When does the sale of corporate assets produce business income for state corporate franchise tax purposes?

• Author: Faber, Peter L.

1. Introduction

   When the assets of a corporate business are sold, the resulting gain or loss is either apportioned among the various States in which the corporation does business or it is allocated entirely to one or more States. The typical pattern is that income that is classified as "business" income is apportioned pursuant to a formula (typically based on property, payroll, and sales), whereas income that is treated as "nonbusiness" income is allocated (typically to the State of the taxpayer's commercial domicile or to the State in which tangible property producing the gain is located). This is the pattern of the Uniform Division of Income for Tax Purposes Act (UDITPA), which is followed by many of the States.

   When a corporation sells a business, the classification of any resulting gain or loss as business or nonbusiness income can have significant consequences. If the State of the corporation's commercial domicile has high tax rates, classifying the income as nonbusiness income and allocating it entirely to that State can be less desirable than classifying the income as business income and apportioning it among all of the States in which the corporation does business. On the other hand, if the State of commercial domicile has low tax rates, the taxpayer may prefer to have the gain on the sale of its assets treated as nonbusiness income and allocated all to that State. Although the pattern in several recent cases has been for the taxpayer to argue for nonbusiness income treatment (and the state tax department to argue for business income treatment), taxpayers and tax administrators have sometimes found themselves on different sides of the fence.

   UDITPA defines "business income" in deceptively simple terms, as follows:

   Income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations.(1)

   Nonbusiness income is defined as "all income other than business income."(2)

   These provisions are certainly among the simpler tax statutes around, but their meaning is by no means clear and their interpretation has given rise to extensive litigation. This article reviews the state of the law.

2. Interpretation of the Statute

   1. Introduction

      The courts have developed two approaches in determining whether the sale of business assets produces business or nonbusiness income under UDITPA. Under the "transactional" test, income is business income if the transaction that generates it occurs in the ordinary course of the taxpayer's trade or business. Under the "functional" test, income is business income if it results from the sale of assets that were used in the taxpayer's business, even if the transaction producing the income did not occur in the ordinary course of business.(3) The transactional test is clearly part of the statute. One issue with which the courts have had to deal is whether the functional test is an additional and independent test that can produce business income even if the transactional test is not met, or whether the second part of the UDITPA definition--referring to the acquisition, management, and disposition of the property--is merely an elaboration of the transactional test.

      The difference between the transactional and the functional tests is particularly important in connection with the sale of a business because often the sale of the business will not be a regular incident of the taxpayer's operations. If a corporation sells all of its businesses and then liquidates, this clearly will not be a common transaction and, under the transactional test, it will be hard to conclude that it produces business income. On the other hand, the functional test could produce business income in such a transaction.

   2. The Transactional Test

      The source of the transactional test is the first clause of the UDITPA definition, which provides that business income includes "income arising from transactions and activity in the regular course of the taxpayer's trade or business."(4)

      The prototypical example of a sale that produces business income under the transactional test is the sale of inventory to customers in the ordinary course of business. An automobile dealership clearly realizes business income when it sells cars to customers from its regular inventory. A trickier case is presented when the dealer uses a particular automobile as a demonstrator for six months and then sells it. Even though the demonstrator has been used in the business and not merely held for sale to customers, its sale is a regular part of the dealer's business and was undoubtedly contemplated when it was bought from the manufacturer. A reasonable argument can be made that the resulting income should be business income under the transactional test. The issues get murkier where the dealer sells a lot and building on which it does business. If the lot and building represent the dealer's only facility and it then liquidates and goes out of business, courts applying the transactional test will generally find that the resulting income is nonbusiness income. If, instead, the dealer sells one of several facilities and remains in business at other locations, the answer is not so clear. It may depend on whether the sales proceeds are reinvested in the business or distributed to the shareholders.

   3. The Functional Test

      Under the functional test, income from the sale of property is business income if the property is used in the taxpayer's business, even if its sale is not a regular incident of the business. Courts applying the functional test find its source in the second clause of the UDITPA definition of business income, which includes income from property "if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations."(5) Under the functional test, the transaction giving rise to the income can be an extraordinary transaction. If the property that is sold produced business income while used by the taxpayer, its sale also produces business income even if the sale is not a regular incident of the taxpayer's business. Under the functional test, the "extraordinary nature or the infrequency of the transactions is irrelevant."(6) The courts that apply the functional test have not claimed that it is the only test but merely that it is applied in addition to the transactional test. Under this approach, income will be business income if it satisfies either test.

3. The Multistate Tax Commission Regulations

   The Multistate Tax Commission (MTC) has adopted regulations under the UDITPA business income definition that incorporate a strong presumption in favor of business income. The general definition of business and nonbusiness income provides:

   [A]ll income which arises from the conduct of trade or business operations of a taxpayer is business income. For purposes of administration of Article IV, the income of the taxpayer is business income unless clearly classifiable as nonbusiness income. ... In general all transactions and activities of the taxpayer which are dependent upon or contribute to the operations of the taxpayer's economic enterprise as a whole constitute the taxpayer's trade or business and will be transactions and activity arising in the regular course of, and will constitute integral parts of, a trade or a business.(7)

   The regulation specifically dealing with gain from the sale of property clearly adopts the functional test:

   Gain or loss from the sale, exchange or other disposition of real or tangible personal property constitutes business income if the property while owned by the taxpayer was used in the taxpayer's trade or business.(8)

   It is hard to imagine a sale of property that will not be treated as business income within the meaning of the MTC regulations.

   The courts, however, have been more restrictive. The Missouri Supreme Court in James v. International Telephone & Telegraph Corp. held that gains from the sale of four subsidiaries pursuant to an antitrust consent decree were not business income. In doing so, the court criticized the sweeping nature of the regulations, holding that they purported to expand a "broad" statute "even further."(9) The Supreme Court of Kansas was even less kind, holding in Appeal of Chief Industries, Inc. that the taxpayer's gain from the sale of stock was nonbusiness income under the transactional test.(10) In that case, the taxpayer manufactured and sold recreational vehicles and other types of products. It had an automotive division that produced and sold automobile frame straighteners. In order to raise money for its other operations, it decided to sell the automotive division, which it did by transferring the assets of that division to a new corporation and making a public offering of that corporation's stock.

   In an earlier case, the court had held that the transactional test was the sole test determining whether income was business income; the functional test did not apply.(11) After the earlier case was decided, the Kansas Department of Revenue adopted the MTC regulations.(12) The Department then argued in Chief Industries that the earlier case was distinguishable because the regulations had not been in effect and that the regulations were controlling in the case before the court. The court was unimpressed. It brusquely observed that its holding in the earlier case had not been modified in the intervening 25 years and that the legislature had not seen fit to reverse it by changing the statute.(13) It reminded the Department of Revenue that, while the legislature had the power to overturn a decision of the State's highest court, the Department did not.

   The dissent in Chief Industries argued that the history of the Multistate Tax Compact and its adoption by Kansas and other States...