Persistence Pays Off in Sale of Idaho Pass-Through Entity

Bloomberg Tax

Authored Article, Publications

Author(s) , Steven N.J. Wlodychack

Retired Navy SEALs apparently have a persistence that other taxpayers may not have. Case in point (literally)—Noell Industries, Inc. v. Idaho State Tax Commission, decided on May 22, 2020, by the Idaho Supreme Court.

Upholding a decision of the district court, the majority of the Idaho Supreme Court ruled that $120 million of gain on the sale of the membership interest in a limited liability company doing business in the state by an S corporation-member that itself had no business activities in the state does not constitute apportionable business income and was erroneously taxed by Idaho. The Idaho State Tax Commission had held to the contrary and was therefore overruled.

The Noell Industries case is another in a series of recent cases around the country focusing on which state or states can tax gains on a sale of either ownership interests in, or the underlying assets of, a business operating as a pass-through entity (PTE). As the court’s ruling suggests, the critical question is whether income is ‘‘business income’’ or ‘‘nonbusiness income’’ (or, in the parlance of the new model apportionment regulations of the Multistate Tax Commission (MTC), ‘‘apportionable income’’ or ‘‘allocable income,’’ respectively) in order to properly source income to the ‘‘right’’ state for income tax purposes.

The court properly (in our opinion) pointed out that the analysis requires consideration of principles on the limits of state taxation under the Due Process and Commerce Clauses of the U.S. Constitution and the state statutes developed in response to those concerns. Under unitary business principles laid down by the U.S. Supreme Court, business income is income that is subject to income tax in any state in which the activity occurs subject to apportionment, while nonbusiness income is allocable to a specific state and only subject to tax there. In the context of the sale of equity interests in a PTE, that decision is crucial in determining which state or states can tax the gain. The court’s thoughtful ruling and discussion of this issue could be useful to taxpayers in other states.

First, some important background. Mike Noell was a retired Navy SEAL who, from his experience in battlefronts throughout the world, thought he could develop better protective tactical gear for the military, law enforcement, and ultimately, outdoors enthusiasts. He founded Noell Industries, Inc. in his garage in Virginia in 1993. Noell Industries elected from inception to be treated as an S corporation. In 2003, Noell Industries transferred its net assets to a Virginia limited liability company Mr. Noell created named Blackhawk Industrial Products Group Unlimited, LLC (Blackhawk), in exchange for 78.54% of the membership interests of Blackhawk. The remaining interests in Blackhawk were subscribed by other investors. Blackhawk operated in multiple states.

In 2004, Blackhawk opened a facility in Idaho and in 2007 leased a factory in Boise that operated as its ‘‘West Coast operations center,’’ but ultimately expanded to become one of four U.S. factories producing duty gear, body armor, holsters, and other outdoor hunting products. By 2010, Blackhawk operated in substantially all states and the court found that it owned approximately$20 million of real and personal property in Idaho. In contrast, the court also found that Noell Industries, the corporate member of Blackhawk, never owned any real property located in Idaho. Instead, the court found that other than owning the majority interest in Blackhawk, Noell Industries simply leased real property located in Virginia to Blackhawk. Almost all of Noell Industries’ income came directly from Blackhawk. As an owner of Blackhawk, Noell Industries annually filed returns with and paid tax to Idaho on its apportioned share of Blackhawk's income. Noell Industries had no employees following the formation of Blackhawk.

Republished with permission. The complete article, "Persistence Pays Off in Sale of Idaho Pass-Through Entity," was first published by Bloomberg Tax on July 30, 2020.