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Jamie C. Yesnowitz
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The Minnesota Tax Court recently ruled 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 Tax Court found that the holding corporation was part of a “unitary business” with the 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 founded the Web hosting company and Internet domain registrar, GoDaddy, and 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, a series of restructuring 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 purchased 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. The GoDaddy business carried on 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.
Apportion, assign or allocate?
The Tax Court began its analysis by referencing Minn. Stat. Sec. 290.17 and grappling with three primary concepts: apportionment, assignment and allocation.
The Tax Court analyzed Minn. Stat. Sec. 290.17, subd. 1(a), which states that income from a trade or business that is carried on “within and partly without” Minnesota must be apportioned to Minnesota, except nonbusiness income. Because “trade or business” is not defined within Chapter 290, the Tax Court looked to the definition of “nonbusiness income.” Nonbusiness income is not subject to apportionment and is instead either allocated or assigned to a state or states. Income that is not apportioned to a state must either be assigned to a particular state or allocated among several states using some method other than the statutory apportionment factor.
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.”
After analyzing the Minnesota statutory framework, the Tax Court turned its attention to numerous U.S. Supreme Court, Minnesota Supreme Court and Minnesota Tax Court cases to determine whether the gain could constitutionally be taxed. In addressing YAM’s argument that the transaction was merely an investment, the Tax Court first clarified what it means for purposes of state apportionment to be constitutional and to satisfy the Due Process Clause. The Tax Court stated 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.
The Tax Court cited the 1992 U.S. Supreme Court case Allied-Signal, Inc. v. Director, Division of Taxation2
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. The state of 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 Tax Court noted that although YAM and the unrelated investors were not part of a unitary business at the time of the transaction, YAM and the 12 domestic subsidiaries through which GoDaddy operated were a unitary business. Because of this relationship, the Tax Court determined the gain generated by the sale of the interest in the subsidiaries could be apportioned to Minnesota.
YAM argued that the sale of an S corporation interest by its nonresident owner represented non-apportionable investment income. The Tax Court addressed YAM’s argument that the transaction was merely an investment by first examining former Minn. Stat. Sec. 290.17, subd. 6 to determine the meaning of “nonbusiness income.” In two separate decisions (filed on the same day in 1998), the Minnesota Supreme Court held that the transactions resulted in nonbusiness income, but provided differing methods as to how subd. 6 should be interpreted.
In the first case, Hercules, Inc. v. Commissioner of Revenue,3
the Court concluded that the gain on the sale of stock was allocable to its state of commercial domicile instead of apportionable, because neither the stock itself nor the proceeds of that sale were used in Hercules’ day-to-day business operations.
In the second case, Firstar Corp. v. Commissioner of Revenue
the Court noted that Minnesota had adopted a “transactional test” where the controlling factor is the “nature of the particular transaction giving rise to the income” such as the “frequency and regularity of similar transactions, former business practices, and subsequent use of proceeds.” The Court concluded that the gain on the asset sale of Firstar’s headquarters was considered nonbusiness income and therefore not subject to apportionment.
Subsequent to these two decisions, the Minnesota legislature amended subd. 6 to narrow the definition of nonbusiness income. After the amendment, the U.S. Supreme Court continued to provide guidance regarding the apportionment of income. In MeadWestvaco Corp. ex rel. Mead Corp. v. Illinois Department of Revenue
the Court rejected the idea that there is a test for apportionability apart from the concept of whether a unitary business exists. Read together, Allied-Signal
stand for the proposition that as long as an asset that generated the income is part of a unitary business being conducted in Minnesota (i.e. “asset unity”), income can be constitutionally apportioned to the state. On that basis, the Tax Court concluded domestic subsidiaries through which GoDaddy operated served not just an investment function, but an operational function as well.
Rejection of Nadler approach
In the instate case, the Tax Court chose not to follow the unique approach taken in Nadler v. Commissioner of Revenue
the last significant nonbusiness income case heard by the Tax Court in 2006. At issue in Nadler was the characterization of income by nonresident taxpayers selling their interests in an S corporation. The Nadler
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, including some in Minnesota. 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.
YAM’s other arguments
“Operating” a business in Minnesota
As an alternative to the nonbusiness income approach, YAM claimed that even if the gain on the sale to the unrelated investors were apportionable, it did not “operate” a business in Minnesota. According to YAM, because it did not have employees or property in Minnesota, it therefore was not operating in the state. The Tax Court pointed out that this argument was irrelevant, since allocating gain on the sale of goodwill is only applicable when the income is nonbusiness income. But even if the question were addressed, the Tax Court viewed YAM’s activity to constitute the operation of a business in Minnesota by applying an economic nexus standard, pointing to the fact that YAM generated revenue from Minnesota customers.
Amount of gain taxed
YAM also contended that the amount of gain allocated to Minnesota was incorrect, arguing that the amount should be limited to the exact dollar amount of the previous year’s income. But again, the Tax Court clarified that since the allocation of gain is only relevant when the gain is considered nonbusiness income, the issue need not be addressed, and if it were, Minn. Stat. Sec. 290.17, subd. 2(c) would be read to conclude that the allocation references a percentage or ratio, not an actual dollar amount.
In the instant case, the Tax Court left no doubt that Minnesota will 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.
The Tax Court also expressed frustration with the seeming inconsistency in the previous business versus nonbusiness income frameworks that the Minnesota Supreme Court outlined in Firstar
and in Hercules
YAM appealed this decision to the Minnesota Supreme Court on Jan. 6, 2020. Under Minnesota’s law, the Minnesota Supreme Court is required to take the case and will likely schedule a date for oral arguments later this year. The case is currently undergoing briefing. It will be interesting to see if the Supreme Court takes the same approach as the Tax Court by looking at how unitary the domestic subsidiaries are to each other and to the overall business. Or in the alternative, the Court could take a different approach by examining whether the state has the right to tax the individual owner of the S corporation solely based on the end-user Minnesota customers of the operational business. Taxpayers contemplating a sale of a business or business assets should follow the Minnesota Supreme Court’s impending oral arguments and subsequent decision carefully.
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