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Jamie C. Yesnowitz
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On May 22, 2020, the Idaho Supreme Court ruled that the gain from the sale of a majority-owned interest in a limited liability company (LLC) did not constitute business income and therefore was not apportionable to Idaho.1
In a 3-2 ruling affirming a lower court decision, the Court determined that the one-time sale of the LLC did not constitute a regular trade or business activity. The Court also found that the taxpayer’s interest in the LLC served a passive investment function and that the two entities were not unitary. Therefore, the gain did not meet the definition of apportionable business income under Idaho law.
Noell Industries, Inc. (Noell) is a Virginia-based company that manufactured and sold combat and tactical gear throughout the United States. In 2003, Noell’s eponymous founder and owner transferred Noell’s net assets to Blackhawk Industries Products Group Unlimited, LLC (Blackhawk), in exchange for a 78.54% membership interest. While Noell’s founder served as Blackhawk’s president and CEO, he was considered a “high level executive” who did not manage the company’s day-to-day operations. A Virginia LLC with multistate operations, Blackhawk established a physical presence in Idaho in 2004 when it purchased and developed real property in the state, hired employees and leased a factory located in Boise to serve as its West Coast operation center.
In contrast, Noell did not own real property in Idaho and its activities were limited to holding a majority interest in Blackhawk and owning another business entity that leased real property to Blackhawk in Virginia. Noell described its business activity and product/service as “investment” on its tax returns. From 2003 through 2010, Noel did not have any employees, did not share any assets or expenses with Blackhawk, and did not provide financing or other services to Blackhawk. However, the two companies utilized the same professional service firms for their legal and accounting services.
In 2010, Noell sold its 78.54% interest in Blackhawk for a net gain of $120 million. Treating the gain as nonbusiness income, Noell did not apportion any of the gain to Idaho and instead allocated the gain to its commercial domicile in Virginia. Following an audit, the Idaho Tax Commission concluded that the gain was apportionable business income, assessing over $1.4 million in tax after removing penalty assessments. Noell contested the Commission’s decision by filing an appeal with the Ada County District Court, which found that the gain was not business income as defined under Idaho law. The Commission appealed the district court’s decision to the Idaho Supreme Court.
Supreme Court decision
The Court considered whether Noell’s gain from the sale of an ownership interest in Blackhawk constituted “business income” as defined under Idaho law. Pursuant to Idaho statute, business income is apportioned to Idaho under specific statutory formulas,2
while nonbusiness income is allocated to the taxpayer’s commercial domicile.3
Income constitutes business income if it meets either the transactional test or the functional test. The Court analyzed whether the gain qualified as business income under either of the two tests.
The transactional test looks to whether the income arises from transactions and activity in the regular course of the taxpayer’s trade or business.4
Noell argued that it did not have a trade or business because it merely operated as an investment company. The Court agreed, finding that Noell did not regularly engage in the trade or business of buying or selling subsidiary companies. Rather, its primary function was holding interests in two business entities over a period of several years. Therefore, the Court concluded that a one-time sale of Noell’s interest in Blackhawk was not a transaction that occurred regularly in its trade or business.
Under the functional test, business income is “income from the acquisition, management, or disposition of tangible and intangible property when such acquisition, management, or disposition constitute integral or necessary parts of the taxpayer’s trade or business operations.”5
The Commission argued that Noell satisfied the functional test because the gain from the sale of Blackhawk was income arising from: (i) property acquired as a necessary part of its business; and (ii) property managed as a necessary part of its business. Reviewing Idaho’s income tax regulations, the Court noted that the functional test is met in two ways: (i) by finding that the intangible interest serves an operational function, rather than a passive investment function; or (ii) by meeting the unitary business test.6
Citing to U.S. Supreme Court precedent, the Court noted that the operational function and unitary business tests are to be applied together.7
Beginning with the operational function analysis, the Court reviewed the Idaho regulation requiring that an intangible interest must serve “an integral, functional, or operative component to the taxpayer’s trade or business operations” in order to serve an operational function in the taxpayer’s business.8
The Court noted that Noell ceased most, if not all, of its business activity once it transferred its net assets to Blackhawk in exchange for a majority interest. Further, the Court observed that the sale of Blackhawk served to discontinue Noell’s interest in Blackhawk, rather than furthering its trade or business of holding interests in other entities. Accordingly, the Court concluded that the sale of the LLC interest was a passive investment because its holding of Blackhawk was limited solely to an investment function.
The Court next addressed the question of whether Noell and Blackhawk operated as a unitary business. Citing U.S. Supreme Court case law, the Court stated that a unitary business relationship requires “functional integration, centralized management and economies of scale.”9
The Court also referenced Idaho regulations, which define a unitary business as a “single economic enterprise” made up either of: (i) separate parts of a single business entity; or (ii) a commonly controlled group of business entities that are “sufficiently interdependent, integrated and interrelated through their activities” to provide a “synergy and mutual benefit” that produces a “sharing or exchange of value” among each and a “significant flow of value to the separate parts.”10
Although the court acknowledged that Noell and Blackhawk were part of a commonly controlled group, the Court again noted that Noell was a parent holding company with no shared control or operations over the LLC. Noell shared no centralized management, oversight or headquarters with Blackhawk because Noell had no employees, payroll or offices to share. The “primary common denominator” between the two companies was the involvement of their founder, who, in the Court’s view, did not provide the level of oversight over both entities required to meet the unitary business principle. To the Court, the “high-level separation” between the two companies indicated substantial independence rather than the interdependence required to show unity. For these reasons, the Court determined that the entities were not unitary. Finding that the gain did not meet the definition of “business income” under either the transactional or functional tests, the Court affirmed the district court’s decision.
Two justices dissented from the Court’s majority opinion, disagreeing with the conclusion that the two entities were not unitary. In the dissent’s view, both companies were part of a unitary business because they were part of a commonly controlled group, merely due to the fact that Noell owned 78.54% of Blackhawk. Further, the dissent argued that the two companies were functionally integrated and had centralized management due to the shared know-how and oversight from Noell’s founder.
According to the dissent, both the district court and the majority minimized the founder’s significant management responsibilities. The founder’s role as CEO and president of Blackhawk suggested to the dissent that the income realized by that company was highly dependent upon his contributions as its “spiritual father.” The dissent noted that it was impossible to ignore the founder’s significant contributions to the success of Blackhawk as its CEO and president. Therefore, the dissent concluded that the gain on the sale of the LLC interest could not be characterized as passive income given the founder’s involvement in both companies, no matter how minimal.
In a case concerning a seemingly “straightforward issue of tax law,” the Court’s majority and dissenting opinions reached different conclusions about the character of the gain of the Blackhawk business based on the fact that both companies had the same founder. While the majority determined that the founder’s presence at both companies alone did not rise to the level of oversight required by the unitary business principle, the dissent viewed the founder’s management roles as sufficient evidence of a unitary business relationship, leading to a conclusion that Noell’s interest in Blackhawk served an operational function.
A decision that may be viewed favorably by many taxpayers, the Noell
case comes at a time when states are becoming increasingly aggressive in disallowing nonbusiness income positions with respect to gain recognized on the sale of intangible interests. Therefore, the case may have potential applicability outside Idaho as persuasive authority, based on the unique fact pattern and application of the transactional and functional tests utilized by many states to define business income. This is especially true in the case of shell companies created for non-tax reasons. For example, the Commission effectively viewed the taxpayer as a sham entity after the transfer of assets to Blackhawk, and part of an overall reorganization effort to avoid paying tax to Idaho after the sale of its interest in Blackhawk. The Court, however, noted that the seven-year time period between the reorganization of the business in 2003 and the sale of Blackhawk in 2010 indicated that the reorganization was not pursued for tax avoidance purposes. Moreover, Noell allocated the gain to Virginia, its commercial domicile, and paid tax on the gain. Factors such as these distinguish the Noell
case from other cases arriving at a business income conclusion.
It should be noted that despite Noell
, the scrutiny from state tax authorities with respect to high-stakes nonbusiness income positions taken by multistate taxpayers likely will continue, leading to a likelihood of more court cases on these types of issues. This is because taxpayers claiming that a transaction generates nonbusiness income as the income does not meet applicable transactional, functional or operational tests generally must disclose such treatment on their income tax returns. Even in cases where taxpayers try to uniformly classify income from a one-time transaction as nonbusiness, allocable income on all multistate returns, it may be very difficult to do so without challenge because the state tax laws governing the classification of business and nonbusiness income are not completely consistent.
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