The field of state income taxation is constantly evolving and continually riddled with complexity. One particular area pertains to state income taxation of gains arising from sales of interests in partnerships. Sales of interests in partnerships are generally regarded as sales of an intangible asset, the gains from which may typically be sourced to the state of seller’s domicile. However, states have been growing increasingly aggressive in their attempts to include such gains within the broader scope of business income that would generally be subject to apportionment and, therefore, likely taxable by the states where the partnership has nexus or established a business situs. Specifically, there have been two recent state tax decisions that potential taxpayers looking to engage in such transactions should be wary of as part of their general tax planning.

Generally, when an individual sells their ownership interest in a partnership, any resulting gain is treated as a gain from the sale of an intangible property, which is sourced to and taxable by the state of domicile or residency of the individual owner. In contrast, when a business entity owns the interest in a partnership, the same gain from the sale of the ownership interest may be considered business income and subject to apportionment and tax. Some states have taken a more aggressive approach to close the “loophole” on taxpayers evading state income taxation based on sourcing that income to their state of domicile.

In Massachusetts, the gain recognized by a non-resident individual from the sale of a business, including the sale of a general partnership, limited partnership, or LLC interest, may be characterized as a gain from a trade or business that constitutes apportionable Massachusetts income.1 Such gain may be apportioned from a multistate partnership based on the average of the partnership’s apportionment factors reported during the individual’’s period of ownership. Regardless of the state’s rules, there must be a constitutional connection for a state to tax the gain of a non-domiciliary (out of state) business.

The United States Supreme Court has stated in previous decisions that the constitutional connection, through the Commerce Clause, “Dormant” Commerce Clause, and Due Process Clause, is assessed through the appropriate device known as the unitary business principle. In short, there is a unitary business relationship when there is functional integration, centralized management, and economies of scale.2 The divergence among the states is how to interpret the constitutionality of when the gain from the sale of a pass-through entity interest can be taxed when a unitary business relationship does not exist.

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