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The Adage “Heads We Win; Tails You Lose” Continues to Apply in California

Tax Development May 23, 2023

The Adage “Heads We Win; Tails You Lose” Continues to Apply in California

Double taxation is alive and well in California. The California Office of Tax Appeals (OTA) determined that a California resident was not eligible for the other state tax credit (OSTC) for income taxes paid to Massachusetts on the gain from a sale of his membership interest in a limited liability company doing business in Massachusetts.1 While citing the California Court of Appeals decision in The 2009 Metropoulos Family Trust v. FTB,2 on very similar facts, the OTA reached the opposite conclusion. The court in Metropoulos held, in essence, that the sale by a California nonresident of intangible property of a business, which gave rise to a gain, established situs in California, and the gain on the property is sourced to California. Of course, this is inconsistent with California’s longstanding rule under R&TC Sec. 17952 that says that nonresidents should source such gains to their state of residence, unless that property acquired a business situs in California. In contrast, in Matter of Buehler, the OTA opined that the sale of the intangible membership interest in a business that increased in value because of the business’s operation in three states, did not establish situs for the stock or gain in any state other than the California resident’s state.

In this case, the taxpayer, J. Buehler, was a managing member of EIF Management, LLC (EIF), providing portfolio services. In 2015, Buehler sold his 23% membership interest in EIF to a third party, realizing a gain of $15.2 million. The gain clearly reflected an increase in value in the business enterprise that operated in California, Massachusetts, and New York. Buehler apportioned approximately half of the gain to Massachusetts, as was done with the income of EIF on the relevant K-1s issued to the members. He then reported the apportioned gain on his Massachusetts nonresident income tax return and paid the related tax to Massachusetts. On his 2015 California resident income tax return, Buehler claimed an OSTC for the taxes paid to Massachusetts. The Franchise Tax Board (FTB) denied the credit and issued an assessment, resulting in the appeal to OTA.

California’s nonresident sourcing provisions provide that nonresidents must use California’s nonresident sourcing rules and further provide that nonresident income from intangible personal property is not income from California sources unless the property has acquired a business situs in California. Under 18 Cal. Code Reg. § 17951-4(d), the nonresident partner’s distributive share of multistate partnership’s business income is required to be apportioned by a formula using the partnership’s apportionment factors, as determined in Metropoulos.

Buehler argued that his membership interest had acquired a business situs in Massachusetts under R&TC § 17952. Alternatively, Buehler argued that he and EIF constituted a unitary business and, therefore, the gain from the sale of his LLC member interest is business income apportioned to Massachusetts under 18 Cal. Code § 17951-4(d). Buehler asserted that his situation was no different from the taxpayer in the Appeal of Bindley3 and that his involvement as one of EIF’s three managing members was so inextricably linked with EIF’s operations in Massachusetts that such involvement created a single unitary business with EIF.

In denying the appeal, the OTA agreed with the FTB that the sale of the LLC interest in EIF was a sale of intangible personal property, and the resulting gain should be sourced to Buehler’s California residence. What was not raised or considered was what gave rise to the source of the gain in what would seem an arbitrary way based on the formalistic structuring of the sale and investment. In Buehler, where the membership interest is sold, the OTA only looked at the membership interest and concluded that the gain on the sale of the interest could only be sourced to California, as that is where the holder of the interest resided. In Metropoulos however, when assets were sold and one of the assets gave rise to the gain, the asset located in California acquired situs in California, necessitating that the gain be sourced to California. The essence of both transactions is similar (i.e., a gain is generated based on the operation of a business over a period of time). In one case, when the interest of the entity is sold, the gain is sourced to the taxpayer’s residence, while when the underlying asset is sold, the asset can establish situs and the resulting gain is sourced to the situs of the asset.

This dilemma falls under the aggregate versus entity theory of flow through entities. Are the assets of a flow through entity owned by members according to their share of their membership interest (aggregate theory), or are the assets considered as a part of the legal entity (entity theory)? In Buehler, the OTA has opted for the entity theory and solely looked at the membership interest. While in Metropoulos, the appellate court looked at the gain under the aggregate theory and sourced the gain to California.

Regarding Buehler’s alternative argument of what we will call “personal unity,” the OTA chose to ignore its own precedential opinion in Bindley. The OTA made the distinction that Bindley was a sole proprietor and, therefore, could have personal unity; however, the OTA stated that Buehler was not “operating a sole proprietorship or any kind of business activity that could be considered unitary with EIF.” Therefore, the OTA said that 18 Cal. Code Reg § 17951-4(d) did not apply.

This decision highlights the dilemma created when individuals conduct business activities through pass-through entities. The conflict often arises between imposing individual taxation principles (resident-based sourcing) as was done here under the aggregate theory and business principles (apportionment rules) as was done in Metropoulos under the entity theory. The result, in this instance, is double taxation, an outcome frowned upon by the Commerce Clause and the Due Process Clause of the U.S. Constitution. While the OTA in Buehler may have clarified when intangible personal property has acquired a business situs in a state, has the OTA done so unconstitutionally?

As you consider how you might source a gain from a sale of your pass-through entities’ assets/holdings, please consult our income tax experts at Ryan to help guide your decision-making process.

1 Matter of Buehler (February 28, 2023) OTA Case No. 21067960, 2023-OTA-215P (pending precedential).

2 The 2009 Metropoulos Family Trust v. California Franchise Tax Bd. (2022) 79 Cal. App.5th 245.

3 Appeal of Blair S. Bindley, 2019-OTA-179P (May 30, 2019) (precedential).


Gina Rodriquez

Greg Rottjakob

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