The Michigan Supreme Court has just released a unanimous decision upholding the taxpayers’ position in Estate of Wheeler et al v Department of Treasury (Wheeler) and Malpass v Dep’t of Treasury (Malpass). Honigman represented the Estate of Wheeler. The Department had contended in each case that the unitary principle did not apply to the apportionment of business income originating from flow through entities under the Michigan Individual Income Tax Act (Act). The application of the unitary business principle under the Act was originally decided in favor of the taxpayer by Preston v Department of Treasury, a Honigman Court of Appeals victory obtained in mid-2011 applying the unitary business principle to the combined income and factors of a parent-subsidiary tiered flow-through group. The December 2011 Court of Appeals decision in Malpass held that two brother-sister S corporations could not report the income to the individual owners under the unitary business principle because the entities, while demonstrating characteristics of unity, were separate business entities. The Court held that the Act did not allow individual taxpayers to combine their business income from separate entities and use combined apportionment factors.
The Court of Appeals held to the contrary in Wheeler, which involved a parent-subsidiary S corporation structure in which the lower-tier entity was a German partnership. The Department argued that not only did the unitary business principle not apply but, even if it did, the income and factors of the German partnership should not be included. The Court of Appeals upheld the application of the unitary business principle to report the combined income of the tiered flow-through entities and specifically held that the foreign entity’s income and factors were properly included under the plain language of the Act. The Court of Appeals differentiated Malpass based upon the structure of its flow-through entities.
The Michigan Supreme Court granted leave to appeal to resolve the conflict between the two cases. The Court held that the unitary business principle is applicable to any state that taxes a multistate business. The Court held that the language in the Act allowing for formulary apportionment of income of a multistate business is broad enough to allow both the separate-entity reporting and combined reporting method of formulary apportionment. The Court noted that while the Department had argued that it required separate entity reporting for flow-through business income in the past, the Department had not promulgated a rule requiring that method. Each group of flow-through entities Malpass and Wheeler constituted a unitary group and thus, were permitted under the Act to use combined reporting to apportion business income to the state. Finally, the Court held that the plain language of the Act requires the inclusion of foreign income and factors in the calculation of apportioned business income, thus, combined reporting is proper even when the unitary business includes an entity located in a foreign country.
This case will change the reporting options for business income for flow-through entities under the Act. It is important to note that while the Michigan Supreme Court specifically stated that the unitary business principle and combined reporting of income and factors is allowable, the Court did not say that this method is required. Rather, the Court specifically indicated that the language of the Act is broad enough to support both reporting methods. Given the Court’s unwillingness to require separate reporting absent a promulgated rule, the Courts may be just as reticent to require the use of combined reporting absent a promulgated rule.