Idaho: Sale of majority-owned LLC was not business income

The Idaho Supreme Court recently held that gain from a sale of a majority-owned interest in an LLC did not constitute business income. In doing so, the Court affirmed an earlier district court decision. The LLC at issue was an LLC that manufactured and sold combat and tactical gear throughout the U.S. The taxpayer at issue was a corporation that held a 78.54 percent membership interest in the LLC. The overall business had been started by a former Navy Seal and was inspired by his experiences.   A number of years ago, the founder transferred the assets of the corporation to a new LLC in exchange for the 78.54 percent interest. After that occurred, the corporate taxpayer’s activities were limited to holding its majority interest in the LLC and owning another business entity that leased real property to the LLC.  During the years leading up to the sale of the LLC, the taxpayer had no employees and described its business activity as “investment” on its tax return.  The founder and owner of the taxpayer corporation was the president of the LLC, but was part of a larger six-person management team and was generally not directly involved in the LLC’s day-to-day operations.  In 2010, the taxpayer sold its interest in the LLC and recognized a $120 million gain.  The taxpayer treated the gain as non-business income allocated gain entirely to its commercial domicile, Virginia.  The State Tax Commission, later re-characterized the gain as apportionable business income and the taxpayer was assessed $1.4 million in additional tax.  The dispute eventually made its way to the state’s highest court.

Under Idaho law, income is business income if it meets either the transactional test or the functional test.  The transactional test looks at whether the gain resulted from a transaction in the regular course of the taxpayer’s trade or business. The Court concluded that the single sale of the LLC was not a transaction that occurred regularly in the corporation’s regular trade or business. Next, the Court looked at whether the gain from the sale of the LLC was business income under the functional test. Under that test, business income is “income from the acquisition, management, or disposition of tangible and intangible property when such acquisition, management, or disposition constitutes integral or necessary parts of the taxpayer’s trade or business operations. Idaho’s administrative rules provide two methods to meet the functional test: (a) a finding that the intangible interest served an operational function—rather than a passive investment function, or (b) by meeting the unitary business test. Citing to the MeadWestvaco decision, the Court noted that it had to apply these tests together.  In addressing the first test, the Court held that the interest in the LLC was a passive investment because the sale was not “an integral, functional, or operative component to the taxpayer’s trade or business operations.” The taxpayer’s business, the Court observed, was to hold interests in other entities, which was discontinued as a result of the sale. The Court next addressed whether the taxpayer and the LLC were unitary. Although the holding company and the LLC were commonly controlled, the Court concluded that the entities were not unitary. Notably, the taxpayer, which the Court viewed as a shell-holding company, shared no centralized management, oversight, or headquarters with the LLC and while the companies utilized the services of the same accounting and legal firms, they did not share resources or employees. The “primary common denominator” between the two companies was the presence of the founder, but the Court concluded his involvement did not rise to the level of oversight that the unitary principle requires for functional integration, centralized management, and economies of scale. Please contact Chris Hoge at 415-963-8241 or Mike Larkin at 801-237-1335 with questions on Noell Industries v. Idaho State Tax Commission.