In Part I of our response to the two-part series on the pending appeal of VAS Holdings & Investments, LLC v. Comm’r of Revenue, Mass by tax practitioners Calhoun, Lawrence and Ely, we explained why we think a state can tax a nonresident owner of a pass-through entity operating within a state—on her distributive share income or capital gain income—without demonstrating that the owner controlled and was actively engaged in the underlying business. The presence of the business and its assets within the state is enough.
We do not think that anything said in MeadWestvaco Corp. v. Ill. Dep’t of Revenue compels a different conclusion, although the case appears to be the source of some confusion. At issue in that case was whether a capital gain derived from the sale of Lexis/Nexis, an information technology business, was sufficiently connected to the taxpayer’s paper business to support inclusion of the gain in the paper business’s apportioned tax base. The court held that it was not. The Multistate Tax Commission and other amici argued that was not the only relevant inquiry because the activities of Lexis/Nexis within Illinois constituted an independent basis for the state to tax a portion of the capital gain. The Multistate Tax Commission’s model general allocation and apportionment regulation contemplates a similar scenario, providing that where a taxpayer has two independent unitary businesses, a separate apportionment formula should be applied to the income arising from each business. Similarly, the Uniform Division of Income for Tax Purposes Act allocates nonbusiness capital gains arising from the sale of real or personal property to the states in which that property is located.
Of course, the court did not reach this alternative argument, expressly finding that it had not been adequately preserved in earlier pleadings and appeals, remanding the case for further proceedings.
The taxpayer in VAS Holdings conceded that Massachusetts had sufficient authority to tax it on its distributive shares of income from the LLC, likening that to taxing income from dividends. What remains after that concession is an argument that capital gain income from the sale of an LLC operating within a state is so different in kind from the operational income derived from that same LLC that the due process clause permits taxation of one type of income but not the other.
The argument for capital gains “exceptionalism” runs contrary to the court’s repeated admonition that the source of income, not its form, determines its taxability, as noted in Mobil Oil Corp. v. Commissioner of Taxes of Vt, ASARCO v. Idaho State Tax Comm’n, and Allied-Signal, Inc. v. Dir., Div. of Taxation. The argument also runs counter to common sense. In our hypothetical rental property scenario, the property owners might have chosen to maximize current income, perhaps by deferring maintenance, or alternatively could have forgone current profits entirely by making major capital improvements in anticipation of a higher sales price. We cannot identify a constitutional principle that would justify a different nexus standard for taxation of gains versus rental income in that situation.
Taking a somewhat different tack, the tax practitioners fire a salvo at the Multistate Tax Commission for failing to address the dormant commerce clause in its amicus brief. There is a good reason for that: Our brief addressed the application of the law to the facts of the case. The taxpayer did not suggest that the taxation of non-resident LLC owners on their capital gains raised any “structural concerns” affecting the economy generally. Massachusetts’ law at the relevant time only imposed tax on non-resident LLC owners’ capital gains if the LLC had more than 50% of its property and payroll within the state. The state also provided a tax credit for its own residents for taxes paid to other states on a source basis. The state’s tax structure therefore met the internal consistency test, as no income would have been subject to double taxation if every state adopted an identical tax system, as seen in Comptroller of the Treasury of Md. v. Wynne. And, where the Appellate Tax Board found that the great majority of the capital gain was attributable to activities that occurred in Massachusetts, where almost all of the LLC’s property and payroll were located, the tax imposition met the external consistency test as well.
Which brings us to the tax practitioners’ most puzzling argument: “Some income must be sourced by constitutional rules because it cannot easily be said to have been ‘earned’ in any particular location and that each state must allow other states their own sovereignty to tax—or not tax—the income properly sourced under those rules.” We read the passage as suggesting that one state’s choice to tax non-residents’ income on a source basis interferes with other states’ choice as sovereigns to tax their own residents on all or none of their income. These are policy issues that are not currently before the Massachusetts Supreme Judicial Court in VAS Holdings. We don’t agree, of course, that the gain in VAS Holdings “cannot easily be said” to have its source in the LLC’s activities undertaken in Massachusetts. But to the extent there might be situations in which one state must yield to the policy choices of another as a constitutional matter—as noted in Mobil Oil, above—it is not at all clear that it is the source state that would be required to yield. And any such rule would only add to what Supreme Court Justice Antonin Scalia once described as the “bestiary of ad hoc tests” under the “Imaginary Commerce Clause.”
In summary, while the Supreme Court has never ruled on the specific issue presented in the VAS Holdings case, it has upheld state taxes on intangibles with a situs in the state, as seen in Whitney v. Graves, and state taxes on shareholders distributions—to be withheld by the corporation, as seen in Wisconsin v. J.C. Penney Co. and Int’l Harvester v. Wis. Dep’t of Taxation. It has also said that there is no difference between capital gains and other types of income for purposes of applying constitutional principles, as seen in Allied Signal. Accordingly, we are confident that these long-established precedents have charted a clear course for the Massachusetts Supreme Judicial Court to steer in upholding the state’s taxing authority in this matter.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Bruce Fort is senior counsel at the Multistate Tax Commission. The views expressed herein are his and those of his legal colleagues at the MTC and do not necessarily reflect the views of the MTC or its member states.
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