Following the U.S. Supreme Court’s decision in Meadwestvaco v. Illinois Department of Revenue April 15, 2008, in which lower courts addressed the “cessation of business” or “liquidation exception” to business income determinations, another case involving such nonbusiness income exceptions was recently decided in Illinois. On Dec. 5, 2008, the Illinois Appellate Court, Fifth District, issued an Order in the matter of Nicor Corporation v. the Illinois Department of Revenue (Illinois Appellate Court, Fifth District, Appeal Nos.: 1-07- 1359 & 1-07-1591, Dec. 5, 2008), finding that, as a matter of law, “[p]ursuant to section 338(h)(10) [of the Internal Revenue Code], [Nicor’s subsidiary group’s] sale must be treated as a complete liquidation and cessation of business, resulting in nonbusiness income for Nicor…” In this transaction, Nicor sold all of the stock of its subsidiary group, which comprised its entire research and exploration business function, and made a valid Internal Revenue Code section 338(h)(10) election. The court found that for federal and Illinois income tax purposes, all of the assets of the subsidiary group were deemed to have been sold, and the subsidiary group was completely liquidated and ceased all operations. The Nicor decision, although unpublished and hence not allowed to be cited as precedent, confirms the holding in American States Ins. Co. v. Hamer, in which the Illinois Appellate Court found that a deemed asset sale resulting from a section 338(h)(10) election yields nonbusiness income as a matter of law.  

Although it appears that transactions in which a valid section 338(h)(10) election were made before July 31, 2004 should now be conclusively be considered nonbusiness income as a matter of law in Illinois, the Illinois Department of Revenue (the “Department”) has already tried to avoid the holding in American States Ins. Co. in several situations involving taxpayers represented by Reed Smith. In one of these situations, the Department contended that the taxpayer was not eligible as a matter of law for a liquidation or cessation of business exception for gain from the disposition of a subsidiary in a transaction in which a valid section 338(h)(10) election was made because, according to the Department, the taxpayer was engaged entirely in the business of buying and selling businesses. In the Department’s view, such a taxpayer is eligible to apply the nonbusiness income classification as a matter of law only to the gain from a disposition of its entire business, and not to the gain from a partial disposition.  

Effective July 30, 2004, section 1501(a)(1) of the Illinois Income Tax Act was amended, defining “business income” as “all income that may be treated as apportionable business income under the Constitution of the United States.” Under the revised definition, gain from the deemed asset sale resulting from a 338(h)(10) election would, in most cases, be treated as apportionable business income. As a consequence, the analysis found in the Nicor and American States Ins. Co. decisions applies only to the now-superseded definition of business income applicable to periods before July 30, 2004. The Department’s view is that the 2004 change to the definition of business income applies only to transactions occurring on or after July 30, 2004. However, Reed Smith currently represents an Illinois-based taxpayer in litigation in which the taxpayer is contending that the 2004 amendment to the definition of business income applies to all transactions that occurred in tax periods that were open for assessment or refund July 30, 2004.  

The decision in Nicor follows the general trend among states, which has been to treat the gain from the disposition of a subsidiary in which a section 338(h)(10) election has been made as nonapportionable or nonbusiness income. However, practitioners need to be aware that there continue to be exceptions to this general trend. For example, on Dec. 9, 2008, the Tennessee Court of Appeals held in Newell Window Furnishing, Inc. v. Johnson that income resulting from the sale of a subsidiary in which a valid section 338(h)(10) election was made, was apportionable business income. In addition, in 2007, the Tax Court of New Jersey reached a similar conclusion in McKesson Water Products Company v. Director, Division of Taxation. McKesson has been appealed, and oral argument before the New Jersey Appellate Division is scheduled for Jan. 27, 2009.  

Take-Away Points:

  • For transactions occuring before July 30, 2004, gain from a deemed asset sale resulting from a section 338(h)(10) election will generally be characterized as nonbusiness income for Illinois purposes. This characterization will generally be favorable for sellers domiciled outside of Illinois and not favorable for sellers domiciled in Illinois.
  • For transactions occuring on or after July 30, 2004, gain from a deemed asset sale resulting from a section 338(h)(10) election will, in most cases, be characterized as business income for Illinois purposes. However, opportunities may still remain for sellers domiciled outside Illinois to dispute this characterization.
  • States other than Illinois continue to grapple with the question of whether the gain from a deemed asset sale resulting from a section 338(h)(10) election constitutes nonbusiness income. Sellers planning 338(h)(10) elections should carefully analyze their facts and circumstances in the context of the laws of all states in which the corporation to be sold owns assets.