AR Court Holds Gain Is Nonbusiness Income

In United States Beef Corporation, an Arkansas circuit court decided that gain from the sale of a business was not business income. Specifically, the court held that gain from a taxpayer’s one-time sale of its franchisee operations did not satisfy Arkansas’ business income definition because an integral part of the taxpayer’s business did not involve the disposition of franchises. Accordingly, gains from the sale were allocated to the taxpayer’s state of commercial domicile.

Background

Arkansas defines business income as “income arising from transactions and activity in the regular course of the taxpayer’s trade or business” (the transactional test) “and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations” (the functional test). States differ in their treatment of the functional and transactional tests, with some recognizing them as independent and distinct methods for classifying business income and others viewing them as elements of a single, unified test. Arkansas recognizes the functional and transactional tests as two alternative tests for establishing whether income is business income.

United States Beef Corporation

In United States Beef Corporation, Taxpayer, an Oklahoma corporation, managed fast food franchises that operated in several states, including Arkansas. In 2018, Taxpayer sold its franchises and liquidated its business. On its 2018 Arkansas corporate income tax return, Taxpayer asserted that the gain from the sale of its franchises was nonbusiness income allocable to its state of domicile, Oklahoma. Upon review, the Arkansas Department of Finance and Administration disagreed and ruled such gain was apportionable business income. Taxpayer filed suit in state court.

The parties agreed that the sale of franchises was outside Taxpayer’s regular course of trade or business. Accordingly, the transactional test was not met, and the gain was not business income under that test. Therefore, the case focused on whether the gain was business income under the functional test. For the gain to be business income under the functional test, the acquisition, management, and disposition of the property had to constitute integral parts of the taxpayer’s regular trade or business.

The court found that Taxpayer’s integral business included acquiring and managing fast food franchises. However, proceeds from the sale were not related to acquiring and managing fast food franchises, but rather were related to disposing of franchises. The court then determined that Taxpayer was not in the business of disposing of franchises. For instance, prior to liquidation, Taxpayer had never sold a franchise. Furthermore, at the time Taxpayer was required to include the gain in income, Taxpayer no longer was involved in the franchise business and none of the proceeds were used in its franchising business. Because disposing of franchises was not an integral business of Taxpayer and the gain was the result of disposing of franchises, the court concluded that Taxpayer did not meet the functional analysis test.

Crowe observation

Although facts provided that Taxpayer liquidated its business shortly after the sale, it does not appear that the liquidation factored into the court’s determination. Rather, the court appears to have decided this matter on the “undisputed facts” that Taxpayer was not in the business of disposing franchises.

Accordingly, the court ruled that the income generated from the sale of Taxpayer’s franchises constitutes nonbusiness income sourced to its domicile state, Oklahoma.

Looking ahead

The United States Beef Corporation decision underscores the importance of a thorough state-level analysis for taxpayers realizing gains from the sale of a business. Whether it’s examining occasional sale exemptions, assessing a state’s classification of business income, or exploring other relevant considerations, a well-informed approach can reveal sourcing methods that diverge from simply apportioning across every relevant jurisdiction. Taxpayers contemplating a sale of their business should consult with their tax adviser to understand the potential state tax consequences.