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)