Colorado Offers Guidance on Corporate Income Tax Treatment of Partnership Sale

In a recent case, Colorado ruled to exclude the gain from the transaction from its sales factor since its inclusion would result in inequitable apportionment.

State income taxes can comprise a considerable cost of a business acquisition or restructuring transaction. The state treatment of the gain from a sale of an entity’s equity or assets, including whether the state will apportion or specifically allocate the income and to what location it will be sourced, varies among the states, and careful consideration must be paid to both how a transaction is structured and how the states’ income tax rules will treat the sale. Colorado recently published a private letter ruling, PLR-16-015, outlining several of the issues which demonstrates the complexity of determining state income tax liability, and can be instructive for transactions with similar fact patterns. [1]

The facts of PLR-16-015 are as follows: A corporate taxpayer owns an interest in a partnership conducting business in several states. The taxpayer is merely a holding company with no activity aside from owning this partnership interest. It files corporate income tax returns in six states where it reports the pass-through income it receives from the partnership’s business operations. As part of the transaction, the holding company first sold a portion of its partnership interest to an unrelated buyer. The holding company’s sole owner, a Colorado-based private equity fund, then sold all of its shares in the holding company to a separate buyer (who is related to the buyer of the partnership interest in the first step). The steps in this transaction were performed at the same time and under the direction of the buying entities. The question at hand is to what extent the original sale of the partnership interest by the holding company is taxable by Colorado.

In order to compute state income taxes on a sale of assets or equity interests, we must determine the tax treatment of gain in each of the states where the seller has a filing requirement. This includes 1) whether the gain from the sale is considered apportionable or allocable income and 2) how the gain/proceeds from the sale should be sourced. [2] In other words, if allocable income, should the gain be allocated to Colorado, and if apportionable income, should the gain be included in the numerator of the Colorado sales factor. (Colorado’s apportionment formula consists of a single sales factor). In this ruling, the Colorado Department of Revenue analyzes these issues as they relate to the taxpayer’s sales of its interest in the partnership.

Colorado first determined that the gain from the sale of the holding corporation’s shares was “business income” which is subject to apportionment rather than specifically allocated to a particular state. Under Colorado law, income is considered business income if it arises “in the regular course of a taxpayer’s trade or business” and includes income from intangible property when the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations. [3] Since the holding company’s sole business activity was to own the partnership interest that would eventually be sold, this sale was within the regular course of its business, and therefore, the income was apportionable business income.

The second issue addressed by the state was whether the gain should be included in the denominator of the sales factor, and if so, should the gain also be included in the numerator (i.e. sourced to Colorado). Generally, gain from the sale of intangible property is sourced to Colorado, and thus included in the numerator of the sales factor when the taxpayer’s commercial domicile, or the principal place from which its business is managed, is located in Colorado. [4] However, state law also provides that items of income may be excluded from the sales factor when necessary to fairly apportion the income of a taxpayer’s trade or business to the state. [5]

Leading up to the transaction, the holding corporation was principally managed from Colorado by its private equity owner, and conducted no active business managed from any other location, facts that seem to indicate a commercial domicile located in the state which would have resulted in sourcing of the gain to the state. However, Colorado ruled the gain should be excluded from the sales factor on the grounds that its inclusion would result in inequitable apportionment.

Colorado based this decision on the following facts: the holding company’s new ownership, which is domiciled outside of Colorado, directed and managed the transaction including the sale of the holding company’s interest in the partnership; the gain was reported to and taxed by all of the other six states where the holding company was filing state returns due to its pass-through income from the partnership, and in each of those six states the taxpayer treated the income as apportionable, and excluded the gain from each state’s sales factor; and inclusion of the gain under the “commercial domicile” apportionment rules would not fairly represent the extent of the holding company’s business activity in Colorado. This decision is notable since the state used its discretion allowed under the apportionment laws to decide in favor of the taxpayer.

This ruling provides insight into the many complex issues that must be addressed when determining how to treat gains from corporate transactions. While Colorado rules are generally similar to other state’s rules, the ultimate outcome may be different depending on how a state interprets and/or applies a particular set of facts to those rules. Aprio’s SALT team is experienced in the state tax consequences of business acquisitions and restructurings and can advise on your company’s transactions in order to minimize unfavorable state income tax results. We constantly monitor these and other important state tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the March 2017 SALT Newsletter. To view the entire newsletter, click here.

[1] CO Private Letter Ruling PLR-16-015 (Sept. 30, 2016).

[2] If allocable income, should the gain be allocated to Colorado, or if apportionable income, should the gain be included in the numerator of the Colorado sales factor? Colorado’s apportionment formula consists of a single sales factor.

[3] CO Rev. Stat. §39-22-303.5(1)(a).

[4] CO Rev. Stat. §39-22-303.5(4)(c)(V).

[5] CO Rev. Stat. §39-22-303.5(7)(b) & CO Code Regs. 39-22-303.5.4(a)(2).

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.