June 13, 2022
Massachusetts high court holds commonwealth lacked statutory authority to tax out-of-state taxpayer's capital gains from sale of in-state partnership interests
In VAS Holdings & Investments LLC,1 the Massachusetts Supreme Judicial Court (MA SJC) held that the commonwealth lacked statutory authority under the unitary business principle to impose corporate excise and nonresident composite taxes on gain that an out-of-state limited liability company (LLC) treated as an S corporation and its nonresident owners realized from selling its interests in an in-state LLC treated as a partnership. In so holding, the MA SJC reversed an earlier decision of the Massachusetts Appellate Tax Board (MA ATB). As part of its decision, the MA SJC held that it would have been constitutionally permissible for Massachusetts to tax this capital gain.
The MA DOR filed a motion for reconsideration on June 13, 2022.
VAS Holdings & Investments LLC (VASHI), which had elected to be treated as an S corporation for federal income tax purposes, was not located or operating in the commonwealth. In 2011, Cloud5, LLC (Cloud5) was formed to effect the merger of VASHI and Thing5, LLC (a Massachusetts LLC). To effectuate the business combination, VASHI contributed the stock of its wholly owned subsidiary, VSA USA, to Cloud5 in exchange for a 50% membership interest in Cloud5, and Thing5 LLC contributed its business to Cloud5 in exchange for a 50% membership interest in Cloud5. Through these contributions, Thing5 and VSA USA both became wholly owned subsidiaries of Cloud5.
Following the merger: (1) The business operations of VAS Canada (a wholly owned subsidiary of VAS USA) and Thing5 were integrated; (2) Thing5's employees in Massachusetts took over the functions previously performed by VASHI employees outside of Massachusetts; and (3) VASHI no longer had any employees or operations and did not own or lease any property or participate in the operations of Cloud5 (VASHI's only asset consisted of its member interests in Cloud5).
Between 2011 and 2013, the value of Cloud5 increased due to business activities primarily conducted in Massachusetts. In 2013, VASHI sold its 50% membership interest in Cloud5, realizing over $37 million in capital gain.
Following an audit, the Massachusetts Department of Revenue (MA DOR) issued a notice of assessment and imposed corporate excise and nonresident composite taxes on the capital gain VASHI recognized from the sale of its interests in Cloud5. In upholding the assessment, the MA ATB concluded that the commonwealth's taxation of the capital gain did not result in the impermissible taxation of extraterritorial values. The MA ATB also found that most of the capital gain was attributable to the increase in value of Cloud5 between the dates of the business merger and VASHI's sale of its interests in Cloud5, and that this increased value, as well as the capital gain, "were inextricably connected to and in large measure derived from property and business activities in Massachusetts." Critically, the MA DOR and the taxpayers stipulated that VASHI was not engaged in a unitary business with Cloud5.2
VASHI directly appealed the MA ATB ruling to the MA SJC, arguing that "[t]he 'unitary business principle' is the only constitutionally permissible methodology pursuant to which the Commonwealth may impose a tax on such capital gain." The MA DOR conceded that the capital gain was not taxable under the unitary business principle and the facts of this case, but still argued that the capital gain was nevertheless taxable because the gain reflected Cloud5's "growth in the Commonwealth."
MA SJC reverses MA ATB
The MA SJC first agreed with the MA DOR that Massachusetts has the constitutional authority to tax the capital gain realized by VASHI on the sale of its interest in Cloud5. The court noted that the Due Process and Commerce Clauses of the US Constitution require "some definite link, some minimum connection, between a [S]tate and the person, property or transaction [the state] seeks to tax."3 Because VASHI, through its interest in Cloud5, "reaped the benefits afforded to Cloud5 by the Commonwealth," the court reasoned, the protections, opportunities and benefits provided by Massachusetts to Cloud5 were sufficient to create nexus between Massachusetts and VASHI under the US Constitution. Thus, Massachusetts has constitutional authority to tax the capital gain realized by VASHI on the sale of its interest in Cloud5.
Turning to the unitary business argument, the MA SJC found that the unitary business principle is not the only apportionment method under the US Constitution that taxing states can use, finding that "the [US Supreme] Court has declined repeatedly to prescribe a particular formula for State taxation … " The MA SJC noted that it found no "[US Supreme] Court jurisprudence that would preclude [Massachusetts] from asserting its taxing authority based on the nexus to Cloud5 and to determine the tax using Cloud5's apportionment percentage."
Despite finding that imposition of the tax was constitutional, the MA SJC ultimately determined that Massachusetts, which adheres to the unitary business principle, lacked the statutory authority to tax VASHI's capital gain on the sale of its interests in Cloud5 because VASHI and Cloud5 were not engaged in a unitary business and VASHI's commercial domicile was located in Florida. Massachusetts law4 does not authorize the assessment of corporate excise tax on out-of-state business when the unitary principle does not apply.
As for the nonresident composite tax, the MA SJC rejected the MA DOR's argument that it could tax the capital gain under 830 Code Mass. Regs. Section 62.5A.1(3)(c)(8), which allows capital gain from the sale of a business to be taxed "[i]f a non-resident has a trade or business … carried on in Massachusetts." VASHI, the MA SJC determined, did not carry on a trade or business in Massachusetts.
If the decision stands, taxpayers with similar facts to VASHI's should consider filing a refund claim. While the taxes were not authorized under these facts, state legislators and tax authorities could impose new state taxes on their nonresident owners' so-called investee apportionment5 gain based on the MA SJC's conclusion that the constitution does not preclude the imposition of state taxes on the sale of interests in pass-through entities.
1 VAS Holdings & Investments LLC v. Commissioner of Rev., 489 Mass. 669 (2022) (Slip Opinion) ().
2 See MA ATB ruling in VAS Holdings & Investments LLC v. Commissioner of Revenue, Dkt. Nos. C332269 & C332270 at 2020-520 (Oct. 23, 2020) ("The [taxpayer] and the [MA DOR] agreed that none of the three hallmarks of a unitary business is present in these appeals.").
3 Id. (citing Allied-Signal, Inc. v. Director, Div. of Taxn., 504 U.S. 768, 777 (1992), quoting Miller Bros. Co. v. Maryland, 347 U.S. 340, 344-345 (1954)).
4 VAS Holdings Slip. Op. at 29-30 (citing e.g., Mass. Gen. Laws ch. 63, Sections 32B, 32D and 38 (references to "unitary business" concepts).
5 See MA ATB ruling in VAS Holdings & Investments LLC v. Commissioner of Revenue, Dkt. Nos. C332269 & C332270 (Oct. 23, 2020) ("The so-called 'investee apportionment' methodology focuses on taxation of a taxpayer's income that is derived from another entity, via investment or otherwise, which is based on the other entity's property and activities in the taxing state.")