Although the parties only argued the constitutionality of taxing the gain recognized by a nondomiciliary S Corporation from its sale of a 50 percent interest in a limited liability company (“LLC”), the Massachusetts Supreme Judicial Court (“SJC”) ruled that while such taxation is constitutional, it is not permitted under the Massachusetts statutes. VAS Holdings & Investments LLC v. Comm’r of Revenue, No. SJC-13139, 186 N.E.3d 1240 (Mass. May 16, 2022). This case is an important reminder that taxpayers should raise all issues, both constitutional and statutory, when appealing tax assessments. Had the SJC not raised the statutory argument on its own, the assessment would have been upheld by the SJC as being constitutional.
Facts: As the result of capital contributions and mergers, a nondomiciliary S Corporation, VAS Holdings & Investments LLC (“VASHI”), owned a 50 percent interest in an LLC classified as a partnership for tax purposes. The LLC was almost exclusively based in Massachusetts. VASHI itself had no connection to Massachusetts.
VASHI sold its interest in the LLC and recognized a large gain. While VASHI and its shareholders had paid tax to Massachusetts on their distributive shares of the LLC’s income, VASHI asserted that its gain was not taxable because it was not engaged in a unitary business with the LLC.
Although the Department of Revenue (the “Department”) agreed that VASHI and the LLC were not engaged in a unitary business, the Department asserted that it could constitutionally tax the gain due to the protections, opportunities, and benefits that Massachusetts provided to the LLC. Moreover, the Department computed the tax by apportioning the gain to Massachusetts using the apportionment formula of the LLC.
The Decision: The SJC first held that the unitary business principle is not the only way income can be constitutionally subject to taxation. Unlike most decisions where a court will only address constitutionality after it determines that the assessment is proper under the statute, here the SJC first analyzed the constitutional issue. It went through a lengthy analysis to hold the assessment constitutional since the gain was being apportioned using the LLC’s, and not VASHI’s, apportionment formula. The SJC found support for its conclusion based on International Harvester Co. v. Wisconsin Department of Taxation, 322 U.S. 435 (1944) and Wisconsin v. J.C. Penney Co., 311 U.S. 435 (1940), where the U.S. Supreme Court found constitutional Wisconsin’s privilege tax which required a nondomiciliary corporation doing business in Wisconsin to deduct a tax from dividends it paid to its investors, regardless of whether they were domiciled in Wisconsin.
The SJC then held that the Department had no statutory support for taxing the gain. Although raised neither before the Appellate Tax Board nor before the SJC, after oral argument the SJC asked for post-argument briefing on whether the imposition of tax was authorized by statute. After reviewing the statutes, the SJC concluded that the Massachusetts statutes predicated taxation based on the existence of a unitary business or transactions serving an operational function and, therefore, did not permit taxation of the gain. In contrast, the Ohio, New York City, and former New York State tax laws, which use the approach that the Department tried to adopt here, predicated taxation based on the apportionment percentage of the investee rather than the investor.