The Vast Reach of California Tax: A Dispute Over the Taxation of Nonresident Trusts’ Gain from Sale of Out-of-State S Corporation’s Subsidiary

On May 27, 2022, the Fourth District Court of Appeal issued a published decision in The 2009 Metropoulos Family Trust et al., v. California Franchise Tax Board, 2022 WL 1702336 (Cal.App. 4 Dist., 2022) (“Metropoulos”), upholding the trial court’s decision that a nonresident shareholder’s gain from an S corporation’s sale of goodwill is subject to tax in California.

In 2014, the Metropoulos Family Trust and The Evan D. Metropoulos 2009 Trust (the “Trusts”) respectively held 20 percent and 39.5 percent interest in Pabst, a Delaware S corporation based in Connecticut.  Pabst Holdings, Inc. was wholly owned by Pabst.

In November 2014, Pabst sold Pabst Holdings Inc., in a transaction treated as an asset sale for federal income tax purposes.  That sale resulted in a long-term capital gain that Pabst initially reported as apportionable business income on its 2014 California corporate tax return.  Pabst, using its 6.6% California apportionment percentage, apportioned 6.6% of the gain to California on its 2014 return.  The trusts also treated the flow-through gain from the sale as apportionable California income and paid approximately $3.6 million in California taxes for the 2014 tax year.

In June 2016, the Trusts amended the 2014 returns, seeking a refund of the taxes paid based on the argument that since the gain was from the sale of an intangible asset, it was not subject to California taxation according to Revenue and Taxation Code section 17952 (“Section 17952”), which provides that “income of nonresidents from stocks, bonds, notes, or other intangible personal property is not income from sources within this state unless the property has acquired a business situs in this state. . . .”

In 2017, the Trusts appealed the Franchise Tax Board’s (“FTB”) denial of the refund claims to the Office of Tax Appeals (“OTA”), which upheld the FTB’s decision to deny the refunds in an opinion issued in November 2019.  In March 2020, the Trusts filed suit in the superior court, seeking a refund of the over $3.6 million in taxes paid.

The Trusts argued at trial that “none of the income at issue was taxable under California law because the trusts were nonresidents: neither had a California resident fiduciary or California resident noncontingent beneficiaries at any relevant time.”  Furthermore, the Trusts “alleged that the income was not taxable even under the theory that the trusts’ income was derived from California sources” because “Pabst realized capital gains from the sale of intangible personal property—goodwill—and under S corporation pass-through rules, the trusts’ pro rata share of that income was likewise realized from goodwill.”  Therefore, under Section 17952 and the Fourth District Court of Appeal’s prior decision in Valentino v. Franchise Tax Bd. (2001) 87 Cal.App.4th 1284 (“Valentino”), the income should be wholly allocated to the Trusts’ state of residence.

The FTB argued that because the S corporation, Pabst, had characterized its income as apportionable business income the conduit rule meant that the trusts’ flow-through income from the sale was also business income.  As business income, the FTB contended that the income was subject to tax under Revenue and Taxation Code section 17951 (“Section 17951”), and regulation section 17951-4.  The FTB believed Section 17952 was inapplicable in this case because it does not apply to business income.  Furthermore, the FTB reasoned that even if Section 17952 did apply, the Trusts’ income was still taxable because the goodwill was “used to do business in California.”  Since Pabst had a California apportionment percentage of 6.6 percent, the FTB maintained that at least that percentage of the subsidiary’s goodwill acquired a business situs in California, and was consequently subject to California taxation.

Both the FTB and the Trusts moved for summary judgment, and the superior court granted the FTB’s motion.  The superior court ruled that “S corporation shareholders are bound by however an S corporation chooses to characterize and allocate its income for tax purposes, and noted that the tax regulations provided that business income is apportioned at the S corporation level, not the shareholder level.”  Since Pabst had categorized the income at issue as business income, the Trusts were bound to treat the income at issue as business income on their federal and California tax returns.  Moreover, the superior court agreed with the FTB that even if Section 17952 applied, the income would still be taxable in California because the goodwill had acquired a business situs in California.

On appeal, the court of appeal upheld the trial court’s decision.  In the decision, the court of appeal held that Section 17952 is an exemption statute, and not a taxing statute.  As an exemption statute, the court believed that the statute should be “construed strictly against the taxpayer” and any doubts “must be resolved in the FTB’s favor” and not the Trusts.

Furthermore, the court of appeal stated that “because the Legislature granted [FTB] substantive rule-making power in section 17954, its regulation 17951-4—which is specific as to nonresident S corporation shareholder distributive share of income—is ‘to be accorded the same dignity’ as a statute such that it does not subordinate to section 17952.”  As a result, the court concluded that “as between laws generally sourcing nonresident gross income of intangibles and one sourcing income of nonresident shareholders of S corporations carrying on a unitary business, the latter controls over the former.”

Finally, the court of appeal also disagreed with the Trusts’ contention that regulation section 17952 is a rule of allocation that would require 100 percent allocation of the goodwill income to the state where the intangible has acquired a business situs.  The court wrote, “Nor do we glean a 100 percent allocation rule from regulation 17952, stating that where intangible property has a business situs in this state, ‘the entire income from the property’ is income from sources within this state.  The regulation speaks to the entirety of the income, not the entirety of the goodwill.  Its plain terms does not reflect a rule of 100 percent allocation.”  As a result, the court of appeal agreed with the trial court’s assertion that even if the income at issue was governed by Section 17952, it would still be subject to tax based on Pabst’s 6.6% apportionment percentage, as a portion of the goodwill acquired a business situs within the state.

The California Supreme Court denied the petition for review and requests for depublication on August 24, 2022.

The outcome in this case will have widespread impacts on any taxpayer within California’s vast reach beyond its borders.  The Metropoulos ruling upended longstanding taxpayer protections, such as the maxim that any doubts regarding taxing statutes should be resolved in favor of the taxpayer.  Furthermore, the court of appeal ruling allowed an administrative regulation to overrule a statute as it was more “specific to nonresident S corporation shareholder distributive share of income.”  With the overturning of these crucial taxpayer protections, the fallout from this case will be interesting to see going forward.[i]

[i] Disclosure:  Bewley, Lassleben & Miller, LLP has filed an amicus letter in support of the taxpayer in The 2009 Metropoulos Family Trust et al., v. California Franchise Tax Board.