Would-Be Privateers Flounder on the Shoals of Commerce Clause Confusion, Part I.
We want to thank state and local tax practitioners Jaye Calhoun, Kelvin Lawrence, and Bruce Ely for pointing out the importance of the case of VAS Holdings v. Commonwealth in their two-part series “Vas Holdings and the Battle Over Taxing Capital Gains” and “Full Speed Ahead: Competing Amicus Briefs in the VAS Holdings Case,” recently published in these pages. We (the lawyers laboring beneath the decks of the H.M.S. Multistate Tax Commission) agree that there’s a lot at stake. But what we find “breathtaking” about the case, to use their descriptor, is not that the Massachusetts Supreme Judicial Court is being asked to uphold the principle of source-based taxation of income, but that in 2022 there could be so much disagreement and apparent confusion about concepts of nexus and the role of the unitary business principle in that analysis.
Given the wide chasm separating the positions of the parties in the VAS Holdings case, a proper response should begin with a discussion of some basic principles of state taxing authority, which will help to reveal the source of the disagreement.
First, we hope all would agree that the U.S. Constitution permits states to tax the recipients of income on a source basis or on a residency basis. See Comptroller of the Treasury v. Wynne and Mobil Oil v. Commissioner. (In Mobil Oil, the Supreme Court suggested that if a conflict existed between taxing income on a source basis, that is, by apportionment, versus taxation based on the taxpayer’s domicile, the latter might have to yield to the former as a constitutional matter. But we’re getting ahead of ourselves here.)
As an example of source-based taxation, consider the following scenario: Assume you live in Austin, Texas, and that your uncle has devised to you his house in the historic harbor town of Marblehead, Massachusetts. By the time you are able to sell the house six months later, its value has increased by 20%. Presumably, we would all agree that Massachusetts has the right, as a constitutional matter, to impose a tax on the gain you recognized from the sale.
Now consider an alternative scenario, where instead of immediately selling the house, you decide to keep the property and rent it out, hiring a manager to maintain the property and collect the rent. Are you constitutionally subject to Massachusetts’ authority to impose income tax on your rental income? Of course you are.
What role does the unitary business principle play in either scenario? None. You are subject to the state’s taxing jurisdiction because you own property in the taxing jurisdiction, even though you are not “unitary” with the house or with the rental activity.
A final scenario: you decide the house would be worth more if some major improvements were made. To finance those improvements, you invite two friends to contribute capital to a newly formed LLC that will own the house, with the three partners agreeing to share any rental income and the subsequent capital gain or loss upon its sale. Some years later, you sell your interest in the LLC to an outside investor, triggering a capital gain.
Has the creation of the LLC changed the constitutional analysis regarding Massachusetts’ taxing authority, and if so, how? The tax practitioners suggest that with the creation of the LLC, the state is now deprived of jurisdiction to tax you on the capital gain (but oddly, not the rental income) unless you can be said to be “unitary” with the LLC’s activities carried out in the Commonwealth.
The underlying premise of this argument, though never clearly articulated, is that any capital gain from the sale of an interest in a LLC or other pass-through entity is a function of the investor’s activities, effectively disassociating the gain from the location of the business being sold.
The tax practitioners cite no authority, as an economic or constitutional matter, for the proposition that a capital gain recognized on the sale of a business derives from the activities of the business owner (which would then apparently restrict state taxing jurisdiction to the owner’s domicile or residence) and not from appreciation in values occurring in the state(s) where the business operates.
The Supreme Court has taken a very different view of state taxing authority over non-resident business owners. The Court’s jurisprudence has focused on whether the state has provided protections, opportunities, and benefits to the underlying business; if it has, then the business (and the investors in that business) can be asked for something in return, in the form of taxes. The practitioners’ article suggests, however, that the seminal cases establishing this straightforward due process nexus standard, including Wisconsin v. J.C. Penney and International Harvester v. Wisconsin, are now “outdated,” but the article never explains why that would be so.
In its briefing before the Massachusetts Supreme Judicial Court, VAS Holdings goes further, arguing that the source-based taxing principles embodied in these cases are now “subsumed” under the Court’s unitary business analysis, citing a passage in MeadWestvaco v. Illinois that appears to stand for the opposite proposition. We believe that the argument reflects a fundamental misapprehension of the role of the unitary business principle in nexus determinations. As we explained in our amicus brief, the Court’s unitary business analysis has focused on whether particular activities or sources of income are sufficiently connected to the taxpayer’s business activities conducted within the taxing state so as to permit the income to be included in the apportioned tax base. That is, the Court has applied the unitary business principle in analyzing whether income can be taxed on a source basis. Not surprisingly, then, virtually every unitary business case decided by the Court in the modern era, including MeadWestvaco, has favorably cited the “protections and benefits” nexus standard of J.C. Penney.
The presence of tangible or intangible property interests in the state has long been considered an independent and sufficient basis for asserting taxing jurisdiction over the owner of those interests, regardless of any “unitary” relationship between the interests and the owner. The Court established that proposition nearly a century ago in Whitney v. Graves, which upheld New York’s authority to tax a Massachusetts resident on his capital gain from the sale of a trading rights on the New York Stock Exchange. We think that authority is, or should be, dispositive of the states’ authority to tax a non-domiciliary on capital gain income derived from the sale of a business operating within the taxing state, without an additional showing that the taxpayer was actively engaged in that business.
Would-Be Privateers Flounder on the Shoals of Commerce Clause Confusion, Part II.
In part one of our response to the two-part series on the pending appeal of VAS Holdings v. Commonwealth by tax practitioners Calhoun, Lawrence and Ely, we explained why we think a state can tax a non-resident owner of a pass-through entity operating within a state—on her distributive share income or capital gain income—without demonstrating that the owner controlled and was actively engaged in the underlying business. The presence of the business and its assets within the state is enough.
We do not think that anything said in MeadWestvaco v. Illinois compels a different conclusion, although the case appears to be the source of some confusion. At issue in that case was whether a capital gain derived from the sale of Lexis/Nexis, an information technology business, was sufficiently connected to the taxpayer’s paper business to support inclusion of the gain in the paper business’ apportioned tax base. The Court held that it was not. The MTC and other amici argued that was not the only relevant inquiry, because the activities of Lexis/Nexis within Illinois constituted an independent basis for the state to tax a portion of the capital gain. The MTC’s model general allocation and apportionment regulation contemplates a similar scenario, providing that where a taxpayer has two independent unitary businesses, a separate apportionment formula should be applied to the income arising from each business. Similarly, UDITPA allocates nonbusiness capital gains arising from the sale of real or personal property to the states in which that property is located.
Of course, the Court did not reach this alternative argument, expressly finding that it had not been adequately preserved in earlier pleadings and appeals, remanding the case for further proceedings.
The taxpayer in VAS Holdings conceded that Massachusetts had sufficient authority to tax it on its distributive shares of income from the LLC, likening that to taxing income from dividends. What remains after that concession is an argument that capital gain income from the sale of an LLC operating within a state is so different in kind from the operational income derived from that same LLC that the due process clause permits taxation of one type of income but not the other.
The argument for capital gains “exceptionalism” runs contrary to the Court’s repeated admonition that the source of income, not its form, determines its taxability. See Mobil Oil, ASARCO v. Idaho and Allied-Signal v. Director. The argument runs counter to common sense as well. In our hypothetical rental property scenario, the property owners might have chosen to maximize current income, perhaps by deferring maintenance, or alternatively, could have forgone current profits entirely by making major capital improvements in anticipation of a higher sales price. We cannot identify a constitutional principle that would justify a different nexus standard for taxation of gains versus rental income in that situation.
Taking a somewhat different tack, the tax practitioners fire a salvo at the MTC for failing to address the dormant Commerce Clause in its amicus brief. There is a good reason for that: our brief addressed the application of the law to the facts of the case. The taxpayer did not suggest that the taxation of non-resident LLC owners on their capital gains raised any “structural concerns” affecting the economy generally. Massachusetts’ law at the relevant time only imposed tax on non-resident LLC owners’ capital gains if the LLC had more than 50% of its property and payroll within the state. The state also provided a tax credit for its own residents for taxes paid to other states on a source-basis. The state’s tax structure therefore met the internal consistency test, as no income would have been subject to double taxation if every state adopted an identical tax system. See Wynne. And, where the Appellate Tax Board found that the great majority of the capital gain was attributable to activities that occurred in Massachusetts (where almost all of the LLC’s property and payroll were located) the tax imposition met the external consistency test as well.
Which brings us to the tax practitioners’ most puzzling argument: “some income must be sourced by constitutional rules because it cannot easily be said to have been ‘earned’ in any particular location and that each state must allow other states their own sovereignty to tax—or not tax—the income properly sourced under those rules.” We read the passage as suggesting that one state’s choice to tax non-residents’ income on a source basis interferes with other states’ choice as sovereigns to tax their own residents on all (or none) of their income. These are policy issues that are not currently before the Massachusetts Supreme Judicial Court in VAS. We don’t agree of course that the gain in VAS “cannot easily be said” to have its source in the LLC’s activities undertaken in Massachusetts. But to the extent there might be situations in which one state must yield to the policy choices of another as a constitutional matter (See Mobil, above), it is not at all clear that it is the source-state that would be required to yield. And any such rule would only add to what the late Justice Scalia described as the “bestiary of ad hoc tests” under the “Imaginary Commerce Clause.”
In summary, while the Supreme Court has never ruled on the specific issue presented in the VAS case, it has upheld state taxes on intangibles with a situs in the state (Whitney, 1937) and state taxes on shareholders distributions—to be withheld by the corporation (J.C. Penney, 1940) and International Harvester, 1944), and has also said that there is no difference between capital gains and other types of income for purposes of applying constitutional principles (Allied Signal, 1992). Accordingly, we are confident that these long-established precedents have charted a clear course for the Massachusetts Supreme Judicial Court to steer in upholding the state’s taxing authority in this matter.
Reproduced with permission from [copyright 2022] The Bureau of National Affairs, Inc.