Massachusetts: Capital Gain from Sale of Partnership Interest Taxable in Massachusetts

The Massachusetts Appellate Tax Board recently addressed whether the Commissioner’s imposition of tax on capital gain realized by a non-resident S corporation from the sale of an interest in a Massachusetts LLC violated the U.S. Constitution. The Massachusetts LLC, which was treated as a partnership, had a significant presence in the Commonwealth and at least 300 employees at one point. Importantly, the LLC’s value and operations grew significantly in the years before the sale. The S Corporation had no activity other than holding the interest in the Massachusetts LLC. Under Massachusetts law, an S corporation is subject to corporate excise tax at a specified rate, which is linked to its total receipts for a given taxable year.  Further, non-resident individual shareholders of an S corporation are subject to Massachusetts personal income tax. All parties agreed that the distributive share income from the Massachusetts LLC was properly subject to tax. The disagreement involved whether the gain from the sale of the LLC had the requisite minimum connection to Massachusetts or involved availment of the protections and benefits of Massachusetts law as required by the Due Process and Commerce Clauses of the United States Constitution. The taxpayer made a couple arguments supporting its position that Massachusetts could not tax the gain. The first appeared to be that because the S Corporation and the LLC were not engaged in a unitary business and the investment in the LLC did not serve an operational function, the assessments at issue sought to tax extraterritorial values in violation of the United States Constitution.  The Board disagreed, determining that the taxpayer’s “almost singular” focus on the unitary business principle was too narrow. After reviewing a line of cases addressing investee taxation (notably International Harvester and two New York State decisions involving Allied Signal), the Board determined that the business activities that gave rise to the gain necessarily involved availment of the protection, opportunities and benefits given by Massachusetts and which “b[ore] an inherently rational relationship to the manner in which that income was generated.” The taxpayer next asserted that while the distributive share income was taxable because the activities generating the income had a connection to Massachusetts, in contrast, the act that gave rise to the gain from the sale of the LLC interest did not have the requisite connection to Massachusetts. The Board, noting that the taxes imposed by the Commonwealth were not transaction taxes, rejected this position holding that the gain was dependent on and resulted from the Massachusetts business operations of the LLC and its growth in the years before the sale. In the Board’s view, to argue that the activities underlying the gain and the taxpayer’s connection to Massachusetts were distinct for Constitutional purposes would “‘trivialize[] the years of work and business effort that developed the value’” of the taxpayer’s interest in the LLC. In conclusion, the Board upheld the assessments. Please contact Nick Sequeira at 617-988-1787 with questions on VAS Holdings & Investments LLC v. Commissioner of Revenue.