Minnesota: Gain from Sale of Unitary Business Subject to Tax

The Minnesota Supreme Court recently held that gain from the sale of a majority interest in a business was subject to Minnesota income tax.  The taxpayer was an Arizona based S-corporation that operated an Internet-based business through twelve wholly-owned U.S. subsidiaries and nine foreign subsidiaries, all of which were disregarded for income tax purposes.  The taxpayer did not own or rent any property in Minnesota and had no employees in the state, but generated about one percent of its revenues from Minnesota customers.  As part of a plan to add certain investors to the business, the taxpayer formed two new wholly-owned subsidiaries and eventually sold a 71.39 percent interest in one of the new entities to third-party investors.  On its federal income tax return for the year at issue, the taxpayer recognized a capital gain of $1.353 billion.  For Minnesota tax purposes, the taxpayer treated the gain as non-business income that was not subject to Minnesota tax. On audit, the Commissioner determined the gain was apportionable business income and assessed additional Minnesota income tax. The taxpayer disputed the treatment, and the case eventually ended up before the state supreme court.

Before the court, the taxpayer argued that the gain at issue was nonbusiness income. As support for this position, the taxpayer argued that Minnesota lacked a sufficient connection with the sale and thus, due process principles prevented the state from taxing a portion of the gain.  The Commissioner of Revenue disagreed, arguing that because the gain from the sale was generated by a unitary business that received significant revenues from in-state customers, Minnesota had a sufficient connection with the sale. The court agreed with the Commissioner, noting that the value of the operating subsidiaries was based, in part, on the success of the taxpayer’s business operations, which included revenue generated from Minnesota sales.  The taxpayer also argued that the unitary business principle applied only when one of the entities that formed part of the unitary business was physically located in the state that sought to tax the business income of the unitary business. In other words, the taxpayer asserted that because it was not physically present in Minnesota, Minnesota could not tax the gain under the principle that the taxpayer was engaged in a unitary business in the state.  However, the court was not persuaded, noting that, in the cases cited by the taxpayer, the ability to apportion the income of a unitary business to the state did not rely on whether the business was physically in the taxing state but rather that the taxpayer was engaged in a unitary business operating in the state.

The taxpayer’s second argument was that the gain constituted nonbusiness income because the sale did not serve an “operational function” and occurred outside the ordinary course of business.   As support for this position, the taxpayer cited to language in the definition of nonbusiness income that excluded gain from a transaction that served an investment function. In the court’s view, this exclusion did not apply to the taxpayer because here it was clear that the taxpayer and the operating subsidiaries were engaged in a unitary business. Please contact Caroline Balfour  at 612-305-5798 with questions on YAM Special Holdings, Inc. v. Commissioner of Revenue.