Massachusetts state tax implications for sales of PTE interests

Editor: Howard Wagner, CPA

When the sale of an interest in a passthrough entity (PTE) is contemplated, planning for state sourcing and taxability of the gain should both be considered so the owners avoid a large — and sometimes unexpected — state income tax liability. Careful state tax planning could help minimize the overall state income tax liability, depending on both how the transaction is structured and how the gain is sourced to the various states.

Basic rules regarding the sale of an interest in a PTE

Typically, income is apportioned to a state if it is derived through a taxpayer’s regular trade or business. As a result of these general rules, the gain from a transaction could be apportioned to every state in which the seller files and not just the taxpayer’s state of domicile or an individual partner’s state of residence.

Many states use what is called “investee apportionment” to source the gain from the sale of a business. Under this method, the taxpayer uses the apportionment factors of the business to apportion the gain to each state. The apportionment factor may or may not include the gain in the numerator and denominator of the sales factor, depending on that state’s rules. Many states will exclude the gain from the apportionment factor because the state does not include sales of intangible property (such as goodwill) in its definition of sales, or the transaction is treated as an occasional sale outside the regular course of business. Even if the gain is excluded from the sales factor, the gain from the transaction will typically still be included in state taxable income that is apportioned to each state where the taxpayer conducts business.

However, businesses can allocate nonbusiness income to a particular state in certain situations, such as where the entity or asset sold was not unitary with the business. Allocation usually results in sourcing income to the state of domicile or where property is sold and could be beneficial, depending on the states involved. It is important for taxpayers to consult with their tax adviser when planning a transaction, as states will generally scrutinize allocable income as part of a transaction, which may open their business up for audit.

A recent Massachusetts court case

A recent decision by the Massachusetts Supreme Judicial Court addressed the treatment of gains from the sale of a PTE and provides a road map for how states may approach sourcing and taxation of gain realized upon the sale.

In VAS Holdings & Investments, LLC v. Commissioner of Revenue, 489 Mass. 669 (2022), a nonresident S corporation, VAS Holdings & Investments LLC (VAS), owned a 50% interest in Cloud5 LLC, which was taxed as a partnership. Cloud5 was headquartered in Massachusetts, and 100% of its business operations were in Massachusetts. VAS sold its investment in Cloud5 in 2013 and realized a gain on the sale. VAS did not have any property, employees, or connection to Massachusetts other than its ownership in Cloud5. VAS and its shareholders were not involved in the business operations or management of Cloud5 throughout the life of the investment.

The Massachusetts Department of Revenue argued that VAS should be taxed on the entire gain that it realized on the sale of Cloud5 in Massachusetts. Its reasoning was based on the gain being attributable to Cloud5’s physical presence in Massachusetts. VAS argued that it did not have a unitary business relationship with Cloud5, and thus the gain should not be treated as business income and apportioned to Massachusetts, as the gain did not result from an investment that served an operational function. In its argument, VAS cited Asarco Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982), in which the U.S. Supreme Court stated that “[T]he linchpin of apportionability in the field of state income taxation is the unitary business principle” (quoting Mobil Oil Corp. v Commissioner of Taxes of Vermont, 445 U.S. 425 (1980)).

A unitary business is typically defined as a group of related entities whose business activities and operations are interdependent. A unitary business group typically needs to satisfy both a control test (i.e., common ownership) and either a relationship or flow-of-value test. The relationship test is satisfied when a group of individuals or entities have business activities or operations that result in flow of value among members of the group or are integrated with or dependent upon each other. Flow of value is established when the related business group demonstrates one or more traits of functional integration, centralized management, or economies of scale. The Massachusetts Supreme Judicial Court noted in its decision that VAS and the state Commissioner of Revenue agreed that VAS and Cloud5 did not meet either the relationship or flow-of-value test that would establish a unitary business group.

The Massachusetts high court, on appeal of a decision of the Appellate Tax Board, ruled in favor of the taxpayers and held that Massachusetts statutes did not authorize taxation of the gain realized by VAS, since VAS and Cloud5 were not engaged in a unitary business. The court recognized that there was no U.S. constitutional prohibition that would prevent Massachusetts from imposing tax on the apportioned gain of VAS. That is, the court agreed with the Department of Revenue and Appellate Tax Board that Massachusetts was constitutionally authorized to tax the gain realized by VAS, based on Cloud5’s nexus with the state and to use Cloud5’s Massachusetts apportionment percentage to determine the tax (i.e., applying an investee apportionment methodology).

However, the court held that Massachusetts’s tax statutes did not authorize such taxation in the circumstances here. Similarly, while Massachusetts could constitutionally impose a tax on a nonresident individual who derives a gain from the sale of an interest in a PTE, even if the nonresident individual is not actively engaged in the business or management of the PTE, the court held that Massachusetts had not statutorily authorized such taxation here.

Implications of the Massachusetts case

The Massachusetts Department of Revenue issued Technical Information Release (TIR) 22-14 to discuss both the decision in this case and how it will apply to future taxpayers. As the department noted, the holding in VAS expressly does not apply when a nondomiciliary corporation sells an interest in a PTE and the PTE and seller are engaged in a unitary business. In that situation, the taxable gain from the transaction should be reported based on the apportionment of the seller, which includes its share of the PTE’s apportionment factors.

In TIR 22-14, the department explained that it will not apply the VAS decision in the following situations:

• Where the PTE and owner are engaged in a unitary business either directly or through multiple tiers;
• Where the taxable gain is includible in the unitary business income of the seller;
• Where the seller of the PTE interest is an individual who was actively engaged in the business operations or management of the PTE either in the year of sale or in previous years;
• Where the gain from the sale of a PTE interest is not apportionable but, rather, allocable to Massachusetts; or
• Where the gain is derived by a Massachusetts-resident individual from the sale of a PTE interest. Resident individuals are taxed on 100% of their income, including the gain from the sale. They may, however, be entitled to a credit for taxes paid to another state.

The department will, however, consider VAS to apply to a gain from the sale of a PTE interest derived by a corporation that is commercially domiciled in Massachusetts. If the corporate seller is engaged in a unitary business with the PTE, the gain must be apportioned using a combination of the apportionment attributes of both the PTE and the seller. If the corporate seller is domiciled in Massachusetts but is not engaged in a unitary business with the PTE, the seller must allocate 100% of the gain to Massachusetts.

In sum, the department views the applicability of this case as primarily limited to where the facts closely resemble the case. It is recommended that nonresident owners of PTEs carefully review the department’s guidance and understand the implications of a pending sale of an interest in a PTE. Taxpayers who had a sale of a PTE interest in a prior year that is still open through the Massachusetts statute of limitation should consider whether there is an opportunity for a possible refund of the gain if their facts resemble those in the VAS ruling. Furthermore, the VAS case provides insight into how other states may approach taxation of the gains on the sale of a PTE in an analogous situation.

Final thoughts

Whenever the sale of a PTE interest is contemplated, state sourcing and taxation of the gain should be considered when structuring the transaction. The form of the transaction may result in unintended consequences for the PTE owners at both the federal and state levels, as a result of the state sourcing of income provisions discussed here.

Furthermore, depending on the structure of the PTE’s ownership, it may also be beneficial to the PTE to make a passthrough entity tax (PTET) election in instances of a material transaction. This is a valuable planning tool to consider in conjunction with state taxation of gains and may allow the PTE to deduct the PTET liabilities against its federal ordinary income, lowering the amount of income passed on to the individual partners or shareholders. It is important for taxpayers to discuss state tax implications with their tax adviser when considering the sale of their business so that their transaction is structured to minimize both federal and state taxes.

Editor Notes

Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky. For additional information about these items, contact Wagner at howard.wagner@crowe.com. Unless otherwise noted, contributors are members of or associated with Crowe LLP.