United States: Illinois Appellate Court Rules That Section 338(H)(10) Gain is Non-Business Income

The Illinois Appellate Court, in American States Insurance Co., et al. v. Illinois Department of Revenue (No. 1-03-1646, August 27, 2004), 2004 Ill. App. LEXIS 995, affirming the decision of the circuit court, has ruled that a corporation’s gain resulting from a §338(h)(10) election is nonbusiness income. We had reported on the lower court’s decision in the June 2003 edition of State Tax Return. Due to legislative changes made earlier this year, this decision may have more impact in other states than in Illinois.

To recap, the facts of the case are as follows. American States Insurance Company, an Indiana corporation ("ASIC"), was licensed to transact business in Illinois. ASIC was a member of an unitary group and therefore filed an Illinois combined income tax return. In 1997, the stock of ASIC was sold by Lincoln National Corp. ("Lincoln"), which until the sale, had indirectly owned more than 80% of the ASIC stock. As part of the sale, Lincoln and the purchaser of the ASIC stock made an irrevocable election under §338(h)(10) of the Internal Revenue Code. ASIC reported the gain resulting from the §338(h)(10) election as non-business income and allocated that gain to the state of its corporate domicile. The Illinois Department of Revenue contended that the gain was business income and therefore apportionable.

A §338(h)(10) election causes a transaction that is structured as a stock sale to be treated for federal income tax purposes as an asset sale. When this election is made, the target company (i.e., the company whose stock is sold) is treated as having sold its assets in a taxable transaction to an unrelated company and is then treated as having liquidated. See Treas. Reg. §1.338(h)(10)-1(d). Even though the assets remain owned by the same corporation as a mater of corporate law, they are treated for federal income tax purposes as if they had been sold to a new corporation in a taxable transaction.

The Illinois Income Tax Act is, for the most part, based on UDITPA. Business income is apportioned among the states in which a taxpayer did business. Non-business income is allocated under statutory rules and, generally, Illinois’ share of non-business income from sales made by a non-Illinois corporation is limited to gains on sales of property located or used in Illinois. 35 ILCS 5/303(b). For the tax years at issue, the Illinois Income Tax Act defined "business income" as

35 ILCS 5/1501(a)(1). The Illinois Supreme Court has concluded that this definition of business income encompasses two separate tests — a transactional test and a functional test. Texaco- Cities Service Pipeline Co. v. McGaw, 182 Ill. 2d 262, 695 N.E.2d 481 (Ill. 1998). The transactional test is derived from the first clause of the definition under which gain from the sale of assets is business income if the sale occurs in the ordinary course of the taxpayer’s business. The functional test is embodied in the second clause of the definition under which gain from the sale of an asset is business income if the acquisition, management and disposition of the asset constitute integral parts of the taxpayer’s regular trade or business operations. The Illinois Supreme Court concluded that the functional test classifies all gain from the disposition of an asset as business income "if the asset disposed of was used by the taxpayer in its regular trade or business operations." Texaco- Cities, 182 Ill. 2d at 268, 695 N.E.2d at 484.

In 2002, the Illinois appellate court, in Blessing/White, Inc. v. Illinois Department of Revenue, 329 Ill. App. 3d 714 (Ill. App. 2002), modified the functional test for income generated from the sale of assets as part of a corporation’s liquidation. In the event of a corporate liquidation, the appellate court stated that the functional test is satisfied only when the property sold and the liquidation of assets are essential to the taxpayer’s regular trade or business operations. According to the appellate court, when a corporate taxpayer liquidates its business and does not use the liquidation proceeds to support ongoing business concerns, the liquidation is not integral to the taxpayer’s regular business operations, and the gain from the sale does not qualify as business income under the functional test.

The appellate court first affirmed the holding in Blessing/White that held that gain from a sale made in liquidation is non-business income. (Under Illinois rules, principles of stare decisis do not require an appellate court of one division to follow precedent established by another division, so that the fifth division here was not required to follow Blessing/White, which was decided by the third division.) Because Illinois followed the federal treatment of a Section 338(h)(10) election as a "deemed sale" followed by a "deemed liquidation" for Illinois income tax purposes, the appellate court concluded that the gain was non-business income because.

Curiously, this decision may have less of an impact in Illinois than in other states. The definition of "business income" in the Illinois Income Tax Act was changed earlier this year by Public Act 93-840. Business income is now defined as "all income that may be treated as apportionable business income under the Constitution of the United States. Business income is net of the deductions allocable thereto." The apparent intent of this change is to have all corporate income classified as business income to the extent constitutionally permissible. Thus, following the amendment, gain from the sale of assets in Illinois — even if pursuant to an actual or a deemed liquidation — may constitute business income. However, the classification of gain from a Section 338(h)(10) election has not been litigated much in other states. This decision by the Illinois appellate court (as well as the Pennsylvania Supreme Court’s decision earlier this year in Canteen Corp. v. Commonwealth of Pennsylvania (No. 57 MAP 2003, July 20, 2004), which came to the same conclusion) will provide guidance in other states that still utilize the traditional UDITPA definition of "business income."

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