A gain from a deemed sale of assets under I.R.C. § 338(h)(10) recognized by an S corporation was nonoperational income, the New Jersey Tax Court recently ruled in Xylem Dewatering Solutions, Inc. v. Director, Division of Taxation. The court required allocation of the gain to New Jersey, the S corporation’s commercial domicile. Had the case involved a tax year ending after July 1, 2014, the court most likely would have classified the gain as operational income subject to apportionment. This result would be consistent with how many states indicated they would treat the transaction in Bloomberg BNA’s 2017 Survey of State Tax Departments.
Following precedent established by its 2007 decision in McKesson Water Products Co. v. Director, Division of Taxation, 23 N.J. Tax 449 (2007), aff’d, 974 A.2d 443 (N.J. Super. Ct. App. Div. 2009), the court classified the gain as nonoperational because it arose from the deemed sale of assets in connection with a complete liquidation of the corporation, not in the regular course of the corporation’s business. As nonoperational income, the gain must be assigned to the corporation’s domiciliary state.
"This issue has arisen in several state courts, and I think the New Jersey court's analysis was correct and consistent with at least most of the decided cases out there,” Bruce Ely, Partner with Bradley Arant Boult Cummings LLP in Birmingham, Ala. and co-author of Bloomberg BNA State Tax Portfolio 1550, Choice of Entity: An Overview of Tax and Non-Tax Considerations, told Bloomberg BNA.
New Jersey does not impose tax on the S corporation itself, but shareholders are subject to the state’s Gross Income Tax on their pro rata shares of S corporation income. As New Jersey nonresidents, the shareholders in Xylem were subject to the Gross Income Tax only on the portion of S corporation income derived from New Jersey sources, but that income included all the gain from the deemed asset sale.
“Unfortunately for taxpayers, state tax authorities tend to argue nonoperational income when there’s some basis to tie all of the taxpayer’s income to an authority’s home jurisdiction,” said Jamie Yesnowitz, Principal, SALT Services, with Grant Thornton LLP in Washington, D.C.
“This is the classic scenario where the corporation and the shareholders will likely be whipsawed if the corporation is doing business in multiple states,” said Ely, because those states will want to tax a portion of any gain by classifying it as business income.
To reduce their New Jersey tax burden, the shareholders argued unsuccessfully that the source of the gain, although recognized by the S corporation, should be determined under the Gross Income Tax rules. The shareholders’ approach would have avoided classification of the gain as business or nonbusiness income and its subsequent allocation to New Jersey. Instead, the source of the gain would have been determined based on the specific types of property sold and the location of its use by the corporation.
Both the McKesson and Xylem decisions were based on a previous definition of operational income. Before legislation in 2014, New Jersey defined operational income in part as income from tangible and intangible property if the acquisition, management and disposition of the property constitute integral parts of a taxpayer’s regular trade or business operations. Because a deemed sale of assets and corporate liquidation were not an integral part of the taxpayer’s regular trade or business operations, the McKesson court necessarily concluded that gain from the deemed sale was nonoperational income.
The 2014 legislation, enacted subsequent to the tax year at issue in Xylem and effective for tax years ending after July 1, 2014, amended the definition of operational income to clarify that the acquisition, management or disposition of an asset may be independent factors in determining classification of income as apportionable business income. As the Division of Taxation explained, the amendment was in response to the holding in McKesson that all three activities must be integral parts of the taxpayer’s regular trade or business in order for income to constitute operational income.
According to Bloomberg BNA’s 2017 Survey of State Tax Departments, New Jersey is one of 22 states that now indicate that gain from a deemed sale of assets under I.R.C. § 338(h)(10) is apportionable business income. “Given the recent changes in the operational income definition, I think it would be significantly easier for a state like New Jersey to rule that an (h)(10) transaction now generates operational income,” Yesnowitz said.
New Jersey also responded that the gain is included in the target corporation’s sales factor. Only two states, Missouri and West Virginia, reported that gain would be classified as allocable nonbusiness income. Nineteen states indicated that treatment of the gain would depend on the facts and circumstances of the transaction.
Although New Jersey indicated in its Survey responses that it would not rely on a facts and circumstances test to classify deemed sale gain as operational or nonoperational income, the statutory definition provides a taxpayer the opportunity to demonstrate with clear and convincing evidence that gain is nonoperational income. Whether a New Jersey taxpayer will successfully overcome this evidentiary hurdle remains to be seen.
Continue the discussion on BNA’s State Tax Group on LinkedIn: Does the Xylem decision provide a basis for classifying gain from a deemed asset sale, followed by a complete liquidation, as nonbusiness income independent of New Jersey’s statutory definition of operational income?
For more information about state tax issues, sign up for a free trial on Bloomberg BNA’s Premier State Tax Library.
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