Massachusetts issues guidance on the sale of pass-through entity interest

Executive Summary: Massachusetts issues guidance following VAS Holdings case

The Massachusetts Department of Revenue issued Technical Information Release (TIR) 22-14 explaining its position on the Supreme Judicial Court’s decision in VAS Holdings & Investments LLC v. Commissioner of Revenue. The guidance clarifies how the department will apply the Court’s decision to source and tax gains from the sale of pass-through entity interests.

Background

On Nov. 30, 2022, the Massachusetts Department of Revenue issued Technical Information Release (TIR) 22-14 explaining its position on the Massachusetts Supreme Judicial Court’s (SJC) decision in VAS Holdings & Investments LLC v. Commissioner of Revenue. The case, decided in May of 2022, addressed the issue of whether the state could tax the owners of an out-of-state S corporation on the gain associated with the sale of an interest in a lower-tier pass-through entity (PTE) doing business in Massachusetts. The S corporation and PTE were not engaged in a unitary business, and the shareholders of the S corporation were not actively engaged in the PTE’s management.

The state high court held that there was no constitutional prohibition preventing Massachusetts from imposing a tax on the gain of the S corporation based solely on the apportionment factors of the underlying PTE; however, the Court ruled in favor of the taxpayer because state law did not authorize this type of taxation in the absence of a unitary business relationship. For a more detailed overview and analysis of the VAS case, please refer to our alert: Massachusetts high court rules out of state investor not taxable on partnership interest gain.

Prospective interpretation

The TIR explains the department’s interpretation of the SJC decision as it applies prospectively and discusses the circumstances in which it will allow abatements for past tax periods. The guidance emphasizes that the holding in the VAS Holdings case is specific to the facts of the case, so the purpose of the TIR is to explain how the decision will be applied to other fact patterns. The content in the guidance focuses generally on situations where the department believes the decision will not apply. As a result, most of the examples in the guidance (outlined below) describe fact patterns where the state will consider a portion or all of the gain on a sale of a PTE interest to be properly sourced to and taxable in the state of Massachusetts:

• The department will not consider VAS Holdings to apply in situations where a PTE and its non-domiciliary corporate owner are engaged in a unitary business. This includes situations where the investment in the PTE serves an operational function to the corporate owner and situations where the corporate owner indirectly engages in unitary business operations through ownership in a tiered PTE structure.
• The department will not consider VAS Holdings to apply where a gain is recognized on the sale of a PTE interest by a non-resident individual who is, or was at any prior time, actively engaged in the PTE’s business operations within the state of Massachusetts.
• To the extent the gain on the sale of a PTE is deemed to be allocable to Massachusetts rather than apportionable, the decision in VAS Holdings will not apply. The guidance describes a situation where the underlying PTE operates only within the state of Massachusetts as an example fact pattern.
• The VAS Holdings decision will not apply to situations where the gain is recognized on the sale of a PTE interest by a resident individual (but a resident may be entitled to a credit for taxes paid to another state).
• The decision has no impact on and does not apply to the proper sourcing and taxation of a PTE owner’s distributive share of income related to ordinary business operations.

Equally important as these scenarios identified where VAS Holdings does not apply, the department clarifies certain instances where the decision will have an impact. For corporations with their commercial domicile within the state of Massachusetts, the case will apply to any gain recognized on the sale of an underlying PTE interest. If the corporation and the PTE have a unitary business relationship, the gain should be apportioned to the state of Massachusetts based on the corporation’s apportionment factor and the flow-up apportionment from the PTE. If the corporation and the PTE are not unitary, the entire gain should be allocated to the state of Massachusetts.

Abatements

The TIR also provides that the department will grant tax abatements based on VAS Holdings to certain out-of-state corporate and individual taxpayers who paid Massachusetts tax related to a sale of a PTE interest in a prior period. However, to qualify for abatement, taxpayers must have very specific facts that align closely with those of the taxpayer in the VAS Holdings case. Among other criteria, taxpayers must be able to support that they paid Massachusetts tax on a gain related to the sale of a non-unitary PTE interest that was sourced to the state based solely on the underlying PTE’s apportionment attributes. Taxpayers who included the apportionment attributes of any other entity in sourcing the gain, who allocated the gain to Massachusetts, who were engaged in a unitary business with the PTE, who disposed of real property in Massachusetts or who disposed of the PTE interest in a transaction treated as an asset sale under section 338 are not eligible for abatement.

Takeaways

The VAS Holdings case has been closely watched by the state and local tax community over the past year, and the constitutionality of the investee apportionment method continues to stir debate. As expected, the department’s interpretation of the VAS Holdings decision is narrow, limiting its applicability to situations where the facts closely mirror those in the case.

Out-of-state individuals and corporations holding an interest in a PTE operating within the state of Massachusetts should carefully review the department’s guidance to understand the potential implications for any planned or potential future exit transactions. Additionally, any taxpayer that paid Massachusetts tax on the gain of the sale of a non-unitary partnership interest in a prior year should work closely with their state and local tax advisor to consider whether abatement may be available under the latest guidance in TIR 22-14.

Taxpayers with questions about the investee apportionment approach, the VAS Holdings decision or the guidance in Massachusetts TIR 22-14 should contact their state and local tax adviser.