Business/nonbusiness income distinction subject to challenge.

A multistate corporation may be required to pay income tax in all the states in which it does business, but the U.S. Constitution prohibits states from taxing income not connected, at least in part, by activities within the state. Therefore, a corporation generally is allowed to apportion its income among the states in which it operates. The Uniform Division of Income for Tax Purposes Act (UDITPA) was designed to provide a uniform system for a multistate taxpayer to divide income among the states in which it is subject to income tax. Many states have incorporated UDITPA provisions or similar provisions into their statutes or regulations.

Under the UDITPA, business income may be apportioned among all the states in which the taxpayer operates. Nonbusiness income, which generally constitutes all income other than business income, is allocable to a single state, often the state of the taxpayer's commercial domicile. Section 1 of the UDITPA defines business income as "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."

Traditionally, business income has been interpreted to include income arising from sales of property used in the taxpayer's business; see, e.g., MultiState Tax Commission Regulations, Reg. IV.1.(A). However, a number of courts have recently held that gain from extraordinary sales of assets may not be apportionable business income.

Pennsylvania

Laurel Pipe Line Co. v. Commonwealth of Pennsylvania, 642 A.2d 472 (Pa. 1994), involved gain derived from the sale of a pipeline that had been nonoperational for three years prior to the sale. Immediately after the sale, the board of directors declared a dividend equal to the entire after-tax net proceeds from the sale. The Pennsylvania Supreme Court used both the transactional test and the functional test to hold that gain from the sale was nonbusiness income. The court concluded that the statute required that, for income to be treated as business income, the property's disposition must be an integral part of the taxpayer's regular business. Since the gain was not invested to generate income for the company, the court rejected the state's contention that the sale was necessary to maintain the business's financial security. Thus, the court concluded that this singular disposition of the pipeline was not an integral part of the taxpayer's trade or business, but was a liquidation of a portion of the taxpayer's assets. This decision was later relied on in a Pennsylvania Commonwealth Court decision, Ross-ARACO Corp. v. Commonwealth, 644 A.2d 235 (1994), in which the court held that the sale of an unimproved tract of land resulted in nonbusiness income.

Nevertheless, in a policy statement issued Nov. 12, 1994, the Pennsylvania Department of Revenue said that the conclusion in Laurel resulted primarily from the fact that the company liquidated a separate and distinct aspect of its business and did not reinvest those funds in the continuing operations of the rest of the company. The Department's policy will be to continue to treat income as apportionable business income if it meets the functional test and will challenge nonbusiness treatment of dispositions of assets not paralleling the facts in Laurel.

Iowa

In Phillips Petroleum Co. v. Iowa Dep't of Revenue and Finance, 511 N.W.2d 608 (1993), the Iowa Supreme Court used a different analysis to reach essentially the same result as in Laurel Pipe Line. The court held that only the transactional test should be applied to identify UDITPA business income. According to the court, the functional test is not a separate test, but is a limitation on the transactional test; it is intended to limit business income treatment to transactions involving disposal of fixed assets by taxpayers for whom the trading of assets is an integral part of the regular business. The court concluded that the sale of business assets to raise money to fund a stock repurchase as a means of defending a hostile takeover attempt did not result in business income. Thus, the Iowa court's focus on the requirement that the disposition of assets be part of the taxpayer's regular trade or business resulted in a holding similar to the decision reached in Laurel Pipe Line.

Wisconsin

In Wisconsin Dep't of Revenue v. Citizen Publishing Co. of Wisconsin, Inc., No. 93-0328 (Ct. App., 5/26/94), a Wisconsin court of appeals focused on the UDITPA language requiring that a transaction be in the "regular course" of the taxpayer's business in determining that the income received from the rental of assets that had previously been used to generate business income resulted in nonbusiness income. In this case, the taxpayer established a printing business in Minnesota in 1979, ceasing operations the next year. Citizen and another publishing corporation formed a Minnesota corporation, Lithoweb, that leased the printing equipment located in Minnesota. The parties stipulated that Citizen and Lithoweb were not engaged in a unitary business. The court deferred to the decision of the Tax Appeals Commission, which had held that Citizen was not in the rental business, thus concluding that the rental income was not derived from the regular course of its trade or business.

Kansas

Unlike the cases previously discussed, Appeal of Chief Industries, Inc., 875 P.2d 278 Kans. 1994), involved the sale of stock of a subsidiary. Like Phillips Petroleum, however, the question of whether the UDITPA definition of business income includes both a transactional and a functional test was at issue. Chief Industries incorporated one of its divisions, immediately selling over 30% of the stock in an initial public offering; approximately one year later, an additional 30% of the stock was sold. These transactions were intended to raise money to retire debt, purchase assets and meet other general business needs. Kansas, by statute, adopted the UDITPA definition of business income in 1963. The Kansas Supreme Court addressed the business income tests in 1968, holding that only the transactional test was applicable in determining whether income was business income (Western Natural Gas Co. v. McDonald, 446 P.2d 781 (1968)). The Kansas Supreme Court reaffirmed its holding in Western Natural Gas and refused to give a broader interpretation to the transactional test. The court noted that administrative regulations do not supplant statutory law, nor do they preempt judicial statutory construction. Thus, the Department of Revenue could not add an alternative business income test by regulation.

Conclusion

The debate over whether the UDITPA language contains one test or two alternative tests is sure to continue. The Pennsylvania decision, while stating a recognition of two alternative tests, effectively treated an analysis under the functional test as virtually identical to one under the transactional test. The Supreme Courts in Iowa and Kansas eliminated the functional test as a separate test under UDITPA. Regardless of the approach, these cases indicate a willingness by the courts to classify as nonbusiness income the gain arising from the sale of assets used in the taxpayer's business, which traditionally has been treated by the states as apportionable business income.

From Amy Eisenstadt, J.D., LL.M., and Marianne Evans, CPA, J.D., LL.M., Washington, D.C.