The California Office of Tax Appeals (OTA) recently held that a California resident's income tax paid to Massachusetts from the sale of his membership interest in a limited liability company (LLC) doing business in Massachusetts was not eligible for California's other state tax credit. The OTA reached this conclusion while acknowledging that it "will result in the income" from the sale of the membership interest "being double taxed."

The taxpayer in the case, Mr. Buehler, was one of three managing members of an LLC that had an office in Massachusetts and provided portfolio management services for pooled investment vehicles. Buehler "was actively involved in" the LLC's management and operations. After selling his membership interest in the LLC, Buehler filed a Massachusetts nonresident tax return and reported and paid tax on a share of the net gain from the sale of the membership interest, using the LLC's Massachusetts apportionment factors.

The OTA's decision did not question whether Buehler properly determined, under Massachusetts law, the tax owed to Massachusetts from the sale of his LLC membership interest. At that time, the Massachusetts Department of Revenue took the position that such sales of pass-through entity interests were taxable in Massachusetts where the entity conducted business regardless of whether the seller was "unitary" with the entity. (See, e.g., VAS Holdings & Investments LLC v. Comm'r of Revenue, 489 Mass. 669 (2022).) Instead, the OTA focused on the language of California's other state tax credit, which applies to income taxes paid to another state on "income derived from sources within that state." As stated by the OTA, "in order for a California taxpayer to be entitled" to a credit, "income taxes paid to the nonresident state (here, Massachusetts) must be based on income sourced to that nonresident state using California's nonresident sourcing rules." (Emphasis in original).

The OTA determined that under Cal. Rev. & Tax. Code § 17952, the LLC interest was not sourced to Massachusetts because Buehler's LLC membership interest had not acquired a "business situs" in Massachusetts. According to the OTA, Buehler's activities as a managing member of the LLC did not cause the "membership interest itself" to be "integrated into the business activities" of the LLC "in Massachusetts." (Emphasis in original). In other words, while Buehler's "services for" the LLC "as one of its three managing partners may connect him with" the LLC's "Massachusetts business activities, that fact alone does not show that [Buehler's] membership interest was localized in Massachusetts."

The OTA also rejected Buehler's alternative argument that his active involvement in the LLC caused him to "become unitary" with the LLC's business, allowing for combination and apportionment under California Tax Regulation § 17951-4(d). The OTA explained that Buehler did not establish that he was "operating a sole proprietorship or any kind of business activity" separate and apart from the LLC "that could be considered unitary with" the LLC.

The OTA acknowledged that its decision would lead to double taxation of income from the sale of the LLC membership interest but concluded that the other state tax credit "is narrowly drawn" and is not "a panacea for all double taxation." We applaud the OTA's clarification of when intangible personal property has acquired a business situs in a state, and its affirmation of the importance of a unitary relationship between the seller and the entity whose interest has been sold. (See, e.g., MeadWestvaco Corp. v. Ill. Dep't of Revenue, 553 U.S. 16 (2008).)

However, despite the OTA's avowed disclaimers of authority to consider whether the Franchise Tax Board's actions might transgress constitutional requirements (see, e.g., Proposed Title 18 CCR § 30104)-or as Ferris Bueller put it "the question isn't 'what are we going to do,' the question is 'what aren't we going to do'"-under the US Constitution and principles of state sovereignty, it is debatable whether California can deny a tax credit for taxes imposed on the same income by another state simply based on California's view as to what the other state is allowed to tax. Nevertheless, California residents engaged in multistate businesses through LLCs or partnerships should consider themselves warned, if not whipsawed.

Matter of Buehler, OTA Case No. 21067960, 2023-OTA-215P (pending precedential) (issued Feb. 28, 2023).

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