Opinion ID: 2600653
Heading Depth: 2
Heading Rank: 2

Heading: utah has statutory authority to tax the settlement because it was received in lieu of proceeds from the sale of utah assets

Text: ¶ 33 Having determined that the settlement proceeds were received in lieu of proceeds that Mandell should have received from the sale of HAU, we now consider whether the state of Utah had authority to tax the proceeds of the original sale. The Commission's decision offered three statutory sources of authority to tax the sale proceeds, but even one source of authority is sufficient. We hold that Utah had authority to tax the proceeds of the original sale because those proceeds fall within the statutory definition of Utah source income. ¶ 34 Utah has authority to tax all Utah source income. Utah source income is income derived from or connected to the state. See Utah Code Ann. § 59-10-117 (2006). A corporation is deemed to have subjected itself to Utah state taxing authority in return for the privilege of exercising its corporate franchise or for the privilege of doing business in the state. Id. § 59-7-104(1). Consistent with this principle, the state of Utah possesses the authority to tax nonresidents for the portion of their income derived from Utah sources. See id. §§ 59-10-116, -117. ¶ 35 When a corporation is organized as an S corporation for federal income tax purposes, the income it earns is passed through and taxed to the shareholders based on their proportionate share of ownership. See I.R.C. §§ 1363, 1366 (2000); Robinson v. United States, 335 F.3d 1365, 1366 (Fed.Cir. 2003) (The tax consequences of an S-corporation flow through to the shareholders, so the shareholders recognize the corporation's income and expenses on their individual tax returns.). For purposes of determining whether this passed-through income is taxable, the character of the income remains the same as it was when in the hands of the corporation. See I.R.C. § 1366(b). Because Utah taxes S corporations in the same manner as they are taxed for federal tax purposes, a nonresident shareholder of an S corporation must pay taxes on the portion of an S corporation's taxable income derived from Utah sources. Utah Code Ann. §§ 59-7-701, -702(2)(b). ¶ 36 The proceeds from the sale of HAU constituted Utah source income. HAU was an S corporation doing all of its business in Utah. Thus, all of the income received by HAU in the ordinary course of business, which was passed through to its shareholders, was derived from Utah sources. ¶ 37 The structure of the HAU sale further demonstrates that the sale proceeds were Utah source income. All of HAU's shareholders elected to characterize the sale as a deemed asset sale under I.R.C. § 338(h)(10). As a result, the gains realized through the sale were taxable as if the corporation had sold assets rather than stock. See id. § 338(h)(10). The gains from the sale passed through to the shareholders, who bore the responsibility of paying taxes on those gains in proportion to their ownership interests. See id. § 1366(b); see also Utah Code Ann. § 59-7-701. The gains recognized from this deemed asset sale constitute Utah source income under Utah Code sections 59-10-118(1)(a), which defines business income, and 59-7-114(4), which creates a rebuttable presumption that the gain on a deemed sale of assets under a section 338 election constitutes business income. [5] They are therefore taxable under Utah Code section 59-10-117(2)(d). ¶ 38 Because the 2001 settlement proceeds were received in lieu of the original sale proceeds and because the original sale proceeds were taxable as Utah source income, the settlement proceeds are also taxable as Utah source income. And they remain taxable whether or not the shareholders are residents of Utah. ¶ 39 Case law supports the right of a state to tax a nonresident shareholder on the income of an S corporation derived from that state. For example, in Isaacson v. Iowa State Tax Commission, Nebraska residents, who were shareholders of an Iowa S corporation that conducted all of its business in Iowa, challenged Iowa's authority to tax the corporate income that passed through to them. 183 N.W.2d 693, 693-94 (Iowa 1971). During the years for which the Isaacsons were taxed in Iowa, the Isaacsons conducted no business or trade activities there. Id. at 694. Construing statutes similar to those at issue here, the Iowa Supreme Court held that Iowa could tax the S corporation's dividends received by the nonresident Isaacsons. Id. at 695. Other courts have decided this issue similarly. See, e.g., Valentino v. Franchise Tax Bd., 87 Cal.App.4th 1284, 105 Cal. Rptr.2d 304 (2001) (holding that S corporation shareholders are liable for California taxes based on the income earned by the S corporation through income producing activities within the state); Gen. Accessory Mfg. Co. v. Okla. Tax Comm'n, 2005 OK CIV APP 75, ¶ 13, 122 P.3d 476, 480 (holding that nonresident stockholders who made a section 338 election in the sale of their stock were liable for Oklahoma income tax because the corporation was domiciled in the state and derived all of its income from sources within the state); Kulick v. Dep't of Revenue, 290 Or. 507, 624 P.2d 93, 98-99 (1981) (holding that Oregon could constitutionally tax personal income of a nonresident shareholder of an S corporation based on distributed and undistributed income). ¶ 40 In summary, the settlement proceeds are taxable by Utah because they relate to the sale of Utah assets. Gains received from such a sale are clearly taxable under the Utah Code. It is of no import that the Mandells did not receive the sale proceeds until after they moved to Nevada because Utah may tax the income of nonresidents if that income is derived from this state.