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California Office of Tax Appeals decision highlights complexity of sourcing flow-through receipts
March 2023
In brief
The recent California Office of Tax Appeals (OTA) case In the Matter of the Appeal of L. Smith, OTA Case No. 20036033, addresses whether a nonresident taxpayer is liable for California tax upon a gain from the sale of a partnership interest. This case highlights the broad scope of issues taxpayers must navigate in California when sourcing receipts from intangibles, including sales of partnership interests, such as whether the corporate or personal income tax sourcing rules should apply, the impact of a unitary relationship, the aggregate versus entity theory, and business versus nonbusiness income.
Action item: How items of partnership income from intangible assets are sourced may have a significant impact on a non-resident’s California source income. As this case illustrates, under different circumstances either the corporate or personal income tax sourcing rules may apply. Analyzing the impact of unique facts, laws, and regulations may help taxpayers navigate sourcing implications that may materially impact their California tax liability.
In detail
Background
The taxpayer, L. Smith, who was not a resident of California, owned an indirect membership interest in SOSV, LLC (Holdco), which was classified as a partnership for federal and California income tax purposes. Holdco had its principal office in Illinois, where its sole manager, an individual, was located. Holdco directly owned 50.50% interest in Shell Vacations, LLC (Shell), which was based in Arizona and classified as a partnership for federal and California income tax purposes. Shell was in the business of acquiring, developing, and selling timeshare/vacation ownership interests and vacation club memberships, and conducted business within and without California.
In 2012, Holdco sold its entire 50.50% interest in Shell and recognized gain on the sale with none of the gain sourced to California. Holdco did not source any of the gain to California as Holdco on a stand-alone basis had no activity or apportionment factors; it was a pure holding company. Therefore, as an indirect pass-through member of Holdco, the taxpayer did not source any of the gain to California.
On audit, Franchise Tax Board (FTB) determined Holdco and Shell constituted a unitary business and took the position that Holdco’s gain on the sale of its interest in Shell was apportionable business income. Since Holdco had no apportionment factors of its own and Holdco was unitary with Shell, the FTB further determined Holdco’s gain should be apportioned to California using Holdco’s share of Shell’s apportionment factors. Consequently, the FTB issued a Notice of Proposed Assessment (NPA) to the taxpayer that reflected a tax liability attributable to their share of California-sourced income from Holdco’s gain from the sale of its interest in Shell. The taxpayer protested the NPA, but FTB affirmed the decision, and the taxpayer appealed to the OTA.
Application of personal or corporate income tax sourcing rules
On appeal, the taxpayer asserted that the Holdco’s sale of its interest in a lower tier partnership was the sale of an intangible and that the gain under an ‘aggregate theory’ approach should be sourced, for personal income tax purposes, to the taxpayer’s out-of-state residence under California Revenue & Taxation Code (CRTC) section 17952. CRTC section 17952 specifically provides that, “For purposes of computing ‘taxable income of a nonresident or part-year resident’ …, 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 …”
FTB took an ‘entity approach’ whereby the partnership is treated a separate entity and asserted that the corporate sourcing rules under California Code of Regulations (CCR). CCR Sec. 17951-4(d), Income from a Business, Trade or Profession, constitute the governing sourcing provision. This regulation provides that:
“[i]f a nonresident is a partner in a partnership which carries on a unitary business, trade or profession within and without this state, the source of the partner's distributive share of partnership income derived from sources within this state shall be determined in the manner described below.… If the partnership and the business activity of the partner are part of one unitary business, then the rules of Title 18, Cal. Code Regs., § 25137-1(f) [a corporate apportionment regulation] apply and the apportionment of the partnership business income is done at the partner level for the unitary partner or partners. Each partner's distributive share of the partnership business income apportioned to this state is income derived from sources within this state.”
Effectively, the FTB asserted that because Holdco and the lower-tier partnership constituted a unitary business, CCR section 25137-1(f) should be utilized to apportion the gain. Therefore, the gain was properly apportioned to California at Holdco’s level using Holdco’s share of Shell’s apportionment factors. This apportioned income then flows up to the taxpayer retaining the same character and sourcing.
Observation: Under the entity approach, a partnership is viewed as an entity separate and distinct from its partners. Conversely and in alignment with its name, the aggregate approach views a partnership as an aggregation of (or conduit for) its partners and not a distinct and separate entity. California statutes and regulations do not specifically require an aggregate or entity approach; however the FTB has provided guidance on specific facts in Legal Ruling 2022-02.
The OTA agreed with the FTB and concluded the taxpayer was liable for the tax on California-sourced gain from the sale of the partnership interest and the corporate sourcing rules control. The OTA looked to the statutory and regulatory authority that applies to the the sourcing of a nonresident’s income and specifically noted that the personal income tax statute CRTC 17954 grants legislative authority to regulations the FTB may promulgate: “[a nonresident’s income] shall be allocated and apportioned under rules and regulations prescribed by [FTB]”. Consequently, CCR section 17951-4 regarding the nonresident income from a business, trade, or profession would have the same level of authority as the statutory guidance under CRTC section 17952.
Establishing a unitary relationship affects the sourcing method
In arriving at the conclusion that the corporate apportionment rules should apply, the OTA noted that, “the crux of the issue on appeal is which entity’s factors are used to apportion Holdco’s gain. The resolution of that issue turns on whether the entities are unitary.” The OTA further notes that “if Holdco and Shell are engaged in a unitary business, Holdco’s share of Shell’s apportionment factors will flow up to Holdco and be used to apportion its unitary business income, including its gain from the sale of its interest in Shell. But if they are not unitary, Shell’s apportionment factors do not flow up to Holdco, and thus Holdco’s gain, even if it is business income, is apportioned only with Holdco’s own factors in California, which are zero and leads to no California source income.”
Determining whether a unitary relationship exists between two entities is highly fact specific. The OTA highlighted that there was management oversight, some level of financial oversight through Holdco’s creation of written resolutions for two loan agreements that Shell (as guarantor) entered into with third-party lenders in 2011 and 2012, and the existence of a noncompete agreement between the entities as demonstrating a unitary relationship. Additionally, the OTA indicated that the taxpayer had not “carried his burden of showing by a preponderance of the evidence that Holdco and Shell were nonunitary businesses in 2012.”
Conclusion
Given the statutory and regulatory guidance, together with the determination that Holdco and Shell were unitary, the OTA found that the corporate sourcing rules should be applied, that the factors for Shell should be used to determine the apportionment of Holdco’s gain and, finally, that a portion of the taxpayer’s distributive share of the gain was properly sourced to California, resulting in California source income for the nonresident taxpayer.
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