California: S Corporation Shareholders Must Apportion Gain from S Corporation’s Sale of Goodwill

The California Office of Tax Appeals has concluded that S corporation shareholders must apportion their pro-rata share of the gain on the S corporation’s sale of goodwill using the S corporation’s factors. The taxpayers were electing small business trusts that owned interests in Pabst Corporate Holdings, Inc. (Pabst), an S corporation that did business in California and other states.  Pabst sold its interest in a wholly-owned subsidiary in a transaction that was treated as a sale of assets.  The sale resulted in a capital gain of more than $600 million, which the S corporation reported as apportionable business income. The shareholder trusts initially reported their pro-rata share of the gain on their own returns, apportioning the gain to California using the S corporation’s factors.  Subsequently, the trusts filed for a refund, arguing that the gain should not be apportioned. Rather, because the gain resulted from the sale of goodwill (i.e., an intangible) the trusts asserted the gain should be allocated to the states of the trusts’ commercial domiciles, which were states other than California.

A prior California appellate court case, Valentino v. Franchise Tax Board, had addressed a similar issue. In that case, the court had concluded that pro-rata S corporation income should be characterized first at the S corporation level, and then sourced according to the particular sourcing rules applicable to that type of income. In the recent decision, the OTA opined that the income at issue “was properly characterized as business income, which falls under the sourcing rules of Regulation 17951-4(d) for multistate unitary S corporations,” and not the more general rules of Revenue & Taxation Code section 17952. Two of the three OTA administrative law judges (ALJs) noted that Valentino involved an S corporation that did business solely within California, did not involve intangible income, and was decided prior to the issuance of regulations relating to the apportionment of S corporation income. The ALJ determined that the decision in Valentino provided “helpful guidance,” but the conclusion in the instant case should be controlled by the subsequently-issued regulations. 

The third ALJ, in a concurring opinion, reached the same conclusion using a different legal analysis.  That ALJ concluded that the gain was properly treated as business income from the sale of an intangible using the general rules of Revenue & Taxation Code Sec. 17952, not the S corporation sourcing rules of Regulation 17951-4(d).  As such, the income should be sourced to California to the extent of business done in California.  Because the Pabst apportionment factors reflected the extent of business done in California, the resulting tax liability was the same using either of the ALJs’ methodologies. Please contact Gina Rodriquez at 916-551-3132 with questions on The 2009 Metropoulos Family Trust OTA decision.