Illinois: Employees of Disregarded Entity Not Counted in Applying 80/20 Test

The Illinois Independent Tax Tribunal recently addressed whether a member of unitary group was excluded as an 80/20 company. The taxpayer, PepsiCo Inc. and Affiliates (PepsiCo) filed Illinois Income and Replacement Tax Returns on a combined basis taking the position that a member of the taxpayer’s business group, Frito-Lay North American Inc. (FLNA), was an excluded 80/20 company. Under Illinois income tax law, a unitary business group does not include the income of those members whose business activity outside of the United States makes up 80 percent or more of the member’s total business activity. The business activity of the entity is measured by means of the property and payroll factors.

Immediately prior to the tax years at issue, PepsiCo underwent a reorganization where (among a number of other structural changes) a single-member LLC, PepsiCo Global Mobility, LLC (PGM LLC), was formed under FLNA. PGM LLC served as the employer for certain expatriate employees who were sent overseas to work for foreign host companies. After the transfer, the employees were treated as foreign employees whose compensation was foreign payroll for purposes of FLNA’s 80/20 calculation. On audit, the Department disallowed FLNA’s 80/20 exclusion and added FLNA’s income to PepsiCo’s unitary group income. When the matter came before the Tribunal, the Department argued that FLNA was not excluded as an 80/20 company because: (1) PGM LLC could not be considered the employer of the expatriated employees in light of economic realities, and (2) PGM LLC had no economic substance and should be disregarded. In contrast, the taxpayer argued that the 80/20 test was a straightforward mechanical calculation and that the Department was not entitled to analyze and challenge the facts underlying the calculations.

The Tribunal, employing a substance over form analysis, determined that PGM LLC was in reality a shell entity with no economic substance. While companies are free to organize themselves in a manner that reduces their tax liability, common law precedent illustrates such actions must have some economic substance or business purpose. The Tribunal pointed to the following facts as support for its position: (1) while PGM LLC ostensibly became the employer of the expatriates, the switch was simply a name change on the paperwork and nothing changed substantively for the employees; and (2) the employees appeared to be paid by PGM LLC, but in reality these amounts were paid by the foreign host companies.  The Tribunal concluded that “not only was no one at home at PGM LLC, it didn’t even have a home. It was a shell corporation used to list the expatriates as employees.”

The Tribunal next concluded that the LLC was not the true employer of the expatriate employees. The Tribunal reviewed a number of common law factors used to assess an employee/employer relationship and found PGM LLC to fall short of each of them.  The payroll for the employees was handled through a third-party and paid by the host companies, the LLC had no control over the employees and did not sign off on their work assignments, the LLC provided no work tools to the employees, and because it was not a functional business, the employees work could not be considered part of the LLC’s business. The Tribunal concluded that the taxpayer had failed to prove that FLNA was an excluded 80/20 company. For more information on PepsiCo Inc. please contact Brad Wilhelmson.