Key items to consider
The majority of states classify income as either business income subject to apportionment or nonbusiness income subject to allocation; however, states have not uniformly adopted definitions for business and nonbusiness income. In addition, several states do not classify income as either business or nonbusiness. Rather, these states have specific rules to allocate only certain types of income, with all other income being subject to apportionment. Most of the states that classify income as business or nonbusiness have adopted either the Uniform Division of Income for Tax Purposes Act (UDITPA) or the Multistate Tax Compact (MTC) definition or substantially similar definitions.
UDITPA's model language generally defines business income as:
income arising from transactions and activity in the regular course of the taxpayer's trade or business [the "transactional test"] and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business [the "functional test"]. [UDITPA §1(a)]
The MTC's model language has expanded the definition to use the term "apportionable income" rather than "business income" and added the following language to its definition:
any income that would be allocable to this state under the Constitution of the United States, but that is apportioned rather than allocated pursuant to the laws of this state. [MTC, Art. IV, §1(a)(ii)]
Nonbusiness income is generally defined as "all income other than apportionable income" (MTC, Art. IV, §1(e)).
The functional test within the UDITPA's definition of "business income" and the "apportionable income" criterion of the MTC model create complexity in classifying gain or loss from the sale of interests in passthrough entities, requiring taxpayers to closely analyze their business activities to determine whether states will treat their ownership of such an interest as business income under the functional test. The income of a holding entity or venture capital entity with investments as its principal product is classified as business income in some states, which provide that the functional test is met by the acquisition, management, and disposition of intangible property (the passthrough interest investment) as an integral part of the seller's business, and the gain is treated as apportionable income in the state tax base. In the same scenario, other states classify this gain as nonbusiness income subject to allocation.
While factors to consider in determining how to source the gain vary, answering some key questions can help:
- Who are the owners of the passthrough entity? Are they residents or nonresident individuals, C corporations, or a tiered entity structure?
- Is the sale of the passthrough entity an asset sale, or is it a sale of stock, units, or interests in the entity?If it is an asset sale, where is the income-producing property being sold located, including the goodwill intangible? Was the property used to produce business income? If it is a stock sale, how is the sale of the intangible stock sourced?
- Is the business being sold unitary or integral with the seller?
- Is the characterization of how the gain should be treated determined at the level of the tiered passthrough entity/holding entity or at the level of the individual investor?
- Is the individual investor active or passive in the business?
- Where is the commercial domicile of the seller? "Commercial domicile" is generally defined as the principal place from which the trade or business of the taxpayer is directed or managed, which is not necessarily the state of incorporation or formation.
- If the gain is apportioned, does the state include this in the apportionment sales factor? And if yes, are the gross proceeds of the sale or the net gain included in the sales factor of the apportionment formula?
A closer look at a few key states' rules and applications
California: California adopts UDITPA rules by reference for nonresident partners (Cal. Code Regs. tit. 18, §17951-4).
If the gain is business income, then the gain is apportioned using the standard California single-sales-factor apportionment. However, California has different rules regarding nonbusiness income for nonresident individual owners versus corporate owners. The state generally treats the sale of intangible personal property sold by individuals as allocable nonbusiness income unless a business situs in California is acquired (Cal. Rev. & Tax. Code §17952). For corporate partners, gain on the sale of a partnership interest is allocable to California based on the partnership's original cost of tangible personal property sold in California versus everywhere at the time of the sale. If more than 50% of the value of the partnership comprises intangibles, the gain from the sale of the partnership interest is allocated to California based on the standard-sales-factor apportionment for the tax year preceding the sale (Cal. Rev. & Tax. Code §25125). Determining how to treat the gain on the sale of a passthrough entity becomes even more complicated when there is a mixture of different types of owners.
New York: New York has not adopted the MTC or UDITPA standards. For New York franchise tax purposes, business income is defined as the entire net income minus investment income and other exempt income (N.Y. Tax Law §208(8)). For nonresident individual partners, New York treats gain from the disposition of intangible personal property as income from New York sources only to the extent that the intangible personal property is employed in a trade or business in New York (N.Y. Tax Law §631(b)(2); N.Y. Comp. Codes R. & Regs. tit. 20, §132.5).
New York issued Advisory Opinion No. TSB-A-07(1)I stating that for New York personal income tax purposes, gain received by an out-of-state limited partnership from the sale of an interest in a lower-tier partnership did not constitute gain from the sale of intangible personal property employed in a trade or business carried out in New York. The limited partnership did not use its holding in the lower-tier partnership in any New York business activity; therefore, the gain was not includible as New York-source income. As a result of the differences in the corporate and individual tax codes, significant differences can arise in how the gain is ultimately sourced, depending on ownership.
Ohio: Ohio treats a stock sale of a passthrough entity as nonbusiness income and allocable to the taxpayer's state of domicile. The Ohio Department of Taxation has issued guidance regarding an equity investor's apportionment of a gain from the sale of a closely held business (Tax Information Release No. IT 2016-01) in light of Corrigan v. Testa, 149 Ohio St. 3d 18 (Ohio 2016). This decision held that Ohio Rev. Code Section 5747.212 as applied to the taxpayer in Corrigan was unconstitutional under the Due Process Clause of the Fourteenth Amendment to the U.S. Constitution. The Supreme Court of Ohio found that an ownership interest in a business is an intangible asset and that neither the taxpayer nor the sale of the asset had a taxable link to Ohio. Thus, the court followed the general rule of law that a capital gain derived from the sale of an intangible asset is allocable to the taxpayer's state of domicile as nonbusiness income. However, there could be a very different result if the sale of the passthrough interest was an asset sale of a Section 5747.212 entity because the gain would be apportionable business income.
According to Section 5747.212(C)(1):
A "section 5747.212 entity" is any qualifying person [a person other than an individual, estate, or trust] if, on at least one day of the three-year period ending on the last day of the taxpayer's taxable year, any of the following apply:
- The qualifying person is a pass-through entity;
- Five or fewer persons directly or indirectly own all the equity interests, with voting rights, of the qualifying person;
- One person directly or indirectly owns at least fifty percent of the qualifying person's equity interests with voting rights.
Therefore, selling stock versus assets can lead to substantially different results for Ohio nonresident individuals.
Varying results by state
Ultimately, taxpayers and practitioners must consider many factors when deciding how to treat the gain on the sale of a passthrough interest. States are all over the spectrum, from having specific laws to only offering vague guidance. Following each state's specific laws can often lead to an inequitable amount of tax since the gain is not treated the same across all states. Moreover, states have been and likely will continue to be aggressive in this area — trying to capture more gain and thereby add more tax revenue to their shrinking state coffers.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale or email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.