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Jamie C. Yesnowitz
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The Minnesota Supreme Court recently affirmed a Minnesota Tax Court decision holding that the 2011 sale of a majority interest in an S corporation that served as a holding company to an operating business was subject to Minnesota income and franchise tax.1
In its ruling, the Court agreed that the holding company was part of a “unitary business” with 12 domestic operating subsidiaries. Because the unitary business was being conducted “in whole or in part” in Minnesota, the approximate $1.17 billion gain generated by the sale of the interest in the subsidiaries was subject to apportionment and tax by the Minnesota Department of Revenue.
In 1997, an Arizona resident individual founded the Web hosting company and Internet domain registrar, GoDaddy. The individual operated this business as the sole shareholder of a holding company, YAM Special Holdings, Inc. (YAM), which held 12 domestic and nine foreign subsidiaries through which GoDaddy services were provided. Initially, the domestic subsidiaries were organized as qualified Subchapter S subsidiaries (treated as disregarded entities for income tax purposes). The business registered Internet domain names, provided website hosting, security and privacy services, email accounts, and web design tools. YAM’s principal place of business and commercial domicile was located in Arizona. YAM neither owned nor rented any real or tangible property in Minnesota, and never had any employees located in Minnesota. YAM’s sales factor in Minnesota was approximately 1% in 2010 and 2011.
In preparing to sell the company in 2011 to several unrelated investors, multiple structuring steps took place. The first step was to form two limited liability companies (LLCs) as wholly-owned subsidiaries of YAM: Newco and GoDaddy Operating Company LLC (GDO). Later in December, the 12 domestic subsidiaries converted to wholly owned LLCs. Next, YAM contributed the 12 LLCs, most of the other assets, and remaining liabilities to GDO. YAM retained its interest in Newco, some cash, and other intangibles. YAM’s interest in GDO was then contributed to Newco.
On Dec. 16, 2011, YAM was paid $899.5 million in cash by the investors for a 71.39% interest in Newco. That same day, GDO borrowed $750 million to pay various transaction costs and purchase restricted stock units previously issued to YAM employees. Finally, GDO transferred roughly $280 million to YAM, and the net cash proceeds of the sale were delivered to the Arizona resident individual. The GoDaddy business continued as it had before the transaction, with no interruption in service.
YAM reported the approximate $1.35 billion federal long-term capital gain from the transaction as not subject to Minnesota tax on its 2011 Minnesota composite income tax return. The Minnesota Commissioner of Revenue determined that YAM owed $1,639,940 in tax, interest, and penalties on a portion of the gain. YAM appealed the assessment, which the Commissioner affirmed in full, resulting in YAM’s appeal to the Minnesota Tax Court. After the Tax Court ruled in favor of the Commissioner,2
YAM appealed the case to the Minnesota Supreme Court.
Unitary business principle
The Minnesota Supreme Court began its analysis by clarifying that Minnesota uses the unitary business principle and apportionment approach to determine which portion of the income is subject to tax. Once the state determines that a trade or business is part of a unitary business, it is permissible for the state to apply an apportionment formula to that part of the business income subject to tax as long as the apportionment does not offend the Due Process or Commerce Clauses of the U.S. Constitution.3
The Court explained that apportionment satisfies the Due Process Clause when there is a minimal connection or “nexus” between the corporation and the state in which it does business. In order to satisfy the Commerce Clause, constitutional concerns are met if there is substantial nexus, the apportionment is fair, the apportionment is related to the services the state provides, and the apportionment does not discriminate against interstate commerce.4
The Court emphasized that by using this framework, income generated through passive investment or a distinct business operation may be excluded from apportionment.5
Is there a sufficient connection?
After analyzing the Minnesota statutory framework, the Court addressed YAM’s first argument that apportioning income from the sale to Minnesota is unconstitutional because Minnesota does not have a sufficient connection with the income generated from the sale. YAM contended the income is deemed “nonbusiness” income.6
Under Minn. Stat. Sec. 290.17, subd. 6, nonbusiness income is the income of a trade or business that cannot constitutionally be apportioned to Minnesota and includes income “derived from a capital transaction that solely serves an investment function.”
Both YAM and the Court agreed that YAM and its operating subsidiaries formed a unitary business at the time of the sale. According to the Court, based on the undisputed facts, YAM had a sufficient connection to Minnesota. This connection arose from the fact that GoDaddy received 1% of its revenue from transactions with Minnesota customers, and YAM paid income tax on the net income from that revenue. Further, when the operating subsidiaries were sold, their value included revenue generated by YAM from Minnesota sales.
The Court cited Allied-Signal
, Inc. v. Director, Division of Taxation
a 1992 U.S. Supreme Court case, to clarify that even though a payor and payee are not part of the same unitary business, income can be apportioned and taxed by a state if the asset generating the income is part of a unitary business being conducted in whole or in part in the state.
, New Jersey sought to tax the gain on a corporation’s sale of another publicly traded corporation’s stock. Although the parties stipulated that the two corporations were unrelated business enterprises, the New Jersey Supreme Court determined they formed a “unitary business” because the corporation used the proceeds of the stock sale to acquire an interest in a different, complementary business. New Jersey argued that distinguishing between operational and investment assets is “artificial” and the U.S. Supreme Court should abandon the unitary business rule. However, the U.S. Supreme Court found that apportionment was permissible.
In applying Allied-Signal
to YAM, the Court noted that because YAM and the operating subsidiaries formed a unitary business, the sale of the partial interest in the subsidiaries generated income for the unitary business, thus subjecting the transaction to Minnesota tax.
YAM contended that the unitary business principle only applies when one of the entities forming part of the unitary business is physically located in the state seeking to tax the income. To support this assertion, YAM cited several cases concluding that a unitary business was not formed due to a lack of integration and centralized management.8
Additionally, YAM pointed to multiple cases regarding tax-paying trusts concluding the trusts did not have sufficient contacts with the state and were therefore not subject to tax.9
In rejecting YAM’s argument, the Court clarified that the cases cited by YAM either did not address the issue of physical presence directly, or were limited to the specific facts of those cases.
YAM alternatively argued that the sale of an S corporation interest by its nonresident owner represented non-apportionable investment income because, according to YAM, the sale served no operational function and occurred outside the ordinary course of business. To support its argument, YAM asserted that the transaction incurred substantial new debt, working capital was reduced, and that the sale proceeds were not reinvested in regular business operations. The Court addressed YAM’s second argument that the transaction was merely an investment by first examining Minn. Stat. Sec. 290.17, subd. 6 to determine the meaning of “nonbusiness income.”
The Court agreed with the Commissioner of Revenue in that there is no separate test for nonbusiness income and that subd. 6 codifies the standard set forth in Allied-Signal
: if a capital transaction serves an operational rather than investment function, a state can apportion the revenue and apply a tax. This standard was later adopted by the Court in Hercules, Inc. v. Commissioner of Revenue
In Hercules, the Court concluded that the gain on the sale of stock was allocable to its state of commercial domicile instead of a sale subject to apportionment, because neither the stock itself nor the proceeds of that sale were used in Hercules’ day-to-day business operations.
Subsequent to the Hercules
decision, the Minnesota legislature amended subd. 6 to narrow the definition of nonbusiness income articulated in Hercules. Under the revised definition, if the taxpayer and corporation deriving the income do not have a unitary business relationship, and if the income from the sale serves an investment rather than operational function, Minnesota cannot apportion the income. However, the Court declined to find that YAM’s gain fell under an investment function. YAM conceded that it and its subsidiaries formed a unitary business, and because the income generated from the transaction is business income derived from a unitary business, the Court concluded that Minnesota can apportion and tax the gain generated from the sale.
Rejection of Nadler approach
In the instant case, the Minnesota Supreme Court chose not to follow the unique approach taken in Nadler v. Commissioner of Revenue
the last significant nonbusiness income case heard by the Minnesota Tax Court in 2006.12
At issue in Nadler
was the characterization of income by nonresident taxpayers selling their interests in an S corporation. In Nadler
, the Court developed a unique approach designating three categories of income: (i) business income; (ii) nonbusiness income from a trade or business; and (iii) nonbusiness income not from a trade or business. The case involved a sale of an interest in an S corporation by nonresident taxpayers. The S corporation held several restaurant franchise stores in Minnesota and other states. The Nadler
Court found that because an IRC Sec. 338 election was made, the gain arose from a deemed asset sale, but even if it had been treated as a stock sale, the gain would have been characterized as nonbusiness income in Minnesota. As the gain in Nadler
was determined to be nonbusiness income and not derived from a trade or business, it was not subject to Minnesota taxation.
With this decision, the Minnesota Supreme Court has affirmed that Minnesota can apply an economic nexus standard to taxpayers who lack physical presence in the state but make a market in the state through electronic and other advertising and reach Minnesota customers via the Internet.
Because the Department decided not to appeal Nadler
, or follow the decision in subsequent guidance, uncertainty has existed for over a decade among taxpayers and tax practitioners with respect to how to properly apply Minnesota’s rule on business income, especially in the context of the sale of a pass-through entity by an individual. Presumably the state had a stronger position to tax the gain in Nadler
, since the business itself consisted of several restaurants with physical assets located in Minnesota, compared to YAM, whose business had no physical connection to Minnesota.
It is interesting that the Court examined the unitary relationship among the legal entities of the business itself rather than the unitary connection (if any) between the business of the S corporation and its individual owner, a nonresident of Minnesota and the majority shareholder who was the main recipient of the proceeds from the sale. Presumably, under the Court’s analysis, a sale of the assets of a business whose operating income is apportioned to Minnesota would also result in the gain from a sale being apportionable.
C corporations and S corporations doing business in Minnesota that have made a sale of business assets or are contemplating one, should review this case and their facts to determine if apportioning gain to Minnesota is required.
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