To Be Or Not To Be: Nonbusiness Income

In recent years, taxpayers have been confronted with an ever changing sea of definitions, tests and analyses with respect to nonbusiness income claims. From statutory changes to seemingly more frequent adverse court decisions, taxpayers are increasingly confronted with statutes that have been drafted, or interpreted, to narrow the scope of what constitutes nonbusiness income. In fact, many of the recent court decisions classifying gains as nonbusiness income have come from states that amended their statutes after the tax years involved in the cases.

Although initially 26 states adopted the language of the Uniform Division of Income for Tax Purposes Act ("UDITPA") definition of "business income,"1 state legislatures, often in response to favorable court decisions for taxpayers, have slowly changed their statutory definitions of business income by: (i) providing that "business income" is all income apportionable under the U.S. Constitution;2 (ii) modifying the UDITPA definition to provide that "business income" includes income from tangible and intangible property if the acquisition, management or disposition of the property constitutes integral parts of the taxpayer's regular trade or business;3 or (iii) in the case of Pennsylvania, incorporating the changes in both (i) and (ii).4 Currently, approximately half of the original 26 states have retained the traditional UDITPA definition of business income. Despite these statutory changes and recent adverse court decisions, nonbusiness income claims remain viable and continue to be valuable weapons in a taxpayer's arsenal.

This article begins by identifying and analyzing the most common statutory changes designed to expand the definition of "business income," followed by a survey of recent case law involving nonbusiness income claims under both the traditional UDITPA definition and the modified definitions. Finally, this article concludes by providing a framework for analyzing nonbusiness income claims in this continually-evolving landscape.

Recent Statutory Changes

Since the adoption of UDITPA, many state legislatures have sought to broaden the amount of income that is apportionable to their state by changing the definition of business income, primarily in one of the following three ways:

Establishing a Disjunctive Functional Test

In the 1990s, Tennessee and New Mexico changed their statutory definitions of business income to provide for a disjunctive definition under the functional test, so that their statutes now refer to the "acquisition, management or disposition" of property.5

Similarly, in 2001, the Alabama Legislature enacted a new statute to define "business income" in an attempt to legislatively overrule Ex parte Uniroyal Tire Co.6 In Uniroyal Tire, the Alabama Supreme Court held that the UDITPA definition of business income provided for a transactional test only and that a company's liquidation of its entire partnership interest was nonbusiness income as "[a] complete liquidation and cessation of business do[es] not generate business income under the transactional test . . . because, by definition, such events are most extraordinary; they do not occur in the regular course of the taxpayer's trade or business."7

Although the UDITPA definition of business income was left intact, for taxable years beginning after December 31, 2001, the new statute provides in relevant part that:

"[B]usiness income" means income arising from transactions or activity in the course of the taxpayer's trade or business; or income from tangible or intangible property if the acquisition, management, or disposition of the property constitute integral parts of the taxpayer's trade or business operations; or gain or loss resulting from the sale, exchange, or other disposition of . . . tangible or intangible personal property, if the property while owned by the taxpayer was operationally related . . . to the taxpayer's trade or business . . . ; or gain or loss resulting from the sale, exchange, or other disposition of stock in another corporation if the activities of the other corporation were operationally related to the taxpayer's trade or business . . . . 8

U.S. Constitutional Standard

In recent years, several states, including Iowa (effective in 1995), Illinois (effective in 2004), Kansas (effective in 2008), North Carolina (effective in 2002) and West Virginia (effective in 2007), and the District of Columbia (effective in 2004), have amended their definitions of "business income" to provide that "business income" is "all income that is apportionable under the United States Constitution."9

Although Minnesota repealed the UDITPA definition of business income in 1987, based on the fact that the statute continued to provide for the allocation and apportionment of income based on whether the income was derived from carrying on a trade or business, the Minnesota Supreme Court, in Firstar Corp. v. Commissioner of Revenue, applied the transactional test and held that income from the sale of the taxpayer's headquarters building was nonbusiness income. In reaching its decision, the court looked to: (i) the frequency and regularity of similar transactions; (ii) former business practices; and (iii) the subsequent use of the proceeds.10

In response to Firstar, the Minnesota Legislature enacted a definition of nonbusiness income, effective for tax years beginning after December 31, 1998, defining "nonbusiness income" as all "income of the trade or business that cannot be apportioned by [Minnesota] because of the United States Constitution . . . includ[ing] income that cannot constitutionally be apportioned to [Minnesota] because it is derived from a capital transaction that solely serves an investment function."11

Pennsylvania

In 2001, the Pennsylvania Legislature took a somewhat unique approach and amended its definition of business income by changing the "and" to an "or" in the functional test and adding a provision stating that business income also includes all income that is apportionable under the U.S. Constitution. Currently, "business income" is defined in Pennsylvania as:

[I]ncome arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if either the acquisition, the management or the disposition of the property constitutes an integral part of the taxpayer's regular trade or business operations. The term includes all income which is apportionable under the Constitution of the United States.12

Of particular importance, the enacting legislation (the "2001 Act") provided that: (i) the intent of the amendment was to "clarify existing law;" and (ii) the statutory changes applied retroactively to tax years beginning after December 31, 1998.13

The 2001 Act was passed largely in response to the Pennsylvania Supreme Court's decision in Laurel Pipe Line Co. v. Commonwealth, in which the court held that gain from the sale of an idle pipeline, which the court found to be a liquidation of a discrete segment of the company's business, was not business income under either the transactional or the functional tests.14 In reaching its decision, the court emphasized that the functional test required that "the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations" to be considered business income.15

Recent Case Law Developments

In In re Kimberly-Clark Corp. v. Dep't of Revenue, the Alabama Supreme Court sustained the Department of Revenue's argument that gain from the...