Would-Be Privateers Flounder on the Shoals of Confusion: Part I


We want to thank state and local tax practitioners Jaye A. Calhoun, Bruce P. Ely, and Kelvin Lawrence for pointing out the importance of the case of VAS Holdings & Investments, LLC v. Comm’r of Revenue, Mass in their recent two-part series “VAS Holdings and the Battle Over Taxing Capital Gains” and “Full Speed Ahead: Competing Amicus Briefs in the VAS Holdings Case.” We, the lawyers laboring beneath the decks of the 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, as seen in Comptroller of the Treasury of Md. v. Wynne and Mobil Oil Corp. v. Commissioner of Taxes of Vt. 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: You live in Austin, Texas, and your uncle has devised to you his house in the historic harbor town of Marblehead, Mass. 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 in which, 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.

Here’s 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 nonresident 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 Co. and Int’l Harvester v. Wis. Dep’t of Taxation, 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 Corp. v. Ill. Dep’t of Revenue, 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 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 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.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Bruce Fort is senior counsel at the Multistate Tax Commission. The views expressed herein are his and those of his legal colleagues at the MTC and do not necessarily reflect the views of the MTC or its member states.

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