New Jersey Decision on Sourcing of Gain May Present Opportunity for Out-of-State Companies

New Jersey determined that gain from an asset sale and liquidation transaction constituted “non-operational” income, under which the income was entirely sourced to New Jersey instead of being apportioned across multiple states.

On April 10, 2017, the Tax Court of New Jersey issued an opinion regarding the sourcing of a gain from the sale of a business’ assets. In Xylem, shareholders of an S-corporation sold their shares in the business. [1] As part of the transaction, the sellers and buyers of the shares made an election under Internal Revenue Code §338(h)(10), which deemed the sale of the corporate shares to be a sale of the corporation’s assets for income tax purposes, followed by a deemed liquidation of the proceeds from the S-corporation to the shareholders.

Following the filing of the S-corporation returns, the New Jersey Division of Taxation made adjustments to the sellers’ tax returns to classify the gain on the sale as non-operational (i.e., non-business or allocable) income. As non-operational income, the entire gain was assigned to New Jersey (the business’ state of domicile) and the Tax Court of New Jersey affirmed the Division’s position in its decision. [2]

When a company sells business assets, including in this case where an election was made to treat the sale of the business stock as a sale of its assets, states may take one of two approaches in taxing the gain: 1) treat the gain as business income, and apportion such income among the states where the company files tax returns, or 2) treat the gain as non-business income, and specifically assign such income to one state based on the type of asset that generated the income. For example, gain from the sale of real estate that produces non-business income will be sourced to the state in which the real estate is located, and gain from the sale of goodwill or other intangibles may be sourced to the state of the business’ commercial domicile. It is necessary to check each state’s allocation rules to apply the correct sourcing methodology.

In determining whether income should be treated as business income or non-business income, many states, including New Jersey, tend to follow the framework under the Uniform Division of Income for Tax Purposes Act (UDITPA). [3] Under UDITPA, gains are considered part of business income apportioned among the states when those gains arise from activity in the regular course of business (the transactional test) and/or are derived from the sale of property under which the acquisition, management and/or disposition of that property compose an integral part of the taxpayer’s business (the functional test). [4] Often, a gain from the disposition of property is considered to meet the latter, functional test when the underlying asset produced business income while it was owned by the taxpayer. When a gain or other item of income does not meet either of these tests or is otherwise not considered to be business income subject to apportionment, it is separately assigned to a state under different rules.

In Xylem, New Jersey confirmed its position, based on prior case law, that the gain from the sale of assets as part of a liquation of the business (when the proceeds are distributed and not reinvested in continuing business operations) is non-operational income. [5] As a result, the state separately assigned the entire gain from the sale of the business’ tangible and intangible assets to New Jersey, pursuant to its rules for sourcing non-operational income.

While this case went in the state’s favor, it presents a planning opportunity for corporations based outside of New Jersey with similar fact patterns. These corporations may be able to reduce their state income tax liability resulting from an IRC §338(h)(10) transaction by taking the position that the gain is non-operational income for New Jersey tax purposes, thereby allowing the taxpayer to source all of the income outside New Jersey. Although New Jersey’s definition of non-operational income was expanded after the years applicable to Xylem, it appears that the ruling in Xylem and earlier decisions may continue to apply in these limited circumstances. [6]

This case demonstrates the complexity of multi-state tax planning and the potential to plan transactions for more favorable state tax outcomes. Aprio’s SALT group has experience in addressing the state tax consequences of transactions like these and can help your business navigate the complex apportionment, allocation and sourcing rules in order to reduce your effective state income tax rate. We constantly monitor these and other important state 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 May 2017 SALT Newsletter. You can view the full newsletter here.

[1] Xylem Dewatering Solutions,  Inc. v. Director, Docket Nos. 011704-2015, 000056-2016, 000057-2017 (Tax Court of New Jersey, 4/10/2017).

[2] Allocable or non-business income is distinguishable from business or apportionable income, which is divided up among the states based on each state’s apportionment formula. New Jersey refers to allocable/non-business income as non-operational income and to apportionable/business income as operational income.

[3] This is a model statute drafted by the Multistate Tax Commission as guidance for a fair and consistent way for states to develop their income tax apportionment and allocation rules. Note that Georgia is one of a minority of states that do not use language similar to UDITPA.

[4] NJ Rev. Stat. §54:10A-6.1. New Jersey omits the transactional test from its definitions of operational/business and non-operational/non-business income. New Jersey amended this statute effective 7/1/14 to broaden the functional test – only the acquisition, management OR disposition of the underlying property must constitute an integral part of the taxpayer’s regular business, rather than all three. Although Xylem was decided under prior law, it appears that the decision will continue to apply in similar scenarios under the current law.

[5] The prior case upon which the Tax Court relied is McKesson Water Prods. Co. v. Director, Div. of Taxation, 408 N.J. Super. 213 (App. Div.), certif. denied, 200 N.J. 506 (2009), which essentially carved out an exception, in the case of a liquidation of the business, to the functional rule that the gain from the sale of assets that produced business income constitutes business income.

[6] New Jersey amended NJ Rev. Stat. §54:10A-6.1 effective 7/1/14 to broaden the functional test – only the acquisition, management OR disposition of the underlying property must constitute an integral part of the taxpayer’s regular business, rather than all three. Future taxpayers may have a more difficult time contending that gains from the sale of business assets are non-operational income, but in the case of a liquidation of the business, the reasoning in Xylem may still permit taxpayers to treat such income as non-operational in New Jersey.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.