (as defined in reg. section 1.469-5T) in the business of the passthrough entity in the year of sale or during any of the five preceding tax years. The alternative material participation requirement implies that a unitary relationship exists between the passthrough entity owner and the passthrough entity. H.B. 515, section 3. See also H.B. 515, Ohio Legislative Service Commission, Bill Analysis.

20 See also Noell Industries Inc. v. Idaho State Tax Commission, 470 P.3d 1176 (Idaho 2020) (finding nondomiciliary corporation’s gain on sale of interest in LLC with sales in Idaho was nonbusiness income because of the lack of unitary relationship between nondomiciliary corporation and LLC).

21 Illinois Department of Revenue, GIL-IT-22-0008 (May 10, 2022).

22 VAS Holdings & Investments LLC v. Commissioner of Revenue, 186 N.E.3d 1240 (Mass. 2022).

23 Id. However, and somewhat ironically, the state’s own imposition statute required finding of a unitary business, which seems to suggest that the state legislature recognized the requisite unitary business principle in drafting its own imposition statute.

24 J.C. Penney Co., 311 U.S. at 435; International Harvester Co. v. Wisconsin Department of Taxation, 322 U.S. 435 (1944).

25 Allied-Signal, 504 U.S. at 769.

26 See Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955) (finding corn futures contracts owned by corn refiner served an operational function rather than as a capital asset).

27 Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983).

28 International Harvester, 322 U.S. at 435; J.C. Penney Co., 311 U.S. at 435. In contrast to MeadWestvaco and Allied-Signal, the tax in International Harvester and J.C. Penney Co. was a tax on dividends paid out of operational income. Several state courts have said that the source of income, whether capital gain or dividend, is of no consequence in determining apportionability. And while it’s true that the Court in ASARCO stated that interest and capital gains are treated the same as dividend income, the Court went on to say that “one must look principally at the underlying activity, not at the form of investment to determine apportionability. Changing the form of income works no change in the underlying economic realities of whether a unitary business exists.” ASARCO, 458 U.S. at 330 (citing Mobil Oil Corp. v. Commissioner of Taxes of Vermont, 445 U.S. 425, 440 (1980)). Arguably, the type of income at issue is relevant because of the nature of the activity earning each form of income. See also Corrigan, 73 N.E.3d at 392 (reasoning that dividend income has a more direct relationship to corporate earnings, out of which the dividend is paid, than does capital gain from the sale of corporate ownership).

29 J.C. Penney Co., 311 U.S. at 441.

30 Id. at 443.

31 Id. at 445. In his dissent, Justice Owen J. Roberts argued that the management and distribution activities associated with dividend income (a pool of income from sources earned outside the state) had no relation to Wisconsin and, further, that the tax was imposed on shareholders with no connection to the state. Thus, due process was not satisfied. Id. at 448-450.

32 Id. at 442.

33 2009 Metropoulos Family Trust v. California Franchise Tax Board, 2022 WL 1702336 (Cal. Ct. App. 2022).

34 The taxpayers conceded that the S corporation and holding company were engaged in a unitary business.

35 2009 Metropoulos Family Trust, 2022 WL 1702336, at *12. The gain on the sale was predominately attributable to goodwill. In rebuttal, the taxpayers argued that, under personal income tax rules, a sale of intangible property is only sourced to California if the intangible property had acquired goodwill in the state and, further, that the goodwill earned in the sale had not obtained business situs in the state. The court disagreed, saying that because gain is sourced at the S corporation level, the only inquiry relevant to sourcing is whether the gain is business or nonbusiness income.

36 Cal. Rev. & Tax. Code section 17851.

37 See International Harvester, 322 U.S. at 449-450 (Jackson, J. dissenting). Wisconsin’s tax on dividend declaration in practice was not solely a tax on Wisconsin earnings because of the nature of dividends being paid from commingled funds accrued from all sources of a taxpayer’s gain and loss. Moreover, the ability to pay a dividend did not rest solely on Wisconsin earnings.

38 The taxpayer in Matter of Goldman Sachs made this argument, which was rejected by the New York City Tax Appeals Tribunal, stating, “Even if Petitioner’s investment management and negotiating skills secured the highest possible sales price for its interest in Claren, nevertheless, those skills added nothing to the value of Claren’s business, the subject of the sale.” Matter of Goldman Sachs, TAT(E) 16-9 (GC), at para. 12.

END FOOTNOTES

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