California Court Holds Nonresidents’ Pass-through Income from Intangibles Is Taxable if It Is Classified as Business Income at the Entity Level.

The California Court of Appeal held a nonresident S corporation shareholder’s pro rata share of gain on the sale of goodwill classified as business income by the S corporation has a California source and is subject to tax for personal income tax purposes to the extent of the S corporation’s California apportionment formula and is not sourced 100 percent to the nonresident shareholder’s domicile.

The case involved the interplay between California’s two income tax schemes, the Personal Income Tax Law and Corporation Tax Law. The nonresident S corporation shareholders contended their pro rata share of gain from the sale of an intangible was not sourced to California under the Personal Income Tax Law’s longstanding mobilia doctrine statutorily codified at California Revenue and Taxation Code Section 17952 (Section 17952). The Franchise Tax Board (FTB) contended a regulation it promulgated under the Personal Income Tax Law must be applied over the statute.  The FTB’s regulation restricts the application of Section 17952 to nonbusiness income and requires nonresident S corporation shareholders to use California’s corporate apportionment rules for business income to determine the California source of the shareholder’s gain for personal income tax purposes.  The court agreed with the FTB, holding the FTB’s quasi-legislative regulation must be given the same “dignity” as a statute and, contrary to California Supreme Court precedent, equated the FTB’s quasi-legislative regulation with Section 17952, and determined the FTB’s regulation was not “subordinate” to the statute.

Because it was undisputed the gain from the sale of goodwill was business income to the S corporation, the court held the income remained business income in the hands of the S corporation’s shareholders under the federal S corporation conduit rule in Internal Revenue Code Section 1366 and the shareholders must use the California Corporation Tax Law’s apportionment rules to determine how much of the income has a California source for purposes of the Personal Income Tax Law.

The court further held that even if Section 17952 applied, the gain from the sale of goodwill would still be subject to tax in California because it met the business situs exception in Section 17952. Under the business situs exception, the court reasoned that allocating 100 percent of income from an intangible to a single jurisdiction is not appropriate when a taxpayer uses the intangible as part of a multistate unitary business. Regulation 17952 provides, “[i]f intangible personal property… has acquired a business situs here, the entire income from the property… is income from sources within this State.” Upending over 80 years of case law to the contrary, the court did not read this language to explicitly require a rule of 100 percent allocation to the state and declined to construe the regulation as requiring such. 2009 Metropoulos Fam. Tr. v. California Franchise Tax Bd., No. D078790, 2022 WL 1702336 (Cal. Ct. App. May 27, 2022).