- In 2022, the Massachusetts Department of Revenue lost a case at the Supreme Judicial Court involving investee apportionment
- The Supreme Judicial Court ruled that Massachusetts’ attempt to tax nonresidents based upon the activities of the investment in a pass-through doing business in Massachusetts was constitutional, but that Massachusetts’ own statutes did not confer the authority on the state to impose such a tax
- Governor Healey’s FY 2026 budget would amend the statute to allow the state to impose a tax in these circumstances
Background
In 2022, Massachusetts lost a case in its highest court, VAS Holdings & Invs. LLC v. Commissioner of Revenue, 186 N.E.3d 1240 (Mass. 2022), wherein it sought to apply the so-called “investee apportionment” rules to the sale of a pass-through entity doing business in Massachusetts owned by non-residents.
Forvis Mazars Insight: Investee apportionment is a rising trend as states seek to grow tax revenue, especially as it is politically favorable to raise tax revenue from nonresidents.
VAS Holdings
VAS Holdings & Investments LLC (“VASHI”) was an S corporation headquartered in Illinois operating a call center business through various subsidiaries held by Virtual-Agent Services Canada, Inc. (“VAS USA”). In 2011, it entered into a transaction with Thing 5, LLC, (“Thing 5”) which was an LLC owned by two Massachusetts residents and conducted a telephone systems business, focused on hotel clients. The parties formed Cloud 5, LLC (“Cloud5”); the Massachusetts owners of Thing 5 contributed their ownership interest in Thing 5 to Cloud5 in exchange for fifty percent ownership of Cloud5. VASHI contributed its ownership interest in VAS USA (which became a C corporation as a result of the transaction) in exchange for a fifty percent ownership interest in Cloud 5. As a result, Thing 5 operated as a division of Cloud5 (which was treated as a partnership for tax purposes), owned by the Massachusetts shareholders and VASHI, for tax purposes. VASHI subsequently redomiciled to Florida. Cloud5 continued to operate in Massachusetts.
In 2013, VASHI sold its interest in Cloud5 to a third party. VASHI, whose shareholders were not residents of Massachusetts, nonetheless made estimated payments including the gain to Massachusetts. It subsequently reported no gain due and obtained a refund. The Commissioner of Revenue (“Commissioner”) assessed tax upon audit, and VASHI litigated the issue, claiming that it could not be taxed on the gain because its operations were not unitary with Cloud5.
The Supreme Judicial Court ruled that such a tax did not violate the U.S. Constitution, noting that it saw nothing in the Supreme Court’s “…jurisprudence that would preclude the Commonwealth from asserting its taxing authority based on the nexus to Cloud5 and to determine the tax using Cloud5’s apportionment percentage.” Nonetheless, the assessment was overturned; the statutes and regulations being used by the Commissioner did not apply in this instance because VASHI and Cloud5 were not unitary so neither the corporate excise tax nor the nonresident composite tax applied.
On November 30, 2022, the Department of Revenue issued Technical Information Release 22-14 (“TIR”) in response to the VAS Holdings decision. It noted that it would not apply the decision in instances where a pass-through entity and its owner were unitary; where the investment in the pass-through entity served an operational function of the seller’s business; or where a non-resident individual seller was actively involved in the pass-through entity’s business, among other exceptions.
Forvis Mazars Insight: Supreme Court precedent on the unitary business principle can, at times, be inconsistent. It seems that, the reliance on the operational function test, both in the Supreme Judicial Court’s decision and the subsequent TIR seemingly conflict with the holding in MeadWestvaco Corp. v. Illinois Dept. of Rev., 553 U.S. 16 (2008), wherein Justice Alito, writing for a unanimous court, noted, “…our references to “operational function” in Container Corp. and Allied-Signal were not intended to modify the unitary business principle by adding a new ground for apportionment.”
Governor Healey’s FY 2026 Budget
Governor Healey’s current year budget contains two provisions to address the Supreme Judicial Court’s decision in VAS Holdings. Section 33 would modify 62 Mass. Gen. Laws § 5A to treat the business of a pass-through entity as if it were conducted directly by its non-resident owner and provides that apportionment of the gain from the sale of such an entity would be based upon the apportionment of the pass-through entity. Section 38 would modify 63 Mass. Gen. Laws § 38 to provide that gain recognized by a corporation on the sale of an interest in a pass-through entity would likewise be apportioned based upon the apportionment factors of the pass-through entity.
Forvis Mazars Insight: This proposal, like most state tax provisions, is both a sword and a shield. It will benefit Massachusetts based taxpayers selling interests in non-Massachusetts based pass-through entities while burdening those outside of Massachusetts selling interests in Massachusetts based pass-through entities. It lessens, if not outright eliminates, the difference between an asset sale and a sale of an interest in a pass-through entity for Massachusetts. It seemingly contradicts the Supreme Court’s statement in Mobil Oil Corp. v. Commissioner of Taxes of Vermont, 445 U.S. 425 (1980) that"…the linchpin of apportionability in the field of state income taxation is the unitary-business principle."
How Forvis Mazars Can Help
We can help you consider the impact that investee apportionment, both in Massachusetts and elsewhere, can have on the disposition of your business and help so you consider the alternatives available for disposition.