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, which restricts the application of Section 17952 to nonbusiness income and requires nonresident S shareholders to use California’s corporate apportionment rules for business income to determine the California source of the gain, must be applied over the statute. The court agreed with the FTB, holding the FTB’s quasi-legislative regulation must be given the same “dignity” as a statute and thus the regulation was not “subordinate” to Section 17952.
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 in the hands of the S corporation’s shareholders under the federal S corporation conduit rule and the shareholders must use the corporate apportionment rules to determine how much of the income has a California source for personal income tax purposes.
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 contained within that statute. 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.” However, the Court did not read this language to explicitly require a rule of 100 percent allocation to the state, and the Court declined to construe the regulation as such. 2009 Metropoulos Fam. Tr. v. California Franchise Tax Bd., No. D078790, 2022 WL 1702336 (Cal. Ct. App. May 27, 2022).