Gain recognized on the sale of a controlling interest in a limited liability company doing business in Idaho is apportionable business income and subject to tax in Idaho, according to a recent Idaho State Tax Commission decision. The commission disagreed with the majority owner that it held its LLC interest as a mere passive investment but permitted the use of an alternative apportionment method for determining the owner’s Idaho tax liability.
In 1993, a military veteran formed and was the sole shareholder of a Virginia corporation through which he operated a business to manufacture and sell tactical and combat gear. The corporation, which was the petitioner before the Idaho State Tax Commission, elected S corporation tax status beginning on Jan. 1, 2001. In 2004, the petitioner contributed its assets to a newly formed limited liability company in exchange for a 78.4 percent member interest, and the petitioner’s sole shareholder continued to direct operations.
The business also established a physical presence in Idaho in 2004 and expanded this presence in 2007 by leasing a 100,000 square foot factory in Idaho. For taxable years 2004 through 2009, the LLC, classified as a partnership for tax purposes, passed its income through to the petitioner, which in turn paid Idaho tax on behalf of its shareholder. For those taxable years, the petitioner treated its share of LLC income as business income.
Upon the sale of the LLC interest in 2010, the petitioner recognized net gain of almost $120 million, most of which the petitioner attributed to goodwill. Although the petitioner had consistently treated its share of LLC income as business income, it classified the gain from the sale of the LLC as nonbusiness income and excluded the gain from its Idaho taxable income. In addition, the petitioner did not include the receipts from the sale when calculating its Idaho apportionment factor.
Following an audit of the petitioner’s 2010 return, the commission’s audit staff determined that the petitioner had underreported its 2010 income tax liability and assessed almost $4.5 million of additional tax, interest, and penalties. The petitioner countered that its ownership of the LLC interest was a passive investment and, therefore, Idaho could not tax any gain from the sale. If that argument failed to carry the day, the petitioner also requested that the commission apply an alternative apportionment method when attributing a portion of the gain to Idaho because the state’s standard three-factor formula did not fairly represent the petitioner’s business activities in the state.
There was no question that the LLC was doing business in Idaho, where it had a substantial physical presence. Under Idaho regulations, any corporation that is a partner in a partnership transacting business in Idaho is itself transacting business in Idaho even if the corporation has no other contacts with the state. Therefore, the commission concluded the petitioner’s income was taxable in Idaho. The petitioner’s sole shareholder, an Idaho nonresident, did not file an Idaho nonresident individual income tax return or pay Idaho tax for 2010. As a result, the petitioner was responsible for reporting and paying income tax on the gain from the sale of the LLC interest, and thus the commission’s assessment of the petitioner was appropriate.
Idaho regulations, based on the Idaho Supreme Court’s decision in Union Pac. Corp. v. Idaho State Tax Comn., 28 P.3d 375 (2001), apply both a transactional test and a functional test in determining whether income is apportionable business income. Under the transactional test, income arising from transactions and activity in the regular course of a taxpayer’s trade or business is business income. Under the functional test, income from tangible and intangible property is business income if the acquisition, management, or disposition of the property constitutes an integral or necessary part of the taxpayer’s regular trade or business operations.
The key question for the commission under the functional test was whether ownership of the LLC interest was directly connected to the petitioner’s business activity in Idaho and thus served an operational function. As the commission noted, Idaho regulations provide that income arising from the sale of an ownership interest is business income if that ownership interest served “‘an integral, functional, or operative component’” to the petitioner’s business. The commission concluded that the petitioner’s LLC interest “was not just an integral component of the petitioner’s business, it was the petitioner’s business.” Because business operations were under the direction of the petitioner’s sole shareholder, there was a direct relationship between the petitioner’s LLC ownership interest and its business. Therefore, the commission decided, the gain the petitioner recognized on the sale of that interest was business income.
Because the gain was business income, a portion of the gain was subject to tax in Idaho, and generally Idaho requires that a portion of the receipts be included in the Idaho sales factor based on the percentage of the LLC’s real and tangible personal property located in Idaho at the time of the sale. The commission agreed with the petitioner that an alternative method of apportioning the gain should be used. Using an average of petitioner’s Idaho apportionment percentage for taxable years 2005 through 2010, the commission increased the property factor numerator by 12 percent of the value of goodwill and included the total value of goodwill in the denominator. The commission also modified the sales factor so that only 12 percent of the receipts related to the sale were included in the numerator. With the commission’s modifications, the petitioner’s Idaho apportionment percentage was approximately the same as the percentage reported on its 2010 return, but significantly less than the percentage proposed on audit. As a result, the petitioner’s assessed tax liability was reduced to $1.4 million.
Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: How does your state determine whether gain from the disposition of a pass-through entity interest should be treated as apportionable or nonapportionable income?
In addition to the topics addressed within the publicly available Executive Summary, the Bloomberg Tax 2018 Survey of State Tax Departments identifies the states’ positions on myriad topics, including reporting federal changes, sales tax refund claims, and qui tam and class action lawsuits. For an analysis of the results on these topics, and to see the states’ responses to almost 630 different questions, subscribers can access the full survey on the State Special Reports page. The Executive Summary is available here.
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