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California Taxes Gain on Partnership Sale: In the Matter of the Appeal of L. Smith

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A recent decision from California’s Office of Tax Appeals (“OTA”) determined that a non-resident taxpayer had to pay tax on the gain from a business sale where the business sold was unitary with the holding company that was the seller.

In the case, In the Matter of the Appeal of L. Smith, OTA Case No. 20036033 (Dec. 7, 2022), the taxpayer, an individual (“Taxpayer”), held an indirect ownership interest in the partnership, SOSV, LLC (“Holdco”), a holding company. In the year of the sale (2012), Holdco had no tangible property (real or personal), no payroll or other operating expenses, and no sales of its own, but held a 50.50% membership interest in Shell Vacations, LLC (“Shell”), an Arizona-based company, also treated as a partnership, that was in the business of owning and developing timeshares and vacation club memberships. A portion of Shell’s business was in California. The gain at issue was from Holdco’s sale of its ownership interest in Shell.

The Taxpayer took the position that the sale of Holdco’s interest in Shell was the sale of an intangible asset. The Taxpayer took the position that, since the interest in Shell did not have a business situs in California, the gain should be sourced under R&TC section 17952, dealing with non-resident income from the sale of intangibles. This method of sourcing would allocate the gain to the Taxpayer’s home state of Illinois. However, the OTA, agreeing with the California Franchise Tax Board (“FTB”), determined that R&TC section 17952 was not the applicable rule; rather, in the case of income from a unitary business, R&TC section 17951-4 applies. This method views the gain as apportionable business income, flowing up Shell’s apportionment factors to Holdco to determine the portion of the gain taxable by California under its adoption of UDITPA rules.

Unitary Business Analysis

To reach the conclusion about which apportionment rule applies, the OTA had to review whether the relationship between Holdco and Shell was unitary. While acknowledging the continued legitimacy of the “three unities test” for a unitary business, the OTA applied the “dependency or contribution test,” a somewhat streamlined alternative to the three unities test that originated with Butler Bros. v. McColgan (1942) 315 U.S. 501. The dependency or contribution test originated with Edison California Stores, Inc. v. McColgan (1947) 30 Cal.2d 472, 481, and has been cited as an example of a unitary business test by the U.S. Supreme Court.[1] While overlapping considerably with the three unities test, the dependency or contribution test simply asks whether the “operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state.” The OTA cites Appeals of PBS Building Systems, Inc. (94-SBE-008) 1994 WL 719050, “the most recent California decision (administrative or judicial) in the holding company context,” for guidance in its unitary business analysis. In PBS Building, the Board of Equalization (“BOE”) discussed some of the reasons a holding company provides significant advantages to its operating company, even though traditional factors such as intercompany product flow do not exist in this relationship. In the absence of such traditional contributions, other factors, such as shared tax benefits, intercompany financing, or improved credit worthiness, “take on added importance because they are the only factors to consider.” In PBS Building, the likelihood of unity was reflected in the observation, noted by the OTA in L. Smith, that “when a group of corporations conduct only one business, it is expected that the requisite contribution or dependency would exist between the holding and operating companies.”

Applying the contribution or dependency test to Holdco and Shell, the OTA found (1) “significant management overlap” between the two entities in the form of a single person being the sole manager of Holdco and the CEO of Shell; (2) Holdco had approved and recommended that Shell enter into two external loan agreements; (3) the Shell LLC agreement naming Holdco and the external owner as the owners of Shell, contained a non-compete provision between Holdco and Shell. All these factors indicate unitary operations because they each represent a contribution of value from Holdco to Shell. Although the Taxpayer advanced some arguments against a finding of unity, the OTA held that the Taxpayer did not meet his burden of showing the entities were non-unitary. Because the entities were found to be unitary, the gain on Holdco’s sale of its interest in Shell was found to be apportionable income “using Holdco’s share of Shell’s apportionment factors.”

Although the OTA decision marks the end of the Taxpayer’s administrative appeals, the Taxpayer may choose to bring an action in superior court for a trial de novo.


This California case shows the analysis of determining the apportionability of income in the situation where a holding company recognizes income from the sale of a partnership interest. The analysis turns on whether the holding company is unitary with the operating company. In California there is a presumption of unity when a holding company owns an interest in a single business enterprise. This presumption, based on cases such as PBS Building, was expressed by the FTB in Legal Ruling 2021-01: “[W]hen the purpose of a holding company is to hold and control a single unitary business on behalf of its shareholders, the holding company will be treated as unitary with the operating subsidiaries which it holds.”[2]

As seen in the discussion above, California has judicial authority creating a presumption of unity between holding companies and their operating subsidiaries. Such authority does not exist in all states, and some may even take a contrary approach, requiring a party to affirmatively establish unity based on a test for unity that has been accepted in that state. The Taxpayer in L. Smith was unable to overcome California’s presumption of unity. Once unity has been found, California law requires the apportioning of income to California if the company has earned income within the state. When the operating company is a pass-through entity, its factors flow up to the holding company and apportionment is calculated using the holding company’s proportionate share of those factors. Individual taxpayers who own, directly or indirectly, an interest in the holding company are taxed on their proportionate share of the holding company’s gain, as was the Taxpayer in L. Smith.

For advice on the multistate tax impact of the sale of a business, please contact any ZHF professional.

[1] Barclays Bank Plc v. Franchise Tax Bd (1994), 512 U.S. 298, 304 (fn. 1). The Court’s footnote also lists the test from Allied Signal v. Director, Div. of Taxation, 504 U.S. 768, 781-820 (1992), that looks to functional integration, centralization of management, and economies of scale.

[2] California Franchise Tax Board, Legal Ruling 2021-01: Unity of Apportioning Pass-through Entities (Oct. 25, 2021) p. 4 (internal footnotes removed).

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