Minnesota Tax Court Rules that Gain from Goodwill is Apportionable Business Income

January 31, 2023

By: Michael Colavito, SALT Director

At a glance

The main takeaway: In a recent ruling by the Minnesota Tax Court, an S corporation’s gain from the sale of goodwill was considered “business income” and thus subject to apportionment as opposed to allocation.
Assess the impact: The classification of income as “business income” and “nonbusiness income” may vary from state-to-state, making it crucial to understand the impact it can have on a seller’s income tax liability.
Take the next step: Aprio’s State and Local Tax (SALT) team can navigate your business through structuring transactions to proactively minimize state tax liabilities and risks.

Schedule a free consultation today to learn more!

The full story:

The Minnesota Tax Court recently held that gain recognized by an S corporation from the sale of goodwill is considered “business income” that is subject to apportionment as opposed to “nonbusiness income” subject to allocation. This is an issue that an individual selling an interest in a multistate pass-through entity will undoubtedly have to deal with in most states.

A closer look at the case

In Cities Management, Inc. v. Commissioner of Revenue, the Minnesota Tax Court (Tax Court) was asked to address the income tax treatment of gain from goodwill generated by a sale of stock in which two S corporations where the parties to the transaction elected, under Internal Revenue Code (IRC) Section 338(h)(10), to treat the stock sale as a sale of business assets. Based on advice from its accounting firm, the taxpayer took the position that the gain was income not derived from a trade or business.

The advice of the accounting firm was based on a previously-issued Tax Court decision from 2006, holding that the portion of sale proceeds attributable to goodwill was income not derived from a trade or business.^[1] However, the Minnesota Department of Revenue (Department), internally, and eventually publicly, asserted that it did not agree with the reasoning of the Tax Court’s prior ruling and that the Department was not bound by that ruling. In the Cities Management decision, the Tax Court noted that its prior decision was distinguishable from the facts it was currently addressing, and, more importantly, that it was clearly bound by a more recent Minnesota Supreme Court decision from 2020 that held a taxpayer’s gain (including gain from goodwill) from the sale of an interest in operating subsidiaries was business income subject to apportionment.^[2]

Under Minnesota rules, all income derived from a trade or business is subject to apportionment (i.e., business income) unless it is nonbusiness income. Nonbusiness income is defined as “income of the trade or business that cannot be apportioned by this state because of the United States Constitution or the Constitution of the state of Minnesota and includes income that cannot constitutionally be apportioned to this state because it is derived from a capital transaction that solely serves an investment function.”

The ruling explained

In this case, the Tax Court had little difficulty in concluding that the gain derived from goodwill was apportionable business income. For income of a multistate business to be subject to apportionment, the multistate activity must be from a unitary business, which the court described as meaning “business activities or operations which result in a flow of value between them and may apply to a single legal entity or between multiple entities.”^[3] The Tax Court reasoned that the value of the S corporations’ goodwill was based, in part, on the business’ successful operations, which included deriving revenue from Minnesota sales.^[4]

The Cities Management decision has several important aspects to it:

First, taxpayers and practitioners need to understand the precedential value of state tax court decisions and administrative rulings. These may not always be binding on a taxpayer or a state department of revenue, and therefore, contrary positions may be taken and sustained.
Second, the classification of income as “business income” and “nonbusiness income” may vary among the states based on the tax rules, the specific facts of the taxpayer’s business and the structure of the transaction.
Finally, the decision to make a 338(h)(10) election can significantly impact the seller’s state income tax liability on the sale, and it is crucial to understand that impact and address it as part of the transaction negotiations.

The bottom line

Aprio’s SALT team has experience in proactively advising clients on the state income tax implications of a pending exit sale. We work with businesses to structure transactions to minimize state tax liabilities and risks, resulting in more after-sale cash. We are constantly monitoring these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

^[1] Nadler v. Comm’r of Revenue, No. 7736-R, 2006 WL 1084260 (Minn. T.C. Apr. 21, 2006).
^[2] YAM Special Holdings, Inc. v. Comm’r of Revenue, 947 N.W.2d 438, 442 (Minn. 2020).
^[3] Cities Management, Inc., Appellant, v. Commissioner of Revenue, Appellee., 9484-R, 12/20/2022.
^[4] It is also worth noting that Tax Court further concluded that the taxpayer also misinterpreted Minnesota’s unique nonbusiness income allocation rules. Therefore, even if the court concluded that the gain at issue was nonbusiness income, the portion of the gain subject to tax in Minnesota would have been based on the S corporations’ preceding year’s apportionment percentage.