California Rules that S Corporation’s Sale of a Partnership Interest Resulted in Apportionable Business Income

At a glance

• The main takeaway: The California Office of Tax Appeals concluded that an out-of-state S corporation holding company was required to apportion its gain from the sale of a partnership interest, resulting in significant income tax liability to the state.
• Assess the impact: This case is an important reminder of the complexities of determining the state income tax consequences when it comes to the sale of your business or an interest in another business.
• Take the next step: Aprio’s State and Local Tax (SALT) team can recommend possible alternative structures to minimize multistate tax liabilities to help your company comply with multistate income tax obligations. 

Schedule a free consultation today to learn more!

The full story:

In a recently published decision by California’s Office of Tax Appeals (OTA), an S corporation’s gain on the sale of its interest in an LLC (which was treated as a partnership for income tax purposes) constituted business income subject to apportionment.[1] The OTA ruled that the two entities engaged in a unitary business and that the gain satisfied the functional test for business income.

A closer look at the case

Alvaco Trading Company, Inc. (Alvaco), the S corporation, was the largest independent contact lens distributor in the U.S. In 2007, Alvaco created a joint venture with Con-Cise, LLC (Con-Cise), which was the second-largest independent contact lens distributor in the U.S. These entities formed ABB/Con-Cise Optical Group, LLC (ABB) when Alvaco and Con-Cise contributed their operating assets to ABB in return for interests in the LLC (55% and 45%, respectively). 

As a result of the joint venture, ABB became the largest contact lens distributor in the U.S. The case states that during 2012, ABB was doing business in California and had a 29% California apportionment factor. In 2012, Alvaco sold most of its interest in ABB and reported the gain on its California income tax return as nonbusiness income allocated outside of California.

Unpacking the ruling

The first step in this analysis is to determine if Alvaco and ABB constituted a unitary business. A taxpayer that owns an interest in a partnership will include its share of the partnership’s apportionment factors in computing its own apportionment percentage if the taxpayer and the partnership are engaged in a unitary business. Otherwise, the taxpayer will include its share of the partnership’s income that is apportioned to California based solely on the partnership’s apportionment factors. This has particular significance for Alvaco, which happens to be a holding company, because it does not have any apportionment factors of its own. Thus, absent of finding a unitary relationship, there would be no apportionment to California.

The OTA noted that although there isn’t a separate unitary business test in the holding company context, the reality is that with a holding company structure, some of the unitary factors may not exist. As a result, other factors that may normally be viewed as less significant take on added importance because they are the only factors to consider. The OTA then explained why it concluded that Alvaco and ABB satisfied the hallmarks of a unitary business — functional integration, centralized management, and economies of scale.

Alvaco and Con-Cise were the number one and number two U.S. contact lens distributors, and created ABB, which became the number one U.S. contact lens distributor. Alvaco retained its standing as the leading U.S. contact lens distributor through its majority ownership of ABB while absorbing its closest competitor. ABB was given the operational tools (Alvaco’s assets and intellectual property – startup and operating capital) while Alvaco’s CEO and COO became ABB’s CEO and COO. These assets along with the “brains to run and maintain the business” led ABB to become the number one contact lens distributor. These facts satisfy functional integration, centralized management, and economies of scale.

Alvaco argued that even if it and ABB were engaged in a unitary business, the gain did not constitute business income under the “functional test.”[2] It claimed that it did not have control over ABB, and that ABB could not have been integral to its business operations because it became a passive investment vehicle and ceased to carry on any trade or business. The OTA explained that Alvaco’s argument is “misplaced,” and that the property for which control must be shown is its membership interest in ABB, not ABB. 

In applying the functional test, the OTA stated that the “crucial inquiry is the relationship between the property and the taxpayer’s business operations.” That property, Alvaco’s membership interest in ABB, was Alvaco’s only asset and Alvaco managed and controlled that interest. The interest in ABB was a proxy for the business assets Alvaco formerly owned before contributing those assets to ABB, and those same assets previously generated business income for Alvaco. Further, the ABB interest produced most, if not all, of Alvaco’s income. Alvaco, through its CEO and COO, exercised powers associated with the interest, including the appointment of managers and the power to dispose of the interest. Alvaco’s control and use of its interest in ABB materially contributed to its production of business income so that the interest was “interwoven into and inseparable” from its unitary contact lens distribution business. Therefore, the OTA concluded that under the functional test, Alvaco’s gain on the sale of its ABB interest generated business income subject to apportionment. 

The bottom line

This case illustrates the complexities of determining the state income tax consequences when it comes to the sale of your business or an interest in another business. Aprio’s SALT team has experience with analyzing these issues. We can assist you by recommending possible alternative structures to minimize multistate tax liabilities and by ensuring that you comply with your multistate income tax obligations, so that you do not incur unexpected liabilities or penalties.

We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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[1] In the Matter of the Appeals of: Alvaco Trading Company, Inc., OTA Case Nos. 220410259, 220410261, 220410262, 220410263 [2024-OTA-142], 01/23/2024.

[2] The parties agreed that the transactional test for determining business income did not apply.