California sources part of nonresident sale gain to state

On May 27, 2022, the California Court of Appeal for the Fourth Appellate District affirmed the trial court’s decision that a nonresident shareholder’s California source income from a S corporation’s sale of intangible property, specifically goodwill, was partially from California sources and not sourced entirely to the shareholders’ states of domicile.¹ The court concluded that the nonresident S corporation shareholders were taxable on their pro rata share of the gain, because it was business income partially sourced to California under the state’s Uniform Division of Income for Tax Purposes Act (UDITPA) statutes.² After deciding the issue of sourcing under California’s UDITPA provisions, the court noted that, even if the statute addressing a nonresident’s income from intangible property had applied,³ the same result would occur because the goodwill had partially acquired a business situs in California through the S corporation’s activities.

Background

The 2009 Metropoulos Family Trust and the Evan D. Metropoulos 2009 Trust (collectively, the “Trusts”) owned a 39.5% interest and a 20% interest, respectively, in Pabst Corporate Holdings, Inc. (“Pabst Corporate Holdings”), a Delaware S corporation. Both Trusts were nonresident trusts for California purposes and were subject to California’s personal income tax to the extent they received income from California sources.⁴ Pabst Corporate Holdings owned a 100% interest in a qualified subchapter S subsidiary, Pabst Holdings, Inc., that operated a multistate business throughout the United States, including in California.

In November 2014, Pabst Corporate Holdings sold its 100% interest in Pabst Holdings, Inc. in a transaction treated as an asset sale for federal income tax purposes. The primary asset sold was goodwill, and this transaction resulted in a long-term gain of more than $607 million. This gain was originally reported to California as apportionable business income by Pabst Corporate Holdings on its 2014 California S corporation return and was apportioned to California using the S corporation’s 6.6% California apportionment percentage. Based on this flow-through of California sourced income, the Trusts together paid approximately $3,600,000 of tax to California.

In June 2016, the Trusts amended their California returns to treat all flow-through income attributable to the sale of Pabst Holdings, Inc. as not being subject to California taxation. Because the gains arose from the sale of intangible property, the Trusts argued that the gains lacked a California source and should have been sourced to the Trusts’ domiciles outside of California under Cal. Rev. & Tax. Sec. 17952, California’s statute addressing a nonresident’s income from intangible property. In May 2017, the California Franchise Tax Board (FTB) denied these refund claims, and the Trusts appealed these denials to the California Office of Tax Appeals (OTA).

California taxation of income from S corporations

California generally adopts federal tax law concerning the treatment of S corporations,⁵ and the character of a shareholder’s share of S corporation income is determined as if the income were realized directly from the source from which realized by the corporation.⁶ For purposes of sourcing the share of a nonresident’s income from a partnership or S corporation conducting a unitary business both within and outside California, Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1) provides that the total business income of the partnership must be apportioned at the partnership level, and Cal. Code Regs. tit. 18, Sec. 17951-4(d)(3) provides that the source of a partner’s share of items that do not constitute business income must be determined under the sourcing rules of Cal. Rev. & Tax. Code Secs. 17951 through 1 7955.⁷ These same rules expressly apply to sourcing income from S corporations.⁸

Cal. Rev. & Tax. Code Sec. 17952 contains California’s rules for the taxation of a nonresident’s income from intangible property and provides that “income of nonresidents from stocks, bonds, notes, or other intangible property is not income from sources within [California] unless the property has acquired a business situs” in the state. The application of Cal. Code. Regs. tit. 18, Sec. 17941-4(d) versus the application of California’s sourcing rule for a nonresident’s income from intangibles in Cal. Rev. & Tax. Code Sec. 17952 was the primary issue being litigated by the Trusts.

OTA and Trial Court hold nonresident owners subject to tax on gain

In November 2019, the OTA issued a decision in the FTB’s favor denying the Trusts’ refund claims.⁹ Two of the three administrative law judges concluded that the rules for the apportionment of business income provided in Cal. Code. Regs. tit. 18, Sec. 17941-4(d) were determinative, and required that business income be apportioned at the S corporation level and would flow through to the S corporation’s owners with the same character. The logic of the majority’s opinion indicated that Cal. Code Regs. tit. 18, Sec. 17951-4(d)(3), and by extension, Cal. Rev. & Tax. Code Sec. 17952, cannot apply to determine the sourcing of income from intangibles to a nonresident unless dealing with a distributive share of net income which is not characterized as business income of the S corporation.

Following the OTA’s decision, the Trusts appealed the matter to the superior (trial) court.¹⁰ The Trusts and the FTB each made separate motions for summary judgment, and the court denied the Trusts’ motion and granted the FTB’s motion. Similar to the OTA, the trial court ruled that “because Pabst characterized the income at issue as business income, the trusts were bound to treat their respective shares of that income in the same way on their federal and California tax returns.” Further, the trial court noted that even under the assumption that Cal. Rev. & Tax. Code Sec. 17952 applies, “[t]here is evidence indicating that [Pabst] localized the goodwill in connection with its California business” which offered support that the intangible property had acquired a business situs in California. Following the trial court’s granting of the FTB’s motion for summary judgment, the Trusts filed an appeal with the California Court of Appeal.

Court of Appeal affirms taxation of nonresident owners

Like the trial court and the OTA before it, the Court of Appeal was asked to determine whether gain from an S corporation’s sale of goodwill passing through to the Trusts should be apportioned under California’s UDITPA provisions, as incorporated in Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1), or sourced to the nonresidents’ state of domicile under Cal. Rev. & Tax. Code Sec. 17952 under the Trusts’ argument that the intangible property had not acquired a business situs in California.

In addressing the application of California’s UDITPA provisions incorporated into Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1), the court first listed the factual concessions of both the FTB and the Trusts, highlighting that the Trusts had conceded “Pabst is a unitary business and that the gain realized from Pabst’s asset sale is business income . . ..” The court noted that “[t]here is import to plaintiffs’ concession,” and that “[p]laintiffs therefore concede the goodwill was used as an integral part of Pabst’s California business and related to its California business activities, at least for purposes of Pabst’s taxation.” Having established the premise that the goodwill was inseparable from Pabst’s business operations, the court then turned to the flow-through nature of income from an S corporation to its shareholders, explaining:

Under the “conduit” theory that the Trusts, as shareholders, realize their pro rata share of gain from the sale of goodwill as if it were realized directly from the same source as the S corporation, the court concluded that the treatment and sourcing of the gain as apportionable business income to both the S corporation and its shareholders was appropriate.

Although the Trusts argued that, as a specific statute governing a nonresident’s income from intangible property, Cal. Rev. & Tax. Code Sec. 17952 must govern the treatment of the gain passing through to the Trusts, the court deferred to the FTB’s administrative rulemaking authority to establish the governing rule in Cal. Code Regs. tit, 18, Sec. 17951-4(d). On this point, the court noted that “pursuant to the Legislature’s express grant of power to make apportionment rules for nonresident gross income from sources within and without California (§ 17954), FTB regulation 17951-4 . . . governs.” Accordingly, based on the incorporation of California’s UDITPA apportionment provisions in Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1), the court upheld the FTB’s position that the gain must be apportioned to California for purposes of the nonresident shareholders’ California taxation based on the S corporation’s 6.6% California apportionment percentage.

Court of Appeal’s additional analysis of ‘business situs’ rule

Although the Court of Appeal’s conclusion that the Trusts’ pro rata share of gain from the S corporation’s sale of goodwill must be apportioned to California under Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1) should have disposed of the case on appeal, the court nonetheless offered an additional analysis of how it would have applied Cal. Rev. & Tax. Code Sec. 17952 under the circumstances.

As background, Cal. Rev. & Tax. Code Sec. 17952 derives from the common law concept of mobilia sequuntur personam (movables follow their owner). As codified in Cal. Rev. & Tax. Code Sec. 17952, under the mobilia doctrine the income of a nonresident from intangible property is generally not from California sources unless the intangible has acquired a “business situs” in California.

The touchstone of the Trusts’ position on the application of Cal. Rev. & Tax. Code Sec. 17952 was that “the business situs exception is a rule of allocation,” meaning that it is an all-or-nothing determination that would assign gain from the sale of intangible property entirely to California or entirely outside the state. Based on this construction of the mobilia doctrine, the Trusts argued that “they did not do anything affirmative to localize the goodwill in California so as to give it a business situs.”

The court rejected the Trusts’ interpretation of Cal. Rev. & Tax. Code Sec. 17952, explaining:

In tandem with declining to interpret the “business situs” language of Cal. Rev. & Tax. Code Sec. 17952 as an all-or-nothing rule of allocation, the court also explained how it would partially assign business situs of the intangible property to California. On this ancillary issue of splitting business situs, the court noted that:

Based on “Pabst’s integration of the goodwill into its California business operations,” the court suggested that such integration at least partially “gives that intangible a business situs in this state.”

Commentary

The decision highlights concerns faced by a pass-through entity (PTE) and its owners when substantial gains are derived from the sale of a lower-tier PTE (or that lower-tier PTE’s assets) conducting a multistate business, when some or all of the ultimate owners are not California residents. Frequently, the FTB takes the position that the gain from a sale transaction by the entity is treated as apportionable business income to the PTE, and that this characterization dictates the treatment in the hands of the PTE’s nonresident owners under the FTB’s application of Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1).

The interplay of Cal. Rev. & Tax. Code Sec. 17952 and Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1) is often at the heart of audit disputes between a PTE’s nonresident owners and the FTB. The Court of Appeal’s analysis in this case directly addressed the interplay of these provisions, and gave deference to the FTB’s authority to promulgate Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1), which incorporates the rules for apportionment of business income from California’s UDITPA statutes.¹² Based on the court’s deference to the FTB and its construction of Cal. Code Regs. tit. 18, Sec. 17951-4(d)(1), a nonresident’s share of gain from the sale of goodwill would not appear to be subject to Cal. Rev. & Tax. Code Sec. 17952 unless the underlying transaction generates nonbusiness income. Under such circumstances (i.e., when the transaction generates nonbusiness income to the PTE), Cal. Code Regs. tit. 18, Sec. 17951-4(d)(4), which incorporates Cal. Rev. & Tax. Code Sec. 17952 by reference, would then become relevant. With this in mind, the initial categorization of gain as business income to the S corporation, which was not disputed by the Trusts, appears to have been a key factor underlying the Court of Appeal’s reasoning. Accordingly, PTEs and their owners considering how to evaluate their own transaction should pay close attention to the level of support for characterizing gain from the sale of intangible property as business income versus nonbusiness income.

Although not essential to the court’s holding, this decision also has important ramifications concerning the application of the “business situs” sourcing rule within Cal. Rev. & Tax. Code Sec. 17952. As the Trusts noted in their argument before the Court of Appeal, for many decades authorities have construed business situs as a rule of allocation resulting in sourcing to a single location or geography. However, the Court of Appeal’s decision makes clear that it did not believe “business situs” is a strict rule of allocation to a single state. It remains to be seen how this decision will impact prior California decisions that examined and applied the business situs rule when individual owners sold or redeemed their interest in intangible property in their individual capacity, as opposed to receiving a pro rata share of gain from a partnership or S corporation’s sale of intangible property.¹³ In any event, it would not be unreasonable to expect that this decision may embolden the FTB in its examinations of various situations where nonresident individuals have realized gains from goodwill and other intangible property.

It is expected that the Trusts may petition the California Supreme Court for review of this decision. Because such review is discretionary,¹⁴ taxpayers and tax professionals will be closely watching to see if such review is sought and granted.