Nonresident Owners Selling a Business with California Contacts? Be Wary of Selling Through a Conduit Holding Entity

8 min

Clients frequently come to us while in the process of selling interests in California-based businesses. Clients who are not residents of California typically expect that they will not be subject to California income tax on the sale of their business interests. However, often the planned structure of the sale will generate California income tax. For example, if the transaction is structured as an actual asset sale or a deemed asset sale due to a tax election under Section 338 of the Internal Revenue Code, the nonresident owner may have California income tax exposure. In addition, if the direct seller is a partnership or S corporation, rather than a nonresident individual, income from the sale typically will be treated as business income, a portion of which may be subject to California income tax.

The California Franchise Tax Board takes the position that an intervening pass-through entity (i.e., an entity taxable as an S corporation or partnership) can dramatically alter the sourcing of the income from the sale for California state income tax purposes. However, with advance planning, it may be possible to mitigate California state income tax exposure.

Guidance Under California Law

Because the California Franchise Tax Board continues to take aggressive positions in audits and test new theories for recovering additional California income tax, the legal landscape continues to evolve. The following provides a summary of the most recent administrative rulings and court decisions:

  • In the Matter of the Appeal of L. Smith, OTA Case No. 20036033 (Dec. 7, 2022), the California Office of Tax Appeals (OTA) held that merely having an entity taxable as a partnership as a holding company between the nonresident individual owner and the entity that was sold can result in the sale gain being classified as "business income" and apportioned to and subjected to California income tax. First, the OTA concluded that the gain on the sale of the operating company was subject to apportionment under California Code of Regulation Section 17951-4(d), which is applicable to a nonresident's business, trade, or profession. Second, the OTA held that the holding company and the operating company constituted a "unitary business" for state income tax purposes, and, therefore, the holding company's gain on the sale of its membership interest in the operating company constituted business income that had to be apportioned using the holding company's share of the operating company's apportionment factors. Essentially, the OTA held that the holding company must use the apportionment factors of the operating company (the entity that was sold) to apportion the sale gain to California. The net effect is that gain from the holding company's sale of the operating company is apportioned at least in part to California rather than allocated to an individual owner's state of residence.
  • In The 2009 Metropoulos Family Trust, et al. v. Franchise Tax Bd., 79 Cal. App. 5th 245, 266 (May 27, 2022), the California Court of Appeals addressed the California taxation of the sale by an S corporation of its interest in a wholly owned subsidiary. For income tax purposes, the transaction was treated as a sale of the subsidiary's assets, including its goodwill. The California Court of Appeals affirmed the trial court's holding that gain from the sale of the subsidiary's assets should be apportioned to California at the level of the parent S corporation. The California Court of Appeals also noted that even if the personal income tax rules applied, the subsidiary's goodwill had acquired at least a partial business situs in California, and, therefore, the sale of such goodwill would be subject to California income tax. This case illustrates some of the planning difficulties that can arise when the target entity is an S corporation. Buyers will want to acquire the S corporation's assets, rather than its stock. Unwinding the S corporation in advance of a sale to enable a direct asset sale by the nonresident owners is often difficult to do without incurring income tax for the shareholders (as discussed in more detail below).
  • In FTB Legal Ruling 2022-02 (July 14, 2022), the Franchise Tax Board's Legal Division complicated the usual sourcing rules that apply for state income tax purposes when an individual sells interests in an entity taxable as a partnership. In brief, the ruling recharacterizes the sale of a partnership interest as the sale of assets to the extent the partnership has unrealized receivables or inventory that would result in ordinary income for federal tax purposes. Income from the deemed asset sale is subject to apportionment, rather than taxed to the individual seller's state of residence. The ruling relies on federal tax rules (the "hot asset" rules under IRC Section 751) treating certain gain from the sale of a partnership interest as ordinary income rather than as capital gain as a basis for changing the nature of the property being sold from an intangible partnership interest to sale of the underlying partnership assets.

Planning Opportunities

The following provides a summary of some of the planning that can be done to mitigate California state income tax on a sale of a business interest.

Structuring the transaction as a direct sale by a nonresident individual or trust.

California law treats a partnership interest as intangible property, and case law concludes that a partnership interest does not gain a California business situs merely because the partnership operates in California. See Appeal of Amyas and Evelyn P. Ames, 87-SBE-042, June 17, 1987. Therefore, gain on the sale of a partnership interest by an individual seller is generally sourced to the individual's state of residence based on the doctrine of mobilia sequuntur personam (movable things follow the person) (subject to the new exception the FTB is applying based on FTB Legal Ruling 2022-02). The same rule applies for the sale of stock and other intangible assets (e.g., goodwill) when sold directly by a nonresident taxpayer. Transferring ownership of intangible assets to a nonresident individual or to a non-grantor trust formed as a resident of another state has been used to reduce or avoid California income tax on the gain from the sale of those assets.

Nonresident individuals and nongrantor trusts are subject to California income tax only on California source income and could sell assets and accumulate gain without paying California income tax. However, recent changes to California tax law, in California Revenue and Taxation Code Section 17082, are targeted at limiting the benefit of transferring property to certain nongrantor trusts to reduce or avoid California income tax exposure.

Reviewing and correcting apportionment methodology well in advance of a sale.

For a California nonresident taxpayer, the California taxable income resulting from a sale by a holding company is typically generated by the California apportionment factor of the holding company for the year of the sale. In some instances, the apportionment factor of the holding company will be based at least in part on the apportionment factor for the year of sale of the operating company that it is selling (in combination with the factors of any other pass-through entities that it owns).

Income is apportioned to California using a single sales factor and marketplace sourcing, which in the case of a service-based business looks to the location where customers receive the benefit of the services rendered. This can provide favorable income tax treatment for a California-based business with customers located primarily outside of California. If the apportionment factor is expected to result in little or no income being sourced to California, little further California tax planning is necessary.

As shown by the cases discussed above, California is active in the audit of transactions involving the sale of intangible assets and can be aggressive in its application of its sourcing rules in favor of the state. Given the ambiguities in application of the sourcing and apportionment rules, sellers should carefully review their apportionment methodology to prepare for a potential state income tax audit.

Restructuring the ownership of intangible assets in advance of a sale.

When an unfavorable California apportionment factor is anticipated for the year of sale, advance planning for a sale may focus on moving the intangible assets that a potential buyer wishes to acquire out of the holding company prior to a sale. If the holding company is a partnership, intangible assets can frequently be distributed to the partners/members without generating gain. When those owners are nonresidents of California, the sourcing rules should support direct sourcing of gain on the sale to their states of residence and not to California.

Conversely, the distribution of assets out of an S corporation to its shareholders generally will trigger recognition of gain within the S corporation. The distribution of assets will likely be apportioned to California and reported on the entity's California schedules K-1 for flow through to the shareholders. That said, with cooperation from the prospective buyers of those assets, it may be possible to structure the overall sale transaction in a manner that allows the buyer to acquire ownership of the assets (and not the S corporation stock) while also having the gain recognition event occur largely at the shareholder level (as if the shareholders had sold the S corporation stock).


California taxation of the sale of a business having California connections can be significant. But undertaking advance tax planning with the assistance of tax professionals familiar with the nuances of the California tax laws may mitigate California state income tax exposure on a sale of a business interest.