November 4, 2021
California Franchise Tax Board issues legal ruling on unitary apportionment principles for pass-through entities and their owners
On October 25, 2021, the California Franchise Tax Board (FTB) issued Legal Ruling 2021-01, Unity of Apportioning Pass-through Entities (Ruling), on how to apply unitary business principles to pass-through entities (such as partnerships, S corporations and limited liability companies treated as either) for the purpose of apportioning state taxes. Specifically, the Ruling discusses situations where a pass-through entity serves as a holding entity of another pass-through entity.
The FTB has issued previous rulings on holding companies and the unitary business principle in the context of corporate shareholders of other corporations. In Legal Rulings 1995-7 and 1995-8, the FTB determined that holding companies will usually be engaged in a unitary business with the operating company whose stock it holds. Legal Ruling 2021-01 similarly applies the rationale described in Legal Rulings 1995-7 and 1995-8 but in the context of pass-through entity holding companies that hold an interest in pass-through entities.
In Legal Ruling 2021-01, the FTB examines the unitary relationships of general partners and limited partners and the relationship between each such type of partner and the operating partnership whose interest is held. The FTB presumes that general partners are unitary with the limited partnerships in which they participate because: (1) general partners control the business of the limited partnership; and (2) the activities of the general partners evidence contribution or dependency between the general partners and the partnership. In contrast, the FTB posits that limited partners are unlikely to be unitary with the limited partnerships in which they have only limited interests because they lack control of, and direction over, the operating partnership.1
The FTB makes four determinations as part of its discussion of unitary business principles in Legal Ruling 2021-01.
First, other, non-traditional factors are more heavily weighted when evaluating unity in the context of a holding company's ownership of a pass-through entity because holding companies often have limited operations (if any), and the traditional unity tests compare business operations. "Those factors include:
Second, the FTB concludes, like the California State Board of Equalization (CA SBE)2 in many decisions on the unitary aspects of holding companies and the entities they own, that a holding company's purpose within the business structure can support a finding of unity. 3 Similar to a corporate holding company, unity is suggested where a holding company that owns interests in a partnership functions as a conduit between its partners and the unitary business that the partnership indirectly owns. In addition, a finding of unity is supported where a holding company functions as a focal point for the operating business, for example, by representing it in relationships with government or other third parties. The FTB holds, however, that unity is not suggested where the holding company merely furthers the investment objective of its parent by acting as a holder of a nonunitary subsidiary. In this way, the FTB's Ruling echoes the CA SBE's "look-through" analysis in Appeal of Fibreboard Corporation4 by recognizing that imposing a holding company into a business structure does not take what is an investment and transform it into a unitary operational subsidiary.
Third, the FTB notes that the traditional unity tests focus "on the combination of purported separate operating businesses or affiliates." The argument for unity becomes stronger, however, when only a single business exists, as in the case of a holding company in a structure that contains a single operating business. Conversely, where a holding company is affiliated with several distinct operating businesses, it becomes more likely that the holding company is merely holding an interest in the investments of its parent, suggesting that unity is not present.
Fourth, the FTB determines and acknowledges that the traditional tests for unity "are not an exact fit in the context of pass-through entity holding companies." In the corporate context, all factors and income of unitary entities are combined for purposes of apportionment. For pass-through interests, however, "an entity is unitary only to the extent of its interest in the pass-through entity." Therefore, the Ruling holds that if a partner is engaged in a unitary business with the partnership and holds a 25% interest, the partner and 25% of the partnership's income and factors are combined. Unlike a unitary group of corporations, pass-through entities need not hold more than 50% of an entity to be unitary with that entity. Thus, where a pass-through entity holding company holds less than a controlling interest in an operating business, unity can still exist between the holding company and the operating business to the extent of the holding company's interest in the business.
The FTB concludes Legal Ruling 2021-01 by applying the four determinations to a series of scenarios.
The FTB's guidance has important implications for all pass-through entities and their owners regarding unitary matters. For example, non-resident individuals may be affected by the presumption that a holding company that is a general partner, managing member or shareholder of an operating company is engaged in the same unitary business because the general partner or managing owner controls the operating company's operations. The Ruling concludes that sourcing of income and apportionment factors of the pass-through entity flows up to the direct or indirect owner of the pass-through entity based on this presumption of control. Thus, based on this Ruling, a non-resident individual who is a direct or indirect owner of a pass-through entity doing business in California could now be presumed to be receiving income that is California-sourced income. Before this Ruling, the non-resident individual would not have been deemed to be in a unitary relationship with the partnership, so the partnership income would not have been presumed to be sourced to California.
The Ruling likely will require all pass-through entities doing business in California and their owners to address the continuing nature of their California tax obligations. Moreover, considering the Multistate Tax Commission's new and ongoing investigation of the state taxation of partnerships generally, it is possible that the FTB's views in the Ruling could influence the tax authorities of other states in their approaches to the taxation of pass-through entities and their owners.
1 Appeal of Gasco Gasoline, 88-SBE-017 (June 1, 1988).
2 In Footnote 11 of the Ruling, the FTB states that precedential opinions of the California State Board of Equalization (CA SBE) may be cited as precedential authority to the California Office of Tax Appeals (to which the CA SBE's administrative appeals authority over FTB decisions was removed in 2018) unless such authority has been removed, in whole or in part, by a panel of the CA OTA.
3 See Appeal of PBS Building Systems, Inc. and PKH Building Systems, Inc., 94-SBE-008 (Nov. 17, 1994).
4 Appeal of Fibreboard Corporation, 87-SBE-002(Jan. 6, 1987).