Page 564 - TaxAdviser_2022

TAX CLINIC

the income from the S corporation’s
sale of intangible property. As of this
writing, the Court of Appeal decision
had not been appealed to the California
Supreme Court.
In Legal Ruling 2022-02, the FTB’s
position is analogous to the extent that
once gain from a transaction is treated
as apportionable business income at the
(passthrough) entity level, this business
income character taints the income that
is passed through to the nonresident for
individual income tax purposes, resulting
in the apportionment of at least some of
the gain to California, instead of sourc-
ing to the nonresident’s domicile pursu-
Section 17951-4(d). Since the gain or to the state of domicile of the seller ant to California’s individual income
loss is calculated as if the partnership had unless the property establishes business tax statutes.
sold the Sec. 751 property and distributed situs in California.
it up pro rata to the partner, the income In contrast, for the Sec. 751 property, Implications
would be treated as income from a trade, an aggregate approach is used, and The FTB generally treats the sale of a
business, or profession and sourced ac- the FTB gets to its conclusion in part partnership interest by an individual as
cording to the Uniform Division of In- because it concludes that the operation a sale of intangible property, sourced to
come for Tax Purposes Act (UDITPA) of Sec. 751 necessitates that the sale of the state of residence of the seller, based
(RTC Sections 25120 to 25139). the partnership interest be treated as in part on Appeals of Ames, 87-SBE-042
The FTB gets to this result in part two distinct transactions: The Sec. 751 (Cal. State Bd. of Equalization 6/17/87).
by using two competing approaches to assets are first treated as being sold by This case is also cited in Section 3350 of
partnerships under Secs. 741 and 751: the partnership (so characterized as a the FTB’s Residency and Sourcing Techni-
the aggregate approach and the entity sale by the business) and then, second, cal Manual. However, the Sec. 751 gain
approach. Citing Unger, T.C. Memo. as a separate transaction where the or loss is not specifically addressed in
1990-15, the ruling states that the entity intangible partnership interest is sold the manual, and the ruling provides the
theory holds the nature of a partner- by the partner. Following this logic, the FTB’s approach where Sec. 751 gain or
ship to be such that the partnership is two separate “transactions” result in a loss is involved.
a distinct legal entity separate from its deemed distribution, and the nonresi- Tax practitioners should be aware of
partners. The aggregate theory, on the dent partner must recognize gain on the the FTB’s two-step approach to transac-
other hand, considers the partners of a sale, even though the general rule for tions involving Sec. 751 gain: From the
partnership as not forming a collective intangibles sources gain to the seller’s perspective of the selling nonresident
whole. Rather, the partnership is viewed individual domicile. taxpayer, this is one transaction involv-
as merely an aggregate of the individual ing the sale of an intangible interest. If
partners of which it is composed. Metropoulos case taxpayers and their practitioners focus
Sec. 741 applies an entity approach An interesting aspect of the ruling is solely on the personal income tax rules,
to partnerships when a partner sells or that it cites to the FTB’s argument from they may conclude that none of the gain
exchanges their partnership interest. the recent decision of the California is attributable to California at the indi-
Under Sec. 741, the partner generally Court of Appeal in The 2009 Metropou- vidual level. Both taxpayers and practi-
recognizes a capital gain or loss on the los Family Trust v. Franchise Tax Board, tioners must include in their transaction
sale only to the extent the partnership holds No. D078790 (Cal. Ct. App. 5/27/22). analysis considerations of items such as
no unrealized receivables or appreciated In Metropoulos, the court ruled for the Sec. 751 gain (hot assets) that may lead PHOTO BY EISNERDIGITAL/GETTY IMAGES
inventory. California generally treats the FTB, affirming the trial court’s deci- to a reclassification of an item of income
sale of a partnership interest by an indi- sion that nonresident S corporation from a straight sale of an intangible to
vidual under the entity theory as a sale shareholders are subject to California the sale of a business asset. This ruling
of intangible personal property, sourced income tax on their pro rata shares of and the recent Metropoulos decision

22 November 2022 The Tax Adviser