In this episode of the SALT Shaker Podcast, Eversheds Sutherland Associates Jeremy Gove and Annie Rothschild delve into a recent decision out of the California Court of Appeal – Metropoulos Family Trust v. Franchise Tax Board. The court ruled for the Franchise Tax Board, affirming the trial court’s decision that non-resident S corporation shareholders are subject to California income tax on their pro rata shares of the income from the S corporation’s sale of shares in a subsidiary.

Jeremy and Annie discuss the case’s background and substance, as well as what this case’s holdings may mean for other California taxpayers.

Jeremy’s overrated/underrated question this week appeals to our fellow coffee drinkers. Is iced coffee overrated or underrated?

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The pending precedential Office of Tax Appeal’s (OTA) decision of Appeal of L. Smith, OTA Case No. 20036033 (Dec. 7, 2022) concerned whether California could impose income tax on a nonresident’s distributive share of gain from the sale of an interest in a timeshare developer operating in California as a limited liability company (Timeshare). This turned on two issues. 

The first issue was whether a nonresident’s distributive share of gain on a sale of an interest in a pass-through entity must be sourced using the statute for sourcing gain from the sale of intangibles, Cal. Rev. & Tax. Code § 17952, or FTB’s regulation for sourcing partnership income from a trade, business or profession, Cal. Code Regs., tit. 18, § (“Regulation”) 17951-4.  Following the Court of Appeal’s decision in The 2009 Metropoulos Family Trust, et al. v. Franchise Tax Bd. (2022) 79 Cal.App.5th 245, 266 (see our prior coverage here), the OTA found that it must apply FTB’s regulation. Although Metropoulos concerned an S Corporation, OTA found that its holding applies equally to partnerships and limited liability companies taxed as partnerships.

The second issue arose in the course of applying Regulation 17951-4:  whether the parent limited liability company (Holding Co) that sold the interest in Timeshare was engaged in a unitary business with Timeshare. If it was, then the apportionment factors of Timeshare would flow up to Holding Co, resulting in nearly 42 percent of the gain from the sale being sourced to California, as opposed to none. OTA found that Timeshare and Holding Co were engaged in a unitary business. Notably, OTA rejected FTB’s argument that a special unitary test applied to holding companies. It also explained that majority ownership is not required to be unitary in the partnership context because unlike “a corporate shareholder, only the partner’s ownership interest in the partnership’s income and apportionment factors may be combined.” The OTA’s analysis highlighted California’s alternative test for unity — the “three unities test” and “dependency or contribution test” — but focused on the latter because that is what FTB based its assessment on and the taxpayer failed to rebut FTB’s position. Critical factors that OTA relied on in reaching its decision were an integrated executive force, intercompany financing, and a covenant not to compete.

The decision is available here.

The California Court of Appeal ruled that nonresident shareholders were subject to California tax on their pro rata shares of intangible income from an S corporation’s sale of shares in a subsidiary. This sale of intangibles (goodwill of a business) was sourced as business income apportioned at the S corporation level, not as intangible income to a nonresident under the personal income tax law. In its first holding, the court ruled for the Franchise Tax Board, affirming the trial court’s decision that the shareholders’ intangible business income from the multistate unitary S corporation is sourced under Code of Regulations, Title 18, Section 17951-4.  This regulation requires business income to be apportioned at the S corporation level using UDITPA. The gain realized by the S corporation passes to the shareholders in the same form as received by the S corporation – here, as business income, some of which is apportioned to California.

In its second holding, the court found that the goodwill at issue had acquired a business situs in California. The shareholders asserted that the income should be treated as intangible income sourced to the state of the nonresident shareholders’ domiciles under the personal income tax law, Revenue and Taxation Code 17952.  The court rejected this argument in its first holding, finding that instead Regulation 17951-4 governs here. But, in its second holding, the court explained that even if Section 17952 applied, the income would still be taxable by California because the goodwill had acquired a “business situs” in the state. According to the court, the goodwill acquired a business situs because the S corporation apportioned a percentage of its business income to California using UDITPA and this meant that the management and disposition of the intangible property was an integral part of the S corporation’s regular trade or business operations. Once the business situs rule is applied, income from intangibles of a multistate enterprise is apportioned, rather than allocated 100% to the state.

The 2009 Metropoulos Family Trust et al. v. Franchise Tax Bd., No. D078790, 2022 Cal. App. LEXIS 464 (Ct. App. May 27, 2022)

State and local tax jurisdictions continue to evolve their tax systems around the US. Analyzing the latest key decisions, legislative and regulatory changes, and revenue agency guidance, the Eversheds Sutherland SALT team focuses on providing tax professionals with a quick update of the most important developments in US state and local tax. The SALT Shaker