Idaho Rules That Sale of LLC Interest Generates Apportionable Business Income

An Idaho tax commission decision explains when the sale of an LLC membership interest may give rise to apportionable business income.

One of the most confusing aspects of state income taxation of business organizations is the distinction that many states make between business (or apportionable) income and nonbusiness (or allocable) income. Taxpayers often assume that income treated as capital gain for federal income purposes is nonbusiness income, and that ordinary income is the equivalent of business income.  That is simply not the case.  Generally, business income is defined as income arising from transactions in the regular course of business (the transactional test) or income arising from assets, the acquisition, management, and/or disposition of which are integral parts of the taxpayer’s trade or business (the functional test). If a particular item of income does not meet either of these tests, then it is classified as nonbusiness income.

Here’s a simple example of how each test works.  If a business receives income from the sale of its inventory or services in the ordinary course of business, that income would be treated as business income under the transactional test.  If that business were to sell all of its assets, the income from that sale, including any income attributed to goodwill would likely be treated by most states as business income under the functional test since the assets sold were used by the business to produce business income while the company was operating.  An interesting issue arises where the taxpayer sells its ownership interest (e.g., stock, LLC membership interest, etc.) in the entity conducting the business.  Should that income be treated as business or nonbusiness income?  That is the subject of a recent Idaho Tax Commission decision.[1]

In 1993, Owner formed Taxpayer, a manufacturer and seller of tactical and combat gear.  Taxpayer is an S-corporation and conducted the business from 1993-2003.  In 2004, Taxpayer contributed the assets of the business to LLC, a limited liability company treated as a partnership for federal and Idaho income tax purposes, in exchange for a 78.54 percent membership interest.  Following the transaction, Owner still oversaw all aspects of the business as the President and CEO of LLC.

In 2004, LLC created a physical presence in Idaho, resulting in nexus, and thus began filing an Idaho income tax return. For tax years 2004-2009, the LLC passed through its income to Taxpayer who paid Idaho tax on behalf of Owner. Taxpayer treated the pass-through Idaho income as business income.

In 2010, Taxpayer sold its membership interest LLC for a net gain of about $120 million. Taxpayer classified its gain as nonbusiness income on its Idaho income tax return, which resulted in the exclusion of the gain from Idaho taxable income. Upon audit, the state reclassified Taxpayer’s gain as business income, and the Taxpayer appealed to the tax commission.

The tax commission noted that Idaho regulations establish use of both the transactional test and the functional tax for determining business income.[2]  Focusing on the functional test, the tax commissioned explained that the key determination is whether the property was directly connected with the taxpayer’s business operations.  Specifically, with respect to an ownership interest, the question is whether the interest sold was directly connected with the taxpayer’s business activity or whether it was merely a passive investment (i.e., did the ownership interest serve an “operational function” or an “investment function”?).  The Idaho Supreme Court has ruled that an ownership interest serves as an operational function when there is a “direct relationship between the underlying asset and the taxpayer’s trade or business.”[3] Additionally, under Idaho regulations, the sale of an ownership interest is considered business income if the ownership interest served “an integral, functional, or operative component” to the taxpayer’s business.[4]

Based on that guidance the tax commission concluded that the Taxpayer’s sale of its LLC ownership interest meets the functional test requirement and thus generates business income subject to Idaho apportionment. The ownership interest in LLC was not just a component of the Taxpayer’s business, it was the business.  Taxpayer used to operate the business directly until Owner caused Taxpayer to contribute the business to LLC in exchange for a controlling interest in LLC.  Owner was President and CEO of both Taxpayer and LLC and remained so throughout the companies’ business life. Further, income derived from Taxpayer’s ownership interest in LLC drove Taxpayer’s net income, making the ownership more than a passive investment.

This ruling reinforces the significance of the classification of income as business or nonbusiness (which is not always straightforward), since this classification has a direct impact on how the income will be reported on a multistate basis.   Aprio’s SALT team has extensive experience with business/nonbusiness issues and can assist with structuring the transaction in order to minimize state income taxes. We constantly monitor these and other important state and local tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact  Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the April 2018 SALT Newsletter. 

[1] Docket No. 0-976-965-632 (11/8/17).  The identification of the parties has been redacted.

[2] IDAPA 35.01.01.332.01 (2017).

[3] American Smelting & Ref’g Co. v. Idaho St. Tax Comm., 99 Idaho 924, 933, 592 P.2d 39, 48 (1979)

[4] IDAPA 35.01.01.333.08 (2017). See also IDAPA 35.01.01.333.05 (2017).