May 12, 2023

Seller’s Beware: State Income Tax Implications on Gains from Sales of Partnership Interests

By Jeremy Katz, Manager, Tax & Business Services & Christian J. Burgos, National Co-Leader - State & Local Tax

Seller’s Beware: State Income Tax Implications on Gains from Sales of Partnership Interests State & Local Tax

The field of state income taxation is constantly evolving and continually riddled with complexity. One particular area pertains to state income taxation of gains arising from sales of interests in partnerships. Sales of interests in partnerships are generally regarded as sales of an intangible asset, the gains from which may typically be sourced to the state of seller’s domicile. However, states have been growing increasingly aggressive in their attempts to include such gains within the broader scope of business income that would generally be subject to apportionment and, therefore, likely taxable by the states where the partnership has nexus or established a business situs. Specifically, there have been two recent state tax decisions that potential taxpayers looking to engage in such transactions should be wary of as part of their general tax planning.

Generally, when an individual sells their ownership interest in a partnership, any resulting gain is treated as a gain from the sale of an intangible property, which is sourced to and taxable by the state of domicile or residency of the individual owner. In contrast, when a business entity owns the interest in a partnership, the same gain from the sale of the ownership interest may be considered business income and subject to apportionment and tax. Some states have taken a more aggressive approach to close the “loophole” on taxpayers evading state income taxation based on sourcing that income to their state of domicile.

In Massachusetts, the gain recognized by a non-resident individual from the sale of a business, including the sale of a general partnership, limited partnership, or LLC interest, may be characterized as a gain from a trade or business that constitutes apportionable Massachusetts income.1 Such gain may be apportioned from a multistate partnership based on the average of the partnership’s apportionment factors reported during the individual’’s period of ownership. Regardless of the state’s rules, there must be a constitutional connection for a state to tax the gain of a non-domiciliary (out of state) business.

The United States Supreme Court has stated in previous decisions that the constitutional connection, through the Commerce Clause, “Dormant” Commerce Clause, and Due Process Clause, is assessed through the appropriate device known as the unitary business principle. In short, there is a unitary business relationship when there is functional integration, centralized management, and economies of scale.2 The divergence among the states is how to interpret the constitutionality of when the gain from the sale of a pass-through entity interest can be taxed when a unitary business relationship does not exist.

In the recent Massachusetts case of Vas Holdings and Investments LLC v. Commissioner3, the Supreme Judicial Court (“SJC”) of Massachusetts addressed the issue of the constitutional constraints on the Commonwealth’s ability to tax a nondomiciliary corporation on the capital gain it reaped from the sale of its partnership interest in a Massachusetts limited liability company. The SJC ruled in favor of the taxpayer, but only because the current Massachusetts statute defines apportionable income by referencing the unitary business principle, stating “a taxpayer’s income subject to apportionment is its entire income derived from its related business activities within and outside of Massachusetts…”.4 In this case, VAS Holdings & Investments, Inc. (“VASHI”), an S corporation, was domiciled and headquartered in Illinois. Its sole asset was its 50% membership interest in Cloud5, a Massachusetts LLC. VASHI sold its 50% interest in Cloud5, realizing a $37 million gain. Massachusetts sought to source 100% of Cloud5 gain to the state under a regulation requiring S corporations to source all the gain from the sale of a partnership interest to Massachusetts if the Massachusetts property and payroll factors were greater than those of any other state. VASHI argued that Massachusetts could not tax any gain from the sale unless the S Corp. and the partnership were in a unitary business.

The Massachusetts SJC ruled in favor of VASHI and held that Massachusetts lacked statutory authority to tax the gain because the Massachusetts statute did not authorize the assessment of tax on an out-of-state business when the unitary business principle did not apply. However, the Massachusetts SJC also determined that it would have been constitutionally permissible for Massachusetts to tax the gain because the Taxpayer reaped the benefit afforded to the LLC by Massachusetts, and the use of the LLC’s apportionment for the gain was constitutionally permissible. This conclusion was reached despite the absence of a unitary asset, business, or relationship.

The Massachusetts SJC holding is contrary to other states’ interpretations of past United States Supreme Court decisions addressing the constitutionality of taxing a non-domiciliary company. In a Utah Administrative Decision5, the Utah State Tax Commission (the “Commission”) addressed the issue of whether it could constitutionally tax an out-of-state corporate taxpayer’s gain on the sale of its interest in a corporation that operated in Utah when there was no unitary relationship between the corporations. The Taxpayer was granted summary judgment on the basis that it was not in a unitary business relationship with the Utah corporation. The Commission cited the Supreme Court decision in MeadWestvaco Corp v. Ill. Dep’t of Revenue6, which provided the state courts erred in considering whether the asset sold (i.e., another business) served an “operational purpose” in the Taxpayer’s business after determining that the asset and the Taxpayer were not unitary. The Utah State Tax Commission interpreted MeadWestvaco to bar jurisdiction over the gain unless there is a unitary relationship between the taxpayer and the company that was sold. The Commission interpreted MeadWestvaco to limit the operational function test to only situations where the asset being analyzed is not a business. This decision and analysis of the constitutionality of taxing the non-domiciliary company is in direct conflict to the Massachusetts SJC, which agreed with the Commissioner of Revenue that the nondomiciliary corporation (VASHI) reaped the financial benefits from its ownership interest in Cloud5, “whose growth is tied inextricably to the protections, opportunities, and benefits afforded to it by the Commonwealth,”7 despite the finding that there was not a unitary business relationship between VASHI and Cloud5, the gain is not includable Vashi’s unitary business income, VASHI is not actively engaged in the PTE’s business or management, and the gain from the sale did not result from an investment that served an operational function such that the gain could be taxed to VASHI on a unitary basis.

While the Taxpayer prevailed in both cases discussed above, the divergent analyses highlight the current challenges in addressing the proper state income tax treatment of gains arising from sales of partnership interests. These cases leave taxpayers with more questions than answers, and the future tax implications remain to be seen. Taxpayers need to be wary of varying state’s statutes regarding their treatment of gain from the sale of a partnership interest, as well as past cases as to how state courts have interpreted the jurisprudence of the U.S. Supreme Court.

Key Takeaways for taxpayers

  • Be aware of the varying state statutes and interpretations of the U.S. Supreme Court’s jurisprudence when it comes to these transactions.
  • Carefully consider the potential tax implications of sales of partnership interests, especially given some states’ conflicting state court decisions and aggressive stances.
  • Consult with tax professionals to navigate the complexities of state income tax treatment for gains arising from sales of partnership interests.


  1. Mass. Regs. Code tit. 830, § 62.5A.1(3)(c)(8).
  2. For purposes of this article, we will not discuss the intricacies of the unitary business relationship.
  3. Vas Holdings & Invs. LLC v. Commissioner, 489 Mass. 669, 186 N.E.3d 1240 (2022).
  4. 830 Code Mass. Regs. § 63.38.1(3) (emphasis added)
  5. Taxpayer v. Auditing Division of the Utah State Tax Comm’n., No. 16-1358, Order for Summary Judgment (Utah St. Tax Comm’n, Jan. 27, 2022)
  6. MeadWestvaco Corp. v. Ill. Dep’t of Revenue, 553 U.S. 16, 128 S. Ct. 1498, 170 L. Ed. 2d 404, 76 U.S.L.W. 4193 (2008)
  7. Vas Holdings & Invs. LLC v. Commissioner, 489 Mass. 669 at 670, 186 N.E.3d 1240 (2022).