Selling a Business Unit? Understand the Unitary Business Doctrine to Anticipate, Reduce or Avoid State Corporate Income Tax Assessments

Selling a business unit requires closely examining a myriad of potential commercial and financial outcomes. For state corporate income tax purposes, one of the most critical considerations is the unitary business principle. If the business unit being sold operates in an integrated manner with other business divisions or entities, the income arising from the sale may be deemed business income and apportioned to all of the states in which the unitary business operates. If the business unit being sold does not operate in an integrated manner with other business divisions or entities, the income arising from the sale may be nonbusiness income generally allocated to the selling entity’s state of commercial domicile.

How Andersen Can Help

Whether a business unit operates on a unitary basis with other business divisions or entities is a fact-specific determination that depends on several judicially created tests and factors. Andersen’s State and Local Tax (SALT) team can help business taxpayers understand how the unitary business principle could apply to the sale of a business unit and help a corporate parent anticipate, reduce or avoid state corporate income tax assessments in connection with a planned divestiture.

Overview of the Unitary Business Principle

The unitary business principle is premised on the idea that certain integrated businesses should be taxed as a single unit. This principle serves both as the foundation for the common apportionment of related business activities, and the combined reporting method, which is required or permitted in a majority of states. For purposes of state corporate income taxes, a corporation that operates in two or more states must apportion (i.e., assign) its business income among the states in which it operates. Nonbusiness income is allocated to the location of the property generating the income. Nonbusiness income generated from the sale of an intangible asset, such as equity in a subsidiary, is generally allocated to the selling corporation’s state of commercial domicile.

Where multiple trades or businesses are related through common characteristics, income apportionment for taxation requires a unitary analysis. The unitary analysis determines the extent to which a state may tax, through a reasonable apportionment formula, property or income located outside of the state’s jurisdiction. If a business is found to be unitary, the state may apply its apportionment formula to the property or income associated with the business to determine the amount of income that is fairly attributable to the state. To the extent the test of unity is not met, the income from the non-unitary business will be treated as nonbusiness income on the state return of the taxpayer. Generally, nonbusiness income is removed from the taxpayer’s apportionable tax base and allocated to the taxpayer’s state of commercial domicile.

In the case of divestitures, the unitary business principle serves as the backdrop for the extent to which the proceeds from the sale of an asset can constitutionally be taxed by a state. Sales of non-unitary business assets will not be included in the apportionable state tax base. If, for example, a subsidiary is sold, the gain from the sale will only be subject to multistate apportionment if the parent and subsidiary possessed a unitary relationship at the time of the sale.

Tests of Unity

Apportioning a taxpayer’s multistate income is grounded in U.S. constitutional jurisprudence under the Commerce and Due Process clauses. The U.S. Supreme Court and various state courts interpret federal law for purposes of determining whether income is subject to apportionment. Such determination hinges upon whether the activity or the asset precipitating the income is unitary with the other activities of the taxpayer. Through a series of U.S. Supreme Court cases, the flow of value test was developed to make this determination. Under this test, whether the operations of a subsidiary can be considered unitary with the parent corporation depends on whether the activity of that subsidiary and the parent have achieved functional integration, centralization of management and economies of scale.

While states are bound by the U.S. Supreme Court’s interpretation of the unitary business doctrine, several states have adopted supplemental tests for determining unity beyond the federal flow of value test. These include the three unities test and the contribution or dependency test. While these additional tests use different language, the crux of the analysis is generally shared with that of the federal test: did the two businesses derive some tangible or intangible value from their common ownership?

Unity With Respect to Divestitures

When a taxpayer divests itself of a unitary business, the proceeds from the divestiture are treated as business income subject to apportionment. If the business is not unitary, the proceeds are treated as nonbusiness income and will be allocated to the business’s state of commercial domicile.

The U.S. Supreme Court addressed unity with respect to divestitures in MeadWestvaco Corp. v. Illinois Dept. of Revenue (2008). In this case, the taxpayer (Mead) was in the paper products business. Mead sold its interest in a division, Lexis—which engaged in business in Illinois—generating over $1 billion in capital gain. The Illinois state courts found that, while Mead and Lexis did not operate a unitary business, the state nevertheless had the right to tax the gain from the sale of Lexis due to the fact that Lexis served “an operational purpose” in Mead’s business. On review, the U.S. Supreme Court rejected this line of reasoning, emphasizing that a unitary determination was required for Illinois to include Mead’s gain on the sale in its apportionable tax base.

The U.S. Supreme Court’s holding in MeadWestvaco that a unitary relationship is required for a state to tax an out-of-state taxpayer on the gain from the sale of a business with in-state activity has recently been challenged by some state tax agencies. For example, in Utah State Tax Commission Decision No. 16-1358 (April 4, 2022), the commission rejected the state audit division’s argument that an out-of-state taxpayer’s gain from the sale of non-unitary partnership units was subject to Utah tax. The state argued that because the operating income generated by the partnership passed through to the taxpayer and was included as business income on the taxpayer’s Utah return, the gain from the sale of the partnership should likewise be included. The commission found that, while an asset may be included in a unitary business even if there is no unitary relationship between the payor and payee, when the asset in question is another business, a unitary relationship is required. Thus, following the MeadWestvaco analysis, the commission found that because there was no unitary relationship between the taxpayer and the partnership at issue, the gain could not constitutionally be taxed by Utah.

In VAS Holdings & Investments LLC v. Commissioner of Revenue (2022), an Illinois-based company sold its interest in a non-unitary subsidiary that was doing business in Massachusetts. The Massachusetts Department of Revenue argued that a unitary relationship is not required for Massachusetts to tax the gain on the sale as long as the business sold has sufficient connection with the state. The department reasoned that the unitary business principle does not apply as the state’s taxing power is based on the undisputed in-state activity of the subsidiary, not the parent. Conversely, the taxpayer asserted that, based on the U.S. Supreme Court’s holding in MeadWestvaco, the Due Process and Commerce clauses preclude Massachusetts from taxing even an apportioned share of the capital gain realized due to the absence of unity. Essentially, the taxpayer’s position is based on well-settled U.S. Supreme Court jurisprudence that requires a unitary relationship for a state to tax a portion of the gain on the sale of an in-state business.

The Massachusetts Supreme Judicial Court held that the state lacked the statutory authority to tax the capital gain realized by the out-of-state parent company. The Court initially agreed with the state’s contention that the unitary business principle is not the exclusive method by which a state’s taxing power is limited under the Constitution. Because the non-unitary subsidiary had nexus with Massachusetts, there was no constitutional bar to the state asserting its taxing authority over the capital gains from the sale of the subsidiary. However, the Court then found that while there may not be a constitutional impediment to taxation, the tax must be authorized by state statute. In this case, Massachusetts statute defines both apportionable and allocable income by reference to the unitary business principle. Accordingly, because there was no unitary business between the out-of-state parent and the in-state subsidiary, the tax was not authorized by statute as apportionable or allocable income.

The Takeaway

When evaluating the unitary business doctrine before making a divestiture, taxpayers must analyze meaningful connections between businesses indicating a flow of value, rather than superficial indicia of unity. They must also distinguish between a unitary group, with sufficient interrelationship among related entities that are considered parts of a single economic enterprise, and a group of commonly owned businesses or activities, the operations of which have no appreciable effect on one another. Taxpayers engaging in the sale of a subsidiary or other business asset should carefully assess whether the asset is truly unitary with their business under the federal flow of value test, as well as the potential tax savings of excluding the gain from the sale in apportionable income. While caution should be exercised in light of aggressive state action challenging the U.S. Supreme Court’s decision in MeadWestvaco, taxpayers must recognize the precedent set by the U.S. Supreme Court and determine whether unity exists and apportionment is appropriate. To understand how the unitary business doctrine applies to particular businesses, contact a member of Andersen’s SALT team.