Seller Beware – Court Rules That California Can Tax Gain from the Sale of Goodwill

4 min

This client alert was also published in The Daily Journal.

A California state appellate court recently upheld the trial court's decision in The 2009 Metropoulos Family Trust v. Franchise Tax Board that nonresident shareholders of an S corporation source gain on the S corporation's sale of its intangible assets using the S corporation's apportionment factor and not based on the shareholders' state of residence. As a result, the nonresident shareholders were subject to California income tax on their share of the gain passing through the S corporation to them from the sale of the S corporation's interest in a wholly owned subsidiary. The decision addresses what has been a frequent audit issue in California – the sourcing of gain for nonresident owners of a pass-through entity that does business in California and sells its assets.

In Metropoulos, two non-grantor trusts were respectively 20% and 39.5% shareholders of Pabst Corporate Holdings, Inc. (Pabst), a Delaware S corporation based in Connecticut with multistate activities. Pabst sold its interest in a wholly owned subsidiary in a transaction that was treated for income tax purposes as a sale of the subsidiary's assets, including its goodwill. The trusts asserted that income from the sale of the subsidiary's assets should be treated as income from the sale of an intangible asset and sourced to the trusts' state of residence (i.e., outside of California). The California taxing authorities successfully argued that gain derived from the sale of the goodwill should be apportioned within the S corporation as business income of Pabst under regulations of the California Franchise Tax Board (FTB), rather than allocated to the trust shareholders' states of residence.

Under FTB regulations, in the case of a nonresident shareholder of an S corporation that carries on a multistate business, business income is apportioned at the S corporation level. The resulting apportioned amount is treated as California source income to the nonresident shareholder and is subject to California income tax. California's personal income tax statutes, which apply to individuals and trusts, provide that income nonresidents derive from stocks, bonds, notes, or other intangible property is not California source income unless the intangible property has acquired a "business situs" in California.

The trial court ruled, and the appellate court confirmed, that the FTB regulations for apportioning business income within the S corporation applied, rather than the personal income tax rules for sourcing income from the sale of intangibles at the shareholder level. The appellate court also noted that even if personal income tax sourcing rules applied and the asset sale were treated as a sale of goodwill, the goodwill had at least partially acquired a business situs in California, as it was used in connection with Pabst's California business, and, therefore, the sale of such goodwill would be subject to California income tax.

The trusts could have received more favorable income tax results if they had sold their stock in Pabst, rather than Pabst selling its interests in the wholly owned subsidiary in an asset sale. If the nonresident trusts had sold stock in Pabst, the sourcing rules in the personal income tax statutes would apply. As stock is an intangible asset, income derived from its sale would have been sourced to the state of residence of the trusts, which was outside of California. Thus, the sale of Pabst stock by the trusts could have escaped California income tax.

But buyers typically want asset purchase treatment to obtain a stepped-up basis in the assets being acquired. When a sale is structured as a sale of S corporation stock, buyers often negotiate for a tax election under Section 338 of the Internal Revenue Code to treat the sale as an asset sale for income tax purposes, even though in form the sale is a stock sale. A seller needs to be mindful of the fact that making such an election results in the same issue that arose in the Metropoulos case. The resulting gain is sourced as business income within the S corporation and thus overrides sourcing of the gain based on the seller's nonresident status.

Business owners contemplating a sale of their interests should consider whether careful planning and structuring of a transaction could save state income taxes. Among other techniques, establishing a properly structured non-grantor trust in a low- or no-income tax state and transferring business interests or other intangible property to the trust can generate significant state income tax savings upon the trust's subsequent sale of such property. However, establishing a non-grantor trust to hold intangible assets may not generate income tax savings if the sale transaction is not carefully structured well in advance of the sale.

The decision in the Metropoulos case enhances the FTB's tools to attribute income to California in connection with sales by pass-through entities. Thus, sellers of a business with California connections need to be ever more vigilant in the negotiation and structuring of their transactions if they seek to minimize state taxation of gain on the sale.