Tax alert

Nonresident owes tax on the gain from California partnership interest sale

Feb 08, 2023
Personal tax planning Income & franchise tax State & local tax

Executive summary: Traditional unity test applicable to the sale of partnership interest

The California Office of Tax Appeals (OTA) extended a recent ruling on the taxation of nonresident income from unitary S corporations to unitary partnerships by finding a nonresident liable for California income tax on their distributive share of gain from the sale of a partnership interest in a timeshare developer. 

Nonresident owes tax on the gain from California partnership interest sale

In the matter of In re Smith, Cal. Office Tax App., No. 2023-OTA-069P, Leonard Smith, a California nonresident, owned an indirect interest in SOSV LLC (SOSV), classified as a partnership for federal and California tax purposes. SOSV, in turn, owned an interest in Shell Vacations LLC (Shell), classified as a partnership for federal and California tax purposes. Shell, through its subsidiaries and affiliates, was in the business of acquiring, developing and selling timeshare/vacation ownership interests and vacation club memberships. Shell conducted business within and outside California.  

SOSV sold its interest of Shell for a gain in 2012. On its California tax return, SOSV recognized the net gain of the sale but did not source any of this gain to California. Smith, as an indirect pass-through member of SOSV, also did not pay California tax on the gain. 

The Franchise Tax Board (FTB) determined that Shell and SOSV constituted a unitary business and SOSV’s gain on the sale was apportionable business income. This determination resulted in an assessment of $176,936 of tax to Smith, plus applicable interest. Smith appealed the assessment, arguing that the transaction was the sale of an intangible asset governed by Cal. Code Regs. Tit. 18, section 17952 (related to sourcing of nonresident intangible property income). Smith asserted that his gain from the sale should be sourced to his state of residence under section 17952 because SOSV was not doing business in California. Additionally, Smith argued that Shell and SOSV were not in a unitary business relationship.

A unanimous panel of the OTA found for the FTB, determining that the proper governing law was not section 17952, but instead section 17951-4, a different nonresident sourcing provision relating to a nonresident’s income from a business, trade or profession. According to the OTA, section 17951-4 is the appropriate nonresident sourcing provision to apply when a nonresident is a partner in a partnership that carries on a unitary business within and outside California. The OTA found that Shell and SOSV did constitute a unitary business. As such, the gain from the sale of Shell is apportionable business income and apportionable to SOSV, and thus, Smith.


This decision is important for a few reasons. First, the OTA rejected the FTB’s call for a special unitary test for partnership holding companies based solely on control and operational management factors. Rather, it held that the established unitary framework should be used to ascertain unity for partnership holdings companies. In this case, the OTA used established case law and found the existence of a unitary relationship because Shell and SOSV had overlapping management and significant intercompany financing.

Moreover, this decision comes on the heels of an increased frequency of auditing tiered partnerships and pass-through entities in California. In 2022, in the matter of 2009 Metropoulos Family Trust, et al. v. Franchise Tax Bd., 79 Cal. App. 5th 245, 266, a California Court of Appeal rejected an argument similar to the argument raised by the nonresident taxpayer in this case. In Metropoulos, the court similarly relied on section 17951-4 to hold that nonresident trust shareholders of a unitary multistate S corporation are properly taxed on their pass-through pro rata shares of income from the sale of goodwill because it is business income sourced to California. Like Smith, the nonresident taxpayers in Metropoulos unsuccessfully argued section 17952 was the proper governing law. Consequently, this decision is consistent with Metropoulos and extends the Metropoulos reasoning from unitary S corporations and nonresident shareholders to unitary partnerships and nonresident partners. 

Finally, this decision was designated by the OTA as “pending precedential,” and will become precedential in 30 days, if not otherwise changed. If the facts or legal issues of a precedential opinion are similar to those in a pending appeal, the OTA will generally rely on the precedential opinion when deciding the pending appeal.

Investors in partnerships and other pass-through entities that own or partially own businesses in California should be aware of this case. Also noteworthy, the taxpayer did not have representation on appeal. Sourcing of gain on the sale of partnership interests can be highly nuanced and a target for state auditors. Taxpayers considering selling or purchasing partnership interests in California or elsewhere should proactively discuss the tax ramifications of such a transaction with their state and local tax advisers. 

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