Sale of a subsidiary produced “nonbusiness” income.  It is harder for states to tax such income.

An insurance company sold a subsidiary that was doing business in Illinois in 1997 and reported a $1.27 billion gain from the sale for federal income taxes, but it took the position that none of the gain was Illinois source income and, therefore, tax did not have to be paid on it in Illinois.

Illinois, like many states, distinguishes between “business” and “nonbusiness” income.  A corporation must allocate a portion of its business income to Illinois based on the percentage of its total sales, property and payroll that are in Illinois.  However, nonbusiness income is assigned entirely to one state.  It is assigned to the state where the corporation receiving the income is domiciled — the parent company that sold the shares was not domiciled in Illinois — or where the income-producing property is located.

Illinois argued the gain in this case was business income.  Gain is ordinarily business income if it is from a type of transaction in which the taxpayer regularly engages or it is from sale of an asset that was an integral part of the taxpayer’s regular business operations.  The Illinois Supreme Court forced Texaco to treat gain from the sale of 90% of its gas pipelines as business income in 1994 on grounds that the pipelines were income-producing assets regularly used in its business.  Texaco sold all of its pipelines in Illinois.

However, there is a growing consensus among states with similar tax laws to Illinois that gain from complete liquidation of a business is nonbusiness income.  Such states include Pennsylvania, Ohio, Alabama, Tennessee, Kansas, New Mexico and Indiana. (California does not make such an exception.) Many states also treat gain from “partial liquidations” involving sale of only a line of business or geographic segments of a larger business as nonbusiness income.  For example, Pennsylvania treated gain from the sale of two oil pipelines in the state as nonbusiness income, even though the seller retained pipelines in other states.

The Illinois Supreme Court said the gain from sale of the insurance subsidiary was nonbusiness income since, by selling its subsidiary, the insurance company was withdrawing from a separate and distinct portion of its business.  It helped that the parties made a section 338(h)(10) election for federal income tax purposes to treat the sale of the subsidiary as a sale by the subsidiary of all of its assets.  It was easier to see in such a case that the subsidiary was liquidating all of its assets.

The case is American States Insurance Co. v. Hamer.  The court released its decision in late August. 

Keith Martin