Iowa Capital Gain Exclusion Inapplicable to Sale of Partnership Interest

March 11, 2008 | Roger McEowen

Iowa law (Iowa Code §422.7 (21)) provides that certain capital gains can be excluded from taxable income.  For the sale of business property to be eligible, the taxpayer must have either been employed in the business or materially participated in the business for ten years and held the property for ten years.  Also, the statute defines sale of a business as the sale of “all or substantially all of the tangible personal property or service of the business.”  The statute has been modified in recent years, but the provision defining “sale of a business” has not changed. 

A key question under the statute is whether the definition of “sale of a business” includes the sale of a partnership interest.  That was the issue in this case.  Here, the plaintiff was a CPA in a two-person partnership.  In 1989, the partnership merged with another firm, and the two partners became members of the merged firm.  But, a couple of years later, the merger was ended when the acquiring firm failed to make the payments required under the merger agreement.  As a result, all of the original partnership assets were transferred back to the two partners.  The next day, the plaintiff sold his one-half interest in the partnership to other partner who continued the business as a sole-proprietor.  The continuing partner paid for the interest in annual installments from 1992-2000.  That triggered capital gain to the plaintiff, and he claimed the exclusion for years 1992-2000.  The Iowa Department of Revenue (IDOR) denied the exclusion, and assessed additional taxes, interest and penalties.  The IDOR’s reasoning was that the statute only applied to the sale of all or substantially all of the tangible personal property or service of the business (as the statute states), and not the sale of a partnership interest.  Indeed, IDOR’s own interpretive rule specifies that capital gains incurred from the sale of an ownership interest in a partnership, LLC or other entity are not eligible for the exclusion (Iowa Admin. Code §701-40.38(8)). 

The plaintiff believed the IDOR’s interpretation of the statute was too narrow, and claimed that the partnership interest was, by itself, a “business.”  Since 100 percent of the business was sold, therefore, the plaintiff claimed that the exclusion should apply.  But, the trial court upheld the IDOR’s ruling, and the taxpayer sought the Supreme Court’s review of the matter. 

The Supreme Court noted that tax exclusions are to be construed strictly against the taxpayer, and that the use of the phrase “tangible personal property or service of the business” in the statute focused on the sale of tangible and intangible assets that are used in production and marketing, rather than the sale of stock or partnership interests.  So, the “business” involved the accounting partnership and not the ownership interest in the partnership.  On that point, the court noted that under Iowa law (Iowa Code §486A.501), a partner has no interest in partnership property.  That meant that the plaintiff’s sale of his partnership interest did not constitute the sale of any tangible personal property or service of the partnership.   

The court also noted that the legislature did not expressly require the application of federal law in determining what constituted capital gain from the sale of a business and what constituted a capital asset.  Based on these findings, the Court reasoned that the IDOR’s interpretation of the statute was not wholly unjustifiable.  When it comes to challenging government administrative findings, that’s a pretty tough hurdle to overcome.  Ranniger v. Iowa Department of Revenue and Finance,746 N.W.2d 267 (Iowa Sup. Ct. 2008).