Can California tax a nonresident shareholder's share of an S corporation's gain on selling its business?

The three rules and the order in which they apply

A nonresident computes California taxable income from gross income derived from California sources (RTC section 17951). Three rules decide what counts when an S corporation sells its business.

The first is the intangible-property rule. Section 17952 provides that income of a nonresident from stocks, bonds, notes, or other intangible personal property is not income from sources within the state unless the property has acquired a business situs in the state. The regulation gives the business situs test its content: intangible property has a business situs in California if it is employed as capital in the state, or if its possession and control has been localized in connection with a business, trade, or profession in the state so that its substantial use and value attach to and become an asset of that business (Cal. Code Regs., tit. 18, section 17952(c)). Goodwill is intangible personal property.

The second is the apportionment rule for business income. Section 17954 provides that a nonresident's gross income from sources within and without the state is allocated and apportioned under rules and regulations prescribed by the Franchise Tax Board. The regulation under that grant, section 17951-4, covers a nonresident's income from a business, trade, or profession. Subdivision (a) addresses a business conducted wholly within or wholly without California. Subdivision (d) addresses a nonresident partner in a partnership carrying on a unitary business within and without the state: the partnership's total business income is apportioned at the partnership level under the Uniform Act, RTC sections 25120 through 25139 (section 17951-4(d)(1)), and each partner's distributive share of the business income apportioned to California is income from California sources. A separate paragraph, originally (d)(3) and moved to (d)(4) by the 2018 amendments, sources a partner's share of items that are not business income under sections 17951 through 17955 as if the activity were undertaken by the partner individually. Subdivision (f) applies those partnership rules to a nonresident shareholder's pro rata share of S corporation income.

The third is the conduit rule that links the shareholder to the corporation. Under Internal Revenue Code section 1366(b), the character of any item in a shareholder's pro rata share is determined as if the item were realized directly from the source from which the corporation realized it. California applies Subchapter S except as otherwise provided (RTC section 17087.5), while keeping the S corporation itself subject to an entity-level tax at a reduced rate (RTC section 23802).

The order matters. The conduit rule fixes the character of the gain at the corporate level. Business income goes to the apportionment rule through subdivision (f), and section 17952 never engages; nonbusiness income goes to sections 17951 through 17955, where section 17952 decides the question.

Valentino and the conduit rule

The Court of Appeal first applied the conduit rule to nonresident S corporation shareholders in Valentino v. Franchise Tax Board (2001) 87 Cal.App.4th 1284. The S corporation there did business wholly within California, and the nonresident shareholders argued that their income was income from stock, an intangible, sourced to their domicile under section 17952 and the doctrine of mobilia sequuntur personam. The court disagreed: a shareholder's income is characterized by reference to the corporation's income-producing activity, and once characterized it is sourced under the rule applicable to that type of income, so the shareholders' pro rata shares of California business income were California-source income.

Valentino also said what section 17952 still does: it never applies to a shareholder's share of S corporation income unless the corporate income itself is derived from intangibles, and it continues to apply as before Subchapter S, to stock dividends and income from the sale of stock. The Franchise Tax Board amended regulation 17951-4 later in 2001, effective January 23, 2002, to add the S corporation language in subdivisions (d) and (f); the regulation now says expressly what Valentino had inferred.

That sentence is the hinge of the later litigation, because a business sale produces gain mostly from goodwill, an intangible. Read one way, Valentino puts goodwill gain under section 17952 even when the corporation treats it as business income; read the other way, it describes passive intangible income and leaves business income to the regulation.

Metropoulos: the regulation controls, and the goodwill had a situs here anyway

The question reached the Office of Tax Appeals in 2019 and the Court of Appeal in 2022. A Delaware S corporation operating a unitary business within and without California sold its operating subsidiary, a qualified subchapter S subsidiary, in a transaction treated as an asset sale for tax purposes, with the gain attributable to goodwill. The corporation reported the gain as apportionable business income at an apportionment percentage of 6.6 percent. Two shareholder trusts, treated as nonresidents for purposes of the appeal, reported their pro rata shares the same way, then filed refund claims asserting that gain on goodwill was intangible income sourced to their domicile under section 17952.

The OTA denied the claims in a precedential opinion (Appeals of The 2009 Metropoulos Family Trust, 2019-OTA-385P, Nov. 7, 2019). The majority held that income from the sale of intangibles characterized as business income at the S corporation level is apportioned to California under the corporate-level formula, in accordance with regulation 17951-4(f) and (d)(1), and is not sourced under section 17952. It read Valentino as a two-step process, character first and then the sourcing rule for that character, and found in the amended regulation an explicit set of instructions for a multistate S corporation that Valentino, decided on intrastate facts before the amendment, did not have. A summary decision of the former Board of Equalization that the trusts raised was set aside because it states on its face that it is not to be cited as precedent.

One administrative law judge concurred on a different path: section 17952 does reach intangible income outside the corporation's regular trade or business, and a one-time sale of a business produces that kind of income; but goodwill is created and localized wherever a unitary business is conducted, so the goodwill had acquired a business situs in California in part, and because regulation 17952(c)'s reference to the entire income from property with a business situs modifies the income rather than the property, an asset can acquire a situs partly in California. Absent evidence of where the goodwill was built, the concurrence would have measured the California portion by the corporation's as-filed apportionment percentage, so the two paths produced the same number.

The trusts sued for refund and lost, and the Court of Appeal affirmed (The 2009 Metropoulos Family Trust v. Franchise Tax Board (2022) 79 Cal.App.5th 245). It held that the nonresident shareholders of a unitary multistate S corporation are taxed on their pass-through pro rata share of the gain as business income sourced to California under the Uniform Act, the gain having been business income to the corporation. Because the Legislature granted the Franchise Tax Board rulemaking power in section 17954, regulation 17951-4, which speaks specifically to a nonresident S corporation shareholder's share, is accorded the same dignity as a statute and does not subordinate to section 17952. The court did not read Valentino as placing unitary business income from an intangible asset under section 17952.

The court also reached an alternative ground: even if section 17952 applied, the goodwill had acquired a business situs in California because the corporation apportioned the gain to California as business income; facts that the business was managed and marketed from the state contributed but were not necessary. It added that a situs finding did not require sourcing the gain on all of the goodwill to California where the gain was apportionable business income, apportionment of intangible values among the states in which a unitary business operates being an accepted method. The Supreme Court of California denied review and depublication on August 24, 2022 (S275377).

What the rule produces in practice

Once the gain is business income apportioned at the corporate level, the shareholder's California-source share is the corporation's California-apportioned gain multiplied by the ownership percentage. Three consequences follow.

First, the number is the corporation's number. The shareholder reports what the California Schedule K-1 shows and does not re-source the gain by residence; the shareholder's own facts, including never having set foot in California, do not change it. The library's California article on the section 338(h)(10) election walks through the parallel point for a deemed asset sale.

Second, the sale itself may not enter the sales factor. Receipts from a substantial and occasional sale of property outside the regular course of business are excluded from the sales factor under Cal. Code Regs., tit. 18, section 25137(c)(1)(A), while the gain remains in the apportionable base. A nonprecedential OTA opinion applied the OTA's 2019 precedential opinion in Metropoulos to a Virginia S corporation with nonresident shareholders that sold substantially all of its medical supply business in 2011, most of the gain being goodwill (Appeal of Faries, OTA Case No. 18043049, Jan. 5, 2022). Excluding the asset sale receipts from the sales factor moved the California apportionment percentage from roughly 1.7 percent to roughly 6.5 percent. The shareholders argued that a factor built from low-margin operating sales distorted the apportionment of a high-margin one-time gain; the OTA held that relief from the standard formula requires clear and convincing evidence that the result does not fairly reflect California activity, and that the showing had not been made.

Third, the entity-level tax and the shareholder-level tax stack. The S corporation pays California tax on its apportioned net income under section 23802, and the shareholder pays personal income tax on the pro rata share of the same apportioned gain. Whether the corporation must also withhold on distributions of California-source income to a nonresident shareholder is a separate question that the library's article on California pass-through withholding for domestic nonresident owners addresses.

The same framework governs partnerships. The OTA applied Metropoulos to a nonresident partner's share of gain from a lower-tier partnership's sale of its interest in a unitary operating partnership (Appeal of L. Smith, 2023-OTA-069P, Dec. 7, 2022). FTB Legal Ruling 2022-02 (July 14, 2022) went further, treating the Internal Revenue Code section 751 portion of a nonresident's gain on selling a partnership interest as if the partnership had sold the underlying property. The OTA declined to follow that ruling in Appeals of J. Burch, J. Carden and K. Carden, 2026-OTA-527P (July 24, 2026, posted as pending precedential in October 2026), holding that section 751(a) changes the character of the gain, not the nature of the transaction, so a nonresident's gain on a sale of a partnership interest, absent a unitary relationship, stays under section 17952. The ruling remains posted on the Franchise Tax Board's site without a status note.

Where the answer changes or remains open

A sale of stock by the shareholder is still a sale of an intangible by the shareholder. Section 17952 governs it directly, and absent a business situs for the shares the gain is not California-source income. Metropoulos involved an asset sale, and the conduit rule has nothing to pass through when the corporation itself sells nothing. The choice between a share sale and an asset sale, or an election to treat one as the other, is therefore a sourcing decision for a nonresident shareholder, with the entity-level tax and the buyer's basis step-up on the other side of the ledger.

Nonbusiness income at the corporate level is sourced to the shareholder under sections 17951 through 17955, not apportioned; the regulation says so in the paragraph the 2018 amendments moved to (d)(4), which the OTA majority identified as the place where section 17952 operates for a shareholder. Whether gain on an asset is business or nonbusiness income is decided at the corporate level under the definition in RTC section 25120. An S corporation that reports the gain as apportionable business income on its own return has largely answered the shareholder's question. One with a credible position that an asset was held outside the unitary business, and that reports consistently, keeps the section 17952 argument alive for its nonresident shareholders.

An S corporation doing business wholly within California is governed by subdivision (a) of the regulation and by Valentino, not by subdivision (d); for business income the result is the same, all of it is California-source. The regulation's drafting history marks the same boundary: the Franchise Tax Board's initial proposal for the 2018 amendments to regulation 17951-4 added a sentence stating that section 17952 is not applicable in determining the source of income allocated to a nonresident by a partnership, and it was deleted before adoption after commenters objected that a regulation cannot narrow a statute and the hearing officer found it unnecessary because only nonbusiness income is within section 17952's reach.

The business situs holding rested on the corporation's own apportionment, not on where the business was managed, and the court did not read the regulation to compel sourcing of the entire gain to a state where a situs is found. A nonresident shareholder who establishes nonbusiness income and then faces the business situs argument has no published rule on how the California portion is measured, and the OTA concurrence's use of the corporation's apportionment percentage is the likely starting point.

The trust question the OTA flagged in 2019, pending litigation on the application and constitutionality of section 17951 to trusts, was decided in the litigation known as the Paula Trust case, Steuer v. Franchise Tax Board (2020) 51 Cal.App.5th 417. The Court of Appeal held that the code taxes the entire amount of a trust's income from California sources regardless of the residence of its fiduciaries, and that the apportionment by resident fiduciaries in RTC section 17743 applies only to income that is not from California sources; the Supreme Court of California denied review on October 14, 2020 (S263728). A nonresident trust holding S corporation shares is therefore in the same position as a nonresident individual: sourcing decides the tax, and the trustee's residence does not reduce it. A separate refund action, listed as active on the Franchise Tax Board's litigation roster, raises due process and commerce clause challenges to the Franchise Tax Board's method of computing California taxable income for a trust with a nonresident trustee.

Practice notes

The sourcing of a nonresident shareholder's share of an S corporation's sale gain is decided by three facts fixed before the shareholder's return is prepared: whether the corporation sold assets or the shareholder sold shares, whether the corporation is multistate or wholly intrastate, and whether the corporation characterized the gain as business or nonbusiness income on its own return. The corporation's return controls the shareholder's result in the ordinary case, so a nonresident shareholder who expects to contest California-source treatment needs the corporation's characterization and apportionment to be consistent with that position from the first filing, not from an amended return filed after the entity-level tax has been paid. The apportionment percentage that applies to the gain is the percentage of the operating business after occasional-sale receipts are removed from the sales factor where the sale is substantial and occasional, and a distortion argument against it must meet the clear and convincing standard. Where the structure allows a choice between a share sale and an asset sale, the California sourcing consequence for nonresident owners belongs in the same analysis as the entity-level tax and the buyer's basis. G&G State Tax Group provides sourcing and apportionment analysis for owners of pass-through entities selling a business alongside its state and local tax practice.