Gain on Sale of Partnership Interest – Allocable or Apportionable?

by Ibby Michalik, Senior Manager, UHY Advisors, MI Inc.

There are many factors to take into consideration when selling an interest in a passthrough entity. Adding state tax considerations adds another level of complexity. When a pass-through entity operates in multiple states, the taxpayer needs to “increase tax efficiency while minimizing tax risk” according to the Tax Advisor. Taxpayers need to take into consideration how various states treat the gain from a sale of a passthrough entity interest. Many states have a uniform set of apportionment rules that apply to all taxpayers. Other states have separate apportionment rules depending on if the taxpayer is a corporation, a passthrough entity, or an individual.

Once you have determined the gain from the sale, a taxpayer needs to address whether the gain is apportionable business income or allocable nonbusiness income. In general, income is apportionable if it arises from transactions and activity in the regular course of the taxpayer’s trade or business. Allocable nonbusiness income is attributed to a particular state because it is the source of that income. There are factors that may help in determining how to source the gain. Taxpayers may want to review the following items:

  • Who are the owners of the passthrough entity? Are they residents or nonresidents individuals, C corporations, or a tiered entity structure?
  • Is the individual investor active or passive in the business?
  • Where is the principal place from which the trade or business is managed? This may not be the state of incorporation or formation.
  • Is the sale of the passthrough entity an asset sale or are you selling an interest of the passthrough entity? If it’s an asset sale, where is the income-producing property being sold located? If you are selling an interest, you will need to consider how the sale of the intangible is being sourced.
  • If the gain is apportioned, does the state include the proceeds in the apportionment sales factor?

Reviewing state tax statutes may provide help in identifying how a gain of a partnership interest is allocated or apportioned. California indicates that a “gain or loss on the sale of a partnership interest, to the extent it is non-business income, is allocated to California in the ratio of the original cost of the partnership’s tangible property in California to the partnership’s tangible personal property everywhere, determined at the time of sale of the partnership interest. In the event that more than 50% of the value of the partnership’s assets are consistent of intangibles, gain or loss from the sale of the partnership interest is allocated to the state in accordance with the sales factor of the partnership for its full tax period immediately preceding the tax period of the partnership during which the partnership interest was sold.”

New York treats owners of a passthrough entity differently. “Where a corporate taxpayer is a partner in a partnership, any gain or loss that is recognized from the sale of the taxpayer’s interest in such partnership and included in entire net income is business income or loss.”  For non-residents of New York, the gain from the sale of a partnership interest is excluded unless the partnership interest was used in a trade or business carried on in New York.

According to the Tax Advisor, following each state’s specific laws can lead to additional or inequitable taxes since gains are not treated the same among all states. Taxpayers are encouraged to contact their tax professionals to discuss the state tax ramifications of a sale of a passthrough interest.

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