State tax considerations often get short shrift when planning for the sale of a business or investment held in a partnership.[1] That’s not surprising when we compare federal and state tax rates. But sales of partnership interests can be taxable to a corporate or individual nonresident partner in states that the partner has no other connections apart from the activities of the underlying partnership being sold. Taxpayers and their advisors may be caught unaware of the states in which they could be subject to tax on the gain and miss planning opportunities that could be taken to mitigate the state tax impact. The discussion below of some key similarities and differences in how New York, New Jersey and Massachusetts tax the sale of partnership interests is designed to highlight the important state tax considerations and questions when selling a partnership interest.

I.  Who is the Seller?

Whether the seller is an entity or an individual is the first question in determining when and how a state can tax the gain from the sale of an interest in a partnership.

Whereas a resident of a state is taxed on everything, a nonresident individual is generally only subject to tax on income from a trade, business or profession carried on in the state. Thus, a nonresident individual is typically not subject to state tax on the sale of intangibles, including the sale of a partnership interest, but is subject to tax on the sale of assets if they are connected with or used in a trade or business conducted in the state. But that maxim is not universal. There are instances, as discussed below, where a state may recharacterize the sale of a partnership interest as the sale of assets or treat some gains as connected with a business carried on in the state.

A different analysis may apply if the seller is a corporate partner. Even if a corporation has no activities of its own in a state, if the underlying partnership being sold has nexus with the state, and the corporation and the underlying partner are determined to be engaged in a unitary business, the gain from the sale may be treated as apportionable business income and taxable in the state based on the activities of the partnership in the state.

If the seller is another flow-through entity—a partnership or an S corporation—the income flowing through that entity to the ultimate taxpayer will retain its character and source. But the majority of states now have an elective pass-through entity tax that could be a consideration and benefit to both resident and nonresident owners, at least so long as the federal state and local tax deduction for individuals is still limited to $10,000.

II. What is Being Sold?

1. Partnership interest or assets?

As noted above, with an individual nonresident, the sale of an intangible partnership interest is generally not subject to state tax, whereas the sale of assets triggers apportionable gain. For example, in New Jersey, gain or loss from the sale of a partnership interest “is from an intangible not employed in a trade or business, therefore, not subject to tax for a nonresident.” NJAC 18:35-1.3(h), Example 11. But if the sale of a partnership interest comprises a “complete liquidation” of the partnership, so that 1) the partners cease all activities in the partnership;  2) the partnership distributes or sells its assets; and 3) the partners are required to recognize a gain on their sale of the partnership interests for federal tax purposes, then the gain will be apportioned to New Jersey based on an average of the partnership’s allocation percentage over the prior three years. NJAC 18:35-1.3(d).

In New York, the default rule, like in New Jersey, is that income sourced to the state does not include gains from the sale or exchange of intangible personal property. Tax Law section 631. But New York has important exceptions to that rule. First, suppose the partnership owns real property or cooperative shares in New York state whose fair market value equals or exceeds 50 percent of all the assets of the entity on the date of sale (based on assets owned for at least two years). In that case, the gain from the sale is treated as a gain from the sale of real property. Tax Law section 631(b)(1)(A)(1); TSB-M-09(5)I. New York then taxes a portion of the gain representing the percentage of New York’s “real property” value as a total of the total value of the assets owned by the partnership on the date of sale. This rule applies whether or not an individual is selling the partnership interest or another pass-through entity is the selling partner.

Second, New York treats the sale of certain partnership interests as a sale of assets subject to IRC section 1060. Section 1060 applies when the purchaser treats the transaction as a purchase of assets, the assets purchased constitute a trade or business, and the purchaser receives a basis step-up in the acquired assets. However, New York also treats the sales or transfers of partnership interests that terminate the entity’s status as a partnership as a sale of assets. As such, a seller of partnership interests would need to apportion gain from the sale attributable to goodwill or other intangible assets using the partnership’s New York business allocation percentage in the year of sale. TSB-M-18(2)I. This particular exception to the rule regarding taxing nonresidents on the sale of intangibles can cause considerable confusion since sellers may not be aware that the transaction was subject to IRC section 1060. Proper planning so that the partnership doesn’t terminate upon sale could prevent taxation of New York nonresidents on the gain.   

In Massachusetts, however, it cannot be assumed that the sale of a partnership interest would be a nontaxable transaction by a nonresident. Instead, Massachusetts has a broader statutory basis for taxing such gains, so “income from a trade or business may include income that results from the sale of a business or an interest in a business,” including an interest in a partnership. Mass. Regs. Code 62.5A.1(3)(c)(8). An example in the regulations demonstrates the potentially broad reach of this provision, stating that a nonresident member of an LLC that operates a computer consulting business in Massachusetts is taxed on the gain from the sale of the LLC interest, even though the LLC member only contributed funds to the business upon its creation but took no part in the management or operations of the business. Massachusetts cases, however, along with a Technical Informational Release (TIR 22-14) issued in the wake of the VAS Holdings decision (see below), suggest that Massachusetts will still look for some involvement by the nonresident owner in the business before treating the gain as Massachusetts-source income. See, e.g. Craig H. & Natalia I. Welch, Ma. App. Tx. Bd., No. 339531, 2023 WL 8605708 (Nov. 29, 2023).

In addition, Massachusetts, like New York, taxes the sale of a partnership interest holding real property in the state, whether or not the partnership is otherwise engaged in a trade or business in Massachusetts. Mass. Regs. Code 62.5A.1(6)(e). Where the partnership solely holds real property, the gain from the sale of the partnership interest is allocated to Massachusetts using a fraction of the value of the Massachusetts real property divided by the total value of the partnership’s real property. Mass. Regs. Code 62.5A.1(6)(e)(2).

Thus, an individual investor in a business should be wary of investing in a partnership doing business in Massachusetts. Any gain from the sale of that interest could be subject to tax, even if the nonresident investor has no other connections with the state.

2. Corporate Partners: Does it matter what is being sold?

Corporate partners must also look closely at how states tax the sale of a partnership interest. In most cases, where a partnership is doing business in a state, a corporate partner is treated as having nexus in the state, requiring it to report the income flowing up to it. But what about when it sells the partnership interest itself?  

Many states, such as New Jersey, differentiate between apportionable income—i.e., income arising from or related to the taxpayer’s trade or business—that is taxed in the state based on the corporate partner’s activities in the state and allocable nonbusiness income that is generally taxed in the corporation’s state of domicile. Applied to a corporation’s sale of an underlying partnership interest, the gain is typically treated as apportionable income if the corporate partner and the underlying partnership are engaged in a unitary business. If so, states will use “investee apportionment” to attribute the underlying activities of the partnership in the state to the corporate partner and thus use the partnership’s in-state apportionment factors to tax the gain recognized by the corporate partner.

This principle was laid out in the case of VAS Holdings & Investments LLC v. Commissioner of Revenue, 489 Mass. 669 (2022), where an out-of-state LLC taxed as an S corporation sold its interest in an operating company doing business in Massachusetts. The Commissioner of Revenue argued that the corporate partner benefited from the partnership’s growth in Massachusetts and thus had the authority to tax a portion of the gain. But Massachusetts’ highest court concluded that the statutory framework only permitted the corporate partner to be taxed on the gain if there was a unitary business between the corporate partner and the partnership. Since both parties agreed that there was no unitary business relationship, the court held that VAS Holdings could not be taxed on the gain from the sale of the partnership interest.

In the wake of VAS Holdings, the Massachusetts Department of Revenue issued TIR 22-14 indicating that it would only apply the holding of the case in circumstances where a partnership and its owner were not engaged in a unitary business. Otherwise, any gain would be apportioned to Massachusetts based on the underlying partnership’s apportionment factors unless the gain constitutes nonbusiness income allocated to the corporation’s state of domicile.

New York generally includes gains from the sale of a partnership interest in apportionable business income so long as it is constitutionally permissible. But such gains are generally not included in the receipts factor unless it is determined that the inclusion of such gains “is necessary to properly reflect the business income or capital of the taxpayer.” N.Y. Tax Law section 210-A(G). An alternative apportionment example in the newly enacted regulations highlights what sort of circumstances would necessitate the inclusion of the gain in the receipts factor.. Where the net gain from the sale of a partnership interest constitutes a significant portion of the corporate partner’s overall receipts for that year—constituting 75 percent of total receipts in the example—the corporation must reasonably divide the net gain among the underlying assets owned by the partnership and include those gains in the receipts factor pursuant to the apportionment rules. NYCRR 4-1.6(e), example 3. Goodwill is apportioned to where its value accumulated, using a three-year average of the underlying partnership’s business allocation percentage, NYCRR 4-4.3(e), reflecting New York’s application of the investee apportionment principle. It is noteworthy that in New York, unlike most other states, partnerships use a completely different apportionment methodology (3-factor) than corporations (single factor with market-based sourcing), thus completely turning corporate apportionment on its head in the context of a sale of a partnership interest.

III. Other Considerations

In addition to the state income tax considerations, there may be other state and local tax issues that can arise in the sale of a partnership interest. These can include sales taxes, where an asset sale might include the sale of “hot assets,” such as inventory, or where a state’s bulk sales rules do not include an exception for occasional sales (e.g., New York). Real property transfer taxes may apply to the sale of a partnership interest that involves real property. And, of course, residency changes may impact the taxation of an individual’s owner’s sale of a partnership interest, including in states like New York that have an accrual rule. Under that rule, even if an individual owner changes residency prior to the sale, and even if the transaction is treated as the sale of intangible property not taxable to a nonresident, if the seller’s right to the proceeds is fixed and the amount of the proceeds is reasonably knowable prior to the change in residency, then New York will treat the gain as having accrued prior to the residency change and therefore 100 percent taxable by the state. N.Y. Tax Law section 639.

IV. Conclusion

Tax impacts of a partnership sale, including state tax impacts, should be carefully considered prior to the completion of a transaction. In some cases, proper planning—making sure a transaction is treated as the sale of an intangible versus an asset sale for state tax purposes, e.g., can mitigate state taxation or even double-taxation of the owner’s gain. But even if there are no means to avoid or reduce state taxation of the gain, understanding the total tax impact, including state and local taxes, should be a key consideration in the negotiations of any business sale, including the sale of a partnership.

Elizabeth Pascal, Esq., JD, is a partner in the state and local tax group of Hodgson Russ LLP, with a focus on New York State, New York City, Connecticut and multistate tax issues. She assists individual and business clients with New York State and New York City audits, including residency, withholding tax, unincorporated business tax, commercial rent tax, and corporate tax audits. She can be reached at  epascal@hodgsonruss.com or (716) 848-1622. 

Carissa Conley, CPA, is the owner of Bucknam and Conley CPAs, a prominent firm based in upstate New York that specializes in complex income tax returns for pass-through entities and their owners. With over 20 years of expertise in state and local tax consulting, Carissa is a seasoned professional known for her ability to navigate the intricacies of multi-state tax compliance. Carissa's extensive experience in performing nexus studies and her deep understanding of multi-state and federal tax laws allow her to deliver insightful, relevant advice tailored to her clients' unique business needs. Her commitment to staying abreast of the ever-evolving tax landscape ensures that her clients benefit from proactive planning and advisory services aimed at reducing taxes, maximizing profits, and fostering sustainable growth. A trusted advisor, Carissa takes pride in building strong relationships with her clients, dedicating time to truly understand their business dynamics. Her personalized approach and strategic insights make her a sought-after expert in the field, known for driving value and growth for businesses across various industries.