Tennessee: Apportionment allowed due to taxpayer’s out-of-state incorporation


Tom Coley
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Veronica Caputo
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John Ward
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Affan Qureshi
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Jamie C. Yesnowitz
Washington, D.C.
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Chuck Jones
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Lori Stolly
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On Dec. 20, 2018, the Tennessee Court of Appeals held that a taxpayer was entitled to apportion its income because it was incorporated in another state.1 The fact that the taxpayer was incorporated in Florida established substantial nexus in another state for purposes of the Commerce Clause of the U.S. Constitution.

Background The taxpayer,, Inc. (“Popular Categories”), was incorporated under the laws of Florida in October 2000. The corporation was formed for the purpose of reserving domain names and receiving income from advertising conducted on its websites. Popular Categories was originally a C corporation which filed and paid corporate income tax to Florida for the 2000 tax year. In 2001, Popular Categories elected S corporation status for federal income tax purposes and paid no corporate income tax to Florida for the 2001 or subsequent tax years.2

In March 2001, Popular Categories jointly created Popular Enterprises, LLC (“Popular Enterprises”) with another entity and transferred all of its domain names and other assets to the newly formed entity. From 2002 onward, Popular Categories engaged in the business of monitoring its investment in Popular Enterprises as a holding company. In 2002, Popular Categories failed to file its 2002 Florida annual report with the Florida Secretary of State. As a result, it was administratively dissolved until 2006, when Popular Categories filed to have its corporate charter reinstated. In its annual report, Popular Categories listed Knoxville, Tenn. as its principal office. Popular Categories’ accounting and administrative activities occurred in Knoxville, and it listed its address in Knoxville on its federal return. In February 2006, Popular Categories sold its membership interest in Popular Enterprises to a third party.

In 2008, the Tennessee Department of Revenue conducted an audit of Popular Categories and determined that since it was doing business in Tennessee, it was subject to Tennessee excise and franchise tax for the 2006 and 2007 tax years. The Department also concluded that during the audit period Popular Categories was not entitled to apportion its income because it only was doing business in Tennessee. Popular Categories received notices of assessment for the 2006 and 2007 tax years imposing more than $1.5 million in tax, interest and penalties. The notices of assessment were upheld in subsequent informal protests with the Department and by a trial court during litigation. Popular Categories pursued an appeal with the Tennessee Court of Appeals.
Court of Appeals decision The threshold question for the Court of Appeals to consider was whether Popular Categories had sufficient nexus with another state and, therefore, was entitled to apportion income for the 2006 and 2007 tax years. Popular Categories’ primary argument focused on its right to apportion income because it was incorporated in Florida and thus, was engaged in a multistate business.3 Also, Popular Categories argued that the denial of its right to apportion subjected it to the risk of multiple taxation.

Under Tennessee law, apportionment is permitted when a taxpayer has business activities which are taxable both within and outside Tennessee, and the activities which occur in another state would subject the taxpayer to franchise tax or excise tax in Tennessee if the activity occurred in Tennessee and constituted doing business in the state.4

The Court noted that the Due Process and Commerce Clauses control whether or not Popular Categories’ income could actually be apportioned. The Due Process Clause concerns whether or not a state may claim jurisdiction over the person or entity. Specifically, the Due Process Clause “requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”5 The Commerce Clause, on the other hand, “imposes a ‘greater limitation’ on the right to tax.”6 Under the Commerce Clause, Congress is authorized to “regulate Commerce with foreign Nations, and among the several States.”7 In order for a state to impose a tax, the Commerce Clause requires more than a minimum connection. States must also satisfy the Dormant Commerce Clause, which “prohibit[s] certain state taxation even when Congress has failed to legislate on the subject.”8 The negative implication under the Dormant Commerce Clause prohibits states from interfering with interstate commerce.9

In Complete Auto Transit, Inc. v. Brady,10 the U.S. Supreme Court created a four-prong test that a taxing scheme must satisfy under the Dormant Commerce Clause: (1) there must be a substantial nexus between the taxpayer and the state; (2) the tax must be fairly apportioned; (3) the tax must not discriminate against interstate commerce; and (4) the tax must be fairly related to the services provided by the state. In this case, the Court explained that the “looming question is whether Popular Categories had a ‘substantial nexus’ with some other state such that it would be at risk of taxation in that jurisdiction consistent with the demands of the Commerce Clause.”11

The Court concluded that Popular Categories’ incorporation in Florida12 was more than a trivial connection and gave Florida substantial nexus over the taxpayer, satisfying both the Due Process and Commerce Clauses. As explained by the Court, Popular Categories’ incorporation in Florida was “not without significance” because “its corporate life and existence was owed to the state.” The Court determined that “Popular Categories’ legal domicile in Florida necessarily affords it a substantial nexus such that it is subject to Florida’s taxing jurisdiction.”

In addition to the Court finding that Florida would have jurisdiction over the taxpayer, Tennessee law currently provides that a taxpayer has substantial nexus with Tennessee based merely on the fact that the entity was organized in the state.13 Because being organized in Tennessee constitutes substantial nexus in the state, it would stand to reason that organization in another state would thus create substantial nexus in that other state. However, this statute was enacted in 2015, subsequent to the years at issue, and was not controlling. Though the new statute defining substantial nexus was not applicable prior to 2015, the Court took into account the fact that the concept of incorporation establishing nexus is “currently embraced” by Tennessee law.

Commentary This decision, while providing some illustrative discussion on constitutionality and the ever-present debate over what constitutes “substantial nexus,” may be somewhat dated already. As the case concerned the 2006 and 2007 tax years, a number of subsequent changes in Tennessee law likely make the issue more straightforward for more recent years. By operation of Tennessee’s own statutes as amended in 2015, incorporation in Tennessee creates substantial nexus in the state sufficient to impose an income tax.14 Additionally, Tennessee continues to allow for apportionment, provided a taxpayer is taxable in another state.15 “Taxable in another state” is defined to include any activity which, if conducted in Tennessee, would subject the taxpayer to Tennessee tax.16 Therefore, if organization under the laws of Tennessee is a taxable presence in the state, then organization under the laws of another state is a taxable presence in that state, regardless of whether that state chooses to collect such tax.

Additionally, Tennessee enacted a bright-line factor presence or economic nexus standard in 2015.17 Under this standard, a taxpayer is deemed to have substantial nexus with Tennessee to the extent any of the following exist: (1) Tennessee-sourced receipts exceed the lesser of $500,000 or 25% of the total receipts everywhere for the period; (2) the average value of Tennessee property exceeds the lesser of $50,000 or 25 percent of property everywhere; or (3) Tennessee compensation exceeds the lesser of $50,000 or 25 percent of compensation everywhere. Furthermore, revenue from services and sales of other than tangible property is sourced on a market basis.18 Accordingly, even a Tennessee domiciled taxpayer with no presence outside Tennessee may have the right to apportion provided its activities in any other state exceed the Tennessee bright-line standard.

While the constitutionality of economic nexus as applied to income or franchise taxes has not been tested, the Wayfair19 decision in 2018 overturned the physical presence requirement established in Quill20 and upheld the constitutionality of economic nexus as applied to sales tax. While application of Quill was technically limited in scope to the sales tax, it is not unreasonable to expect the states to seek to apply Wayfair in support of economic nexus standards for income or franchise tax purposes as well. This may be particularly relevant in Tennessee and the many other states with statutes construing substantial nexus to the furthest extent allowed under the U.S. Constitution.

1, Inc. v. Commissioner of Revenue, Tennessee Court of Appeals, No. M2017-01382-COA-R3-CV, Dec. 20, 2018.
2 Because Florida does not require an S corporation to file a state income tax return except to report tax on built-in gains, the filing of a Florida return may not have been required.
3 The Court of Appeals rejected Popular Categories’ other arguments positing that it was entitled to apportion its income because of interstate corporate travel, work performed by employees in Florida, and a partnership investment which made it a multistate business. The Court determined that the corporate travel which Popular Categories argued was related to business development was unrelated to its business, was primarily personal in nature and could not be attributed to Popular Categories. The work in Florida was actually performed by an employee of Popular Enterprises who was not acting on behalf of Popular Categories and occurred before the tax years in dispute. Finally, the partnership agreement was not a true partnership agreement but an earn-out agreement related to the sale of Popular Categories to a third party, as no federal partnership return was actually filed and there was no evidence that an actual partnership existed. The Court determined that none of the arguments stated above would provide Popular Categories with substantial nexus with any other state.
4 TENN. CODE ANN. §§ 67-4-2110; 67-4-2010; 67-4-2004(14)(A).
5 Miller Bros. Co. v. Maryland, 347 U.S. 340, 344-45 (1954).
6 Citing J.C. Penney Nat’l Bank v. Johnson, 19 S.W.3d 831, 838 (Tenn. Ct. App. 1999).
7 U.S. CONST. art. 1, § 8, cl. 3.
8 Oklahoma Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 179 (1995).
9 Citing J.C. Penney Nat’l Bank, 19 S.W.3d at 838.
10 430 U.S. 274 (1977).
11 Emphasis added by the Court.
12 Popular Categories made additional points, besides its incorporation, supporting its ties to Florida. For example, Popular Categories also argued that it had bank accounts, a designated agent for accepting service of process, and a corporate office in Florida (the corporate office was the home of one of the corporate officers). These points were briefly mentioned by the Court, but its decision mainly rested on the fact that Popular Categories was incorporated in Florida. 
13 TENN. CODE ANN. § 67-4-2004(49)(A)(i).
14 Id.
15 TENN. CODE ANN. § 67-4-2110(a).
16 Id.
17 TENN. CODE ANN. § 67-4-2004(49)(A)(v).
18 TENN. CODE ANN. § 67-4-2012(i).
19 South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018). For a discussion of this case, see GT SALT Alert: Wayfair ruling overturns Quill physical presence requirement.
20 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

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