Gain From Sale of Goodwill Classified as Business Income
Robert Willens is president of Robert Willens LLC and an adjunct professor at Columbia University School of Business.
In this article, Willens examines a recent Minnesota Tax Court decision that confirms, once and for all, that gain from the sale of goodwill constitutes business income.
Copyright 2023 Robert Willens.
All rights reserved.
Kim Carlson founded Cities Management Inc. (CMI) in 1988 as a Minnesota corporation.1 CMI was primarily engaged in the business of managing community associations in Minnesota and Wisconsin. CMI handled communications, financial reporting, and service contract negotiations.
In 2000 the owners of CMI incorporated Under Construction Services Inc., d/b/a Cities Maintenance (UCS), which provided maintenance for the community associations managed by CMI. CMI and UCS were each S corporations. As of August 31, 2015, Carlson owned 80 percent of the stock in both CMI and UCS, and Michael Egelston owned the remaining 20 percent. On September 1, 2015, Carlson and Egelston sold their stock in CMI and UCS to PMG Holdings Inc. (PMG), an unrelated third party (the CMI transaction).
As is standard operating procedure regarding the sale of stock in S corporations to a corporate purchaser, PMG requested that Carlson and Egelston agree to execute an election under IRC section 338(h)(10). This election transforms the stock sale into a sale by the entity of its assets, thus affording the purchaser a coveted cost basis in the target’s assets. The enhanced basis produces correspondingly greater depreciation and amortization deductions for the purchaser. The election must be made jointly by the purchaser and the S corporation’s shareholders. The shareholders will normally accede to the election when there is “outside/inside basis conformity” — that is, the shareholders’ outside basis in their stock does not differ materially from the entity’s net inside asset basis.
In cases in which the outside basis is substantially more than the corporation’s net inside asset basis, an election becomes problematic considering that, in that circumstance, a stock sale, without an election, will produce substantially less taxable gain. In those cases, an election will only be agreed to if the so-called tax gap can be bridged — that is, if the purchaser is willing to increase its offer price to the point where the shareholders become “tax indifferent” regarding a stock sale versus an asset sale. We can assume, in this case, that the outside basis and net inside asset basis were roughly equivalent.
Carlson solicited professional advice regarding the merits of a section 338(h)(10) election. In estimating the state tax impact of making the election for Carlson — a nonresident of Minnesota — her advisers “followed and relied upon” the Minnesota Tax Court’s decision in Nadler v. Commissioner of Revenue.2 Carlson was apprised that, under Nadler, gain on that portion of the sales proceeds considered goodwill would be taxed under Minn. Stat. section 290.17, subd. 2, that is, would be considered nonbusiness income not derived from the conduct of a business. In reliance on this advice, Carlson agreed to treat the sale of CMI and UCS stock as a sale of assets under section 338(h)(10).
Nadler involved a Minnesota S corporation whose stock was sold by its nonresident shareholders to an unrelated corporate purchaser. A joint section 338(h)(10) election was duly made. The tax court concluded that the gain from the deemed asset sale was nonbusiness income that must be allocated under subd. 2. The court was influenced by the fact that the deemed asset sale was an isolated transaction and that the sale proceeds were not reinvested in the business but instead were distributed to the shareholders. Focusing its attention on the transactional test, to the exclusion of the functional test, the court concluded that the deemed sale gain must be characterized as “not derived from the conduct of a business.” The court then considered how much of the gain allocable to goodwill was properly sourced to Minnesota. It found that gain on the sale of goodwill is allocated to this state “to the extent that the income from the business in the prior year was assignable to Minnesota” — that is, the amount of income in the prior year properly assignable to Minnesota placed a ceiling on the current year’s goodwill gain found to be so assignable.
CMI timely filed a 2015 Form M8 Minnesota S Corporation Return for the short period ending on the date of the sale of the stock. For Carlson, CMI reported gain from the deemed sale of assets, including goodwill, in accordance with Nadler, that is, as income not derived from the conduct of a trade or business, under Minn. Stat. section 290.17, subd. 2. On this basis, Carlson’s 2015 Schedule KS reported $333,844 in Minnesota long-term capital gain for 2015 from the CMI transaction. This amount — once again in conformance with Nadler — was equal to the amount of income CMI apportioned to Minnesota for Carlson in the year preceding the sale — the 2014 tax year.
Commissioner Disavows Nadler
Within a year following the tax court’s decision in Nadler, the Minnesota commissioner of revenue began circulating internal communications advising Department of Revenue personnel not to follow Nadler. On July 3, 2017, the commissioner upped the ante by publicly issuing Revenue Notice 17-02. The notice states that the DOR recognizes only “two categories of income for the purpose of determining the method of allocation under Chapter 290: (1) Business income — that must be ‘apportioned’ to Minnesota; and (2) Non-business income — that cannot be apportioned to Minnesota. . . . Non-business income must be assigned.” This contrasts with the three categories of income recognized in Nadler, which, in addition to business income apportioned to Minnesota, bifurcated the nonbusiness income category into income that is derived from the conduct of a trade or business and income that is not so derived.
Notice 17-02 also disagreed with the way Nadler calculated allocable gains following the sale of goodwill. The DOR indicated that the correct method is to “multiply the taxpayer’s goodwill gain by the business’s prior year apportionment factor,” as opposed to a fixed number, which, in Nadler, was “the actual amount of the income apportioned to Minnesota in the preceding year.” Importantly, the commissioner issued Revenue Notice 17-02 well after CMI made its section 338(h)(10) election based on Nadler.
The commissioner issued a tax order to CMI determining that gain from the CMI transaction was business income subject to apportionment under Minn. Stat. Ann. section 290.17, subd. 3, and assessed CMI $433,017 in nonresident withholding tax. CMI timely filed an administrative appeal with the commissioner, who was intransigent and issued a notice of determination on appeal affirming the assessment.
The parties agree that the proceeds from the CMI transaction should be allocated under section 290.17. The disagreement turns on which allocation provisions of section 290.17 apply to these proceeds. The commissioner contends that the allocation rules in subds. 3 and 4 govern and that the CMI transaction proceeds constitute business income that must be apportioned to Minnesota. CMI, by contrast, argues that gain generated from the CMI transaction is income “not derived from the conduct of a trade or business” and, therefore, must be allocated according to a rule in subd. 2.
Business income must be apportioned “between this state and other states or countries.” The commissioner argues that the CMI transaction proceeds must be apportioned under subds. 3 and 4 because it is the business income of a unitary business operating partly within and partly without Minnesota. If income qualifies as nonbusiness income, as contended by CMI, it may not be apportioned under subd. 3. Nonbusiness income must be allocated under subd. 2. Carlson urges that gain from the sale of CMI’s goodwill is nonbusiness income and importuned the court to adopt her view that her long-term capital gain from the CMI transaction should be capped by the dollar amount of CMI’s 2014 business income that had been apportioned to Minnesota.
Thus, the fundamental disagreement between the litigants was whether gain on the sale of goodwill from the CMI transaction is business or nonbusiness income. The court concluded that the resolution of this disagreement would be controlled by the Minnesota Supreme Court’s decision in YAM Special Holdings,3 in which the nonresident taxpayer operated an internet-based business called GoDaddy, which generated approximately 1 percent of its revenue from transactions with Minnesota customers. YAM conducted its business through disregarded entities, including the “top” entity, Desert Newco LLC. Investors paid YAM approximately $900 million for 71.39 percent of the membership interests in Desert Newco. The transaction was treated as a sale of an undivided interest in that percentage of YAM’s assets.4 The commissioner determined that the gain on the sale was entirely business income and the court agreed. It found that YAM conducted its business through operating subsidiaries and that it sold a partial interest in the operating subsidiaries: “The value of the operating subsidiaries was based, in part, on the success of Yam’s business operations which includes Yam’s revenue generated from Minnesota sales” (emphasis added). Accordingly, the court reasoned, the income generated from the sale of the partial interest in the operating subsidiaries was business income subject to apportionment.
The tax court concluded that the “Supreme Court’s reasoning in Yam is directly applicable in the present case.” The pertinent asset here is CMI’s goodwill. CMI does not, nor could it plausibly, challenge the connection between the goodwill and Minnesota and “has without objection paid tax in prior years on an apportioned share of the net income of CMI’s unitary business.” There can be no doubt that the value of CMI’s goodwill is “based, in part, on the success of CMI’s business operations, which includes CMI’s revenue generated from Minnesota sales” (emphasis added). Finally, there is no dispute, under the so-called functional test used for classifying income as either business or nonbusiness in character, that the goodwill at issue was “an integral asset” of CMI’s unitary business. Accordingly, like decisions consistently reached by courts in other jurisdictions, the court concluded that the income generated from the sale of CMI’s goodwill was business income subject to apportionment.5
Even if, the court noted, “we were to determine that the gain from the CMI Transaction was properly considered non-business income,” that gain would still be allocable to Minnesota as a ratio or percentage, not as a fixed amount. Section 290.17, subd. 6, provides that “non-business income is income ‘of the trade or business’ that cannot be apportioned . . . and must be allocated under subd. 2.” Subdivision 2, in turn, provides in part: “Gain on the sale of goodwill . . . that is ‘connected with a business’ operating . . . in Minnesota is allocated to this state ‘to the extent that’ the income from the business in the year preceding the year of sale was assignable to Minnesota under subd. 3.”6
The court’s conclusion that the CMI transaction proceeds constituted business income to be apportioned under subds. 3 and 4 “makes it unnecessary for us to address this question.” Were we to do so, however, “we would agree with the Court’s previous ruling in Yam that subd. 2(c) requires use of CMI’s apportionment percentage from 2014, the year preceding the sale.”7 In Yam, the court reasoned that the Legislature’s use of the phrase “to the extent that” in subd. 2(c) “refers to the allocation percentage or ratio applied to the previous year’s business income, rather than to the actual dollar amount of the previous year’s income allocated to Minnesota.” Thus, the court repudiated the Nadler holdings regarding the character of goodwill gain as business versus nonbusiness income and the manner in which, were goodwill gain not found to be business income should be allocated to Minnesota.
Estoppel Argument Fails
CMI argued that the commissioner is barred under the theory of nonmutual collateral estoppel from relitigating Nadler. Remember, Revenue Notice 17-02 was issued well after the CMI shareholders agreed to the section 338(h)(10) election that triggered the deemed sale gain. The court disagreed. Collateral estoppel, it noted, in income tax cases must be confined to situations in which the matter raised in the second suit is identical in all respects with that decided in the first proceeding and in which the controlling facts and “applicable legal principles remain unchanged.” CMI has not met its burden because intervening decisions, including Aird v. Commissioner of Revenue,8 “had thrown into doubt the applicability of the Nadler decision.” The court wrote that “given this intervening case law, we cannot conclude that this second case is ‘identical in all respects with that decided in the first proceeding and where the controlling facts and applicable legal principles remain unchanged.’”9
1 Cities Management Inc. v. Commissioner of Revenue, Dkt No. 9484-R (Minn. T.C. Dec. 20, 2022).
3 YAM Special Holdings v. Commissioner of Revenue, 947 N.W.2d 438 (Minn. 2020).
4 See Rev. Rule 99-5, 1999-1 C.B. 434.
5 “The advantage or benefit of goodwill make possible the profitable operation of a business. Goodwill has been found to be inseparable from the business as a whole. Therefore, income from the sale of intangibles . . . constitutes business income.” See The 2009 Metropoulos Family Trust v. California Franchise Tax Board, D078790 (Cal. Ct. App. May 27, 2022). See also First Data Corp. v. Arizona Department of Revenue, No. CV-13-0372-PR (Ariz. Ct. App. 2013): “The gain falls within the functional test and is properly characterized as business income. Prior to the sale, the assets were used to produce business income. The taxpayer treated the income that resulted from the assets as arising in the regular course of business. A fortiori, the disposition of those same assets constitutes business income under the functional test.”
6 See Minn. Stat. section 290.17, subd. 2(c).
7 Cities Management, Dkt. No. 9484-R, slip op. at 17.
8 Aird v. Commissioner of Revenue, Dkt. Nos. 8301-R and 8302-R (Minn. T.C. July 16, 2012).
9 Cities Management, Dkt. No. 9484-R, slip op. at 21-22.
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Tax Notes State, Jan. 23, 2023, p. 335
107 Tax Notes State 335 (Jan. 23, 2023)
Robert Willens LLC
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