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Potatoes and Pilgrims: Business Income Decisions from Idaho and Massachusetts

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The question of when income from the sale of a business is apportionable “business income” versus allocable “nonbusiness income” seems a perpetual question in state tax law. The concepts are based in U.S. constitutional law, but the decisions also involve reference to the laws of the state involved, varying as they do from state to state. In this Buzz, we discuss aspects of two 2020 decisions involving the sale of a business interest by a closely held entity that does not have significant business operations and that was owned by an individual that was heavily involved in the business. Noell Industries, Inc. v. Idaho State Tax Comm’n, 470 P. 3d 1176 (Idaho 2020) cert. denied, 141 S.Ct. 1391 (Feb. 22, 2021), and VAS Holdings & Investments LLC v. Comm’r of Revenue, ATB 2020-506 (Mass. App. Tax Bd. Dkt Nos. C332269 & C33270, Oct. 23, 2020). The appeal of the latter case, VAS Holdings, was accepted for Direct Appellate Review by the Supreme Judicial Court of Massachusetts on June 29, 2021. These cases highlight the question whether there must be unity between the two legal entities or between the entity being sold and the individual owner(s) and the question of the level of required unity and operations. Further, the second case considers the relevance of a business’ operations in a state increasing the value of the company for purposes of that state imposing tax on a gain from the sale of an interest in that business.

Noell Majority

In 1993, Noell Industries, Inc. (“Noell Industries”) was incorporated in Virginia as a corporation founded by Mike Noell, a former Navy SEAL, to develop and sell combat and tactical gear. Noell at 1178-79. In 2003, there was a reorganization in which Noell Industries transferred its net assets to a new company, Blackhawk Industries Products Group Unlimited, LLC (“Blackhawk”). Blackhawk became the operating company, with over 78% of its membership interest owned by Noell Industries. Noell Industries’ activities were limited to holding this membership interest and another business that leased real property to Blackhawk within Virginia. Virtually all of Noell Industries’ income was generated by Blackhawk. Blackhawk operated across multiple states, including Idaho, where it had real property, employees, and sales. Noell at 1179.

In 2010, Noell Industries sold its entire interest in Blackhawk, realizing a net gain of $120 million, nearly all of which was attributed to goodwill. It reported the gain on its 2010 Idaho tax return but apportioned none of it to Idaho, allocating it instead to its headquarters in Virginia. Idaho’s auditors, however, considered the gain “business income” pursuant to Idaho Code § 63-3027, and apportioned it, assessing Noell Industries $1,481,875 in tax (after removal of penalties). Noell Industries challenged the assessment, with both Noell Industries and the Idaho Tax Commission agreeing that the primary issue for review was “whether Idaho has authority to tax the gain on Noell Industries’ sale of its interest in Blackhawk LLC.” Noell at 1179-80. The district court found that the gain was not “business income” under Idaho Code § 63-3027 and thus not subject to apportionment to Idaho.

The Idaho Supreme Court (“Court”), by a 3-2 margin, agreed with the District Court. Idaho has detailed regulations on how to apply the transactional and functional tests to determine whether an income event constitutes apportionable “business income” in the state, and the Court reviewed the transactions under both these tests. Idaho Admin. Code r. provides that, “for a transaction to be in the regular course of the taxpayer’s trade or business, the transaction or activity need not be one that frequently occurs in the trade or business” but must be of a type that is “customary in the kind of trade or business being conducted or [is] within the scope of what that kind of trade or business does.” Although recognizing that the rule does not require frequent occurrence of the transaction, the Court nevertheless concluded that “a one-time sale over a seven-year span does not constitute a ‘regular’ trade or business.” Noell at 1184.

Under the functional test, the Court subjected the transaction to both the operational function test, under which the transaction must relate to the operations of, rather than mere investments held by, the business, and the unitary business test requiring a flow of value between the companies, as evidenced by functional integration, centralization of management, and economies of scale. These tests are all derived from U.S. Supreme Court decisions but their use in Idaho is mediated by regulation in Idaho Admin. Code r. to .341. It is in the application of the functional test that the holding company structure of Noell Industries and Blackhawk became truly significant for the Court:

Rather than dealing with a parent company with full control of the subsidiary holding company, Noell Industries is a parent holding company with no shared control or operations over Blackhawk. Noell Industries shared no centralized management, oversight, or headquarters with Blackhawk. Indeed, Noell Industries held no employees, payroll, or offices at all. Noell at 1187.

As Noell Industries was a “pure holding company” whose only transactions with Blackhawk were the initial transfer of assets to the latter, receipt of income from same, and finally the sale of its interests, the Court viewed Noell Industries as non-unitary:

This high-level separation of the companies – combined with Noell Industries’ only role as a shell holding company – showcases substantial independence rather than the level interdependence required to manifest unity.

Having applied both the transactional and functional tests for business income and finding the source of the gain to come up short on all counts, the Court determined the gain from the sale of Blackhawk to be nonbusiness income, not subject to apportionment. Therefore, the Court held Noell Industries was correct to allocate the entire gain to Virginia, where Noell Industries was commercially domiciled.

Noell Dissent

The dissent in Noell offers an interesting alternative based on the founder and owner’s relationship with the entities. In the dissenting justices’ view, the income satisfies the functional test for business income for several reasons. Rather than focusing on the lack of activity of the holding company as it appears on paper, the dissent focuses on the fact that the founder, Mike Noell, was the creator of both entities, contributing know-how and centralized management to both. He was the sole owner of Noell Industries, and the CEO and President of Blackhawk LLC, “responsible for directing the vision of Blackhawk and overseeing all aspects of Blackhawk, with a particular focus on product development.” Noell dissent at 1190. As the one individual exercising more control than anyone over both entities, Mike Noell’s existence and activity ensure there was a centralization of management and functional integration between the two entities, implying, contra the majority’s view, that there was a unitary business. Noell dissent at 1191.

The difference between focusing the unitary analysis on Mike Noell’s role, rather than the shell holding company, is drawn into sharp focus by footnote 7 in the dissent. In this note, the dissent asks the majority to “consider whether the gain would be taxable if Noell Industries did not exist,” and “the 78.54% interest in Blackhawk LLC was owned by Mike Noell in his individual capacity.” Had that been the case, given that the gain results from Mike Noell’s work as CEO, President, and “creative genius behind product development” at Blackhawk, “there can be little doubt under these facts that Mike Noell would owe Idaho income tax.” It is unclear whether the dissenting justices are correct in this conclusion regarding Idaho law. The dissent cites Union Pac. Corp. v. Idaho State Tax Comm’r, 136 Idaho 34, 38-39 (2001), for the proposition that the functional test applied independently of the transactional test is a sufficient indicator of business income. However, the factual distinctions between Noell and the case cited are too great for the cited case to support the dissent’s application of the test. It is not clear that a gain from the sale would have been taxable in Idaho if the business interest had been sold directly by the individual, and no cases that support this conclusion are cited by the dissent. Idaho’s detailed regulations are also discussed by the dissent, but these rules are geared to the determination of whether the business sold is unitary with a selling business; the rules do not address the sale of a business by an individual, as in the dissent’s hypothetical. However, in the dissent’s view, there is unity between a business and an active leader of that business, and this unity is not broken by the insertion of a holding company between the leader and the business. To allow this insertion to convert the gain from active to passive, and break the unity between owner and business, allows for a simple mechanism by which one can convert the character of income from business to nonbusiness and thus avoid tax in all states but the taxpayer’s domicile: the use of a holding company whose only activity is to invest in, hold, and eventually sell the operating business. The dissent views this as a serious flaw in the majority’s reasoning. Despite the dissent’s comment, there is no indication in the case that the taxpayer established the holding company for any tax avoidance purpose.

VAS Holdings & Investments LLC

The VAS decision from Massachusetts presents another instance in which a state’s constitutional right to tax income from the sale of a business is considered. While the decision’s appeal to the Supreme Judicial Court of Massachusetts is still pending, the Appellate Tax Board’s (“Board”) decision raises interesting questions regarding the ability of a state to tax gain on the sale of a business interest if the business increased in value through activity within that state. Further, the appeal raises arguments regarding the lack of unity between the business entities.

The appellant in the case, VAS Holdings and Investments LLC (“VAS”), began as an Illinois S corporation owned by a handful of individuals and that was the sole shareholder of a qualified subchapter S subsidiary under U.S. and Illinois law (“VAS USA”) and a Canadian C corporation (“VAS Canada”). On October 31, 2011, VAS merged with Thing5, LLC (“Thing5”), a Massachusetts limited liability company founded by Mr. David Thor and owned by Mr. Thor and his wife. The individual owners of VAS were unrelated to Mr. Thor and his wife.

Following the 2011 merger, VAS continued as an S corporation. It owned 50% of a new partnership. Cloud5, with the other 50% belonging to Mr. and Ms. Thor (the former owners of Thing5). Post-merger, Cloud5 owned 100% of Thing5, the operating business primarily located in Massachusetts, and 100% of VAS USA, now a C corporation holding company that owned 100% of VAS Canada, the other operating company. Thing5 became a disregarded subsidiary of Cloud5.

After the 2011 merger, Mr. Thor became CEO of Cloud5, and the value of Cloud5 increased significantly as Thing5’s data and tools were used to benefit the business of VAS Canada, increasing its profitability while reducing the number of Canadian employees. Meanwhile, Thing5’s Massachusetts workforce, as well as its product offerings and customer base, increased.

On October 11, 2013, ten months after reincorporating as a Florida S corporation, VAS sold its entire 50% interest in Cloud5 to an unrelated party, realizing a capital gain of just over $37 million (“Sale Gain”). According to the Board, the majority of the Sale Gain was attributable to the increase in value of Cloud5 between the 2011 merger and the 2013 sale, and it was related to specified business activities in Massachusetts (i.e., the increase in workforce and newly leased space to hold it, product offerings, and customer base). The Massachusetts Tax Commissioner assessed corporate excise tax and nonresident composite tax on the Sale Gain. Appellant VAS’s Applications for Abatement of the assessments were denied and the appeal followed.

In challenging Massachusetts’ taxation of the Sale Gain, VAS argued that it was non-unitary with the Massachusetts business and had insufficient nexus with the state. Although positions regarding the significance of the holding company in the business structure – VAS USA was, at the time of the sale, a pure holding company – had been briefed, the Board never reaches this question because it found sufficient evidence for nexus in a separate analysis.

In VAS, interestingly, “the appellant and the Commissioner agreed that none of the three hallmarks of a unitary business is present in these appeals.” VAS at 520. Nor did the Commissioner “argue that the Sale Gain resulted from an investment that served an ‘operational function,’ which would provide an alternative basis for passing constitutional muster.” Id. The Board instead found a sufficient nexus to impose Massachusetts tax by considering the activities that took place in Massachusetts, where Thing5 was located and where, in the Board’s view, most of the activities that increased the value of the company, resulting in the Sale Gain, took place. But what of the fact that the investor that made the sale, VAS, was an out-of-state S corporation and none of its shareholders were Massachusetts residents?

Rather than looking at the situation of the owner, VAS, or VAS’s individual owners, the Board focused instead on “the so-called ‘investee apportionment’ methodology . . . based on the [investee] entity’s property and activities in the taxing state.” VAS at 521. The Board traces the roots of this methodology to International Harvester v. Wisconsin Dep’t of Taxation, 322 U.S. 435 (1944) as well as two New York decisions taxing income from the same transaction considered by the U.S. Supreme Court in Allied-Signal v. Director, Div’n of Tax’n, 504 U.S. 768 (1992), but arriving at the opposite conclusion. In International Harvester and the New York decisions, unlike the New Jersey law considered in Allied-Signal, the state apportionment was based on the investee’s activities, which took place in the state. Because the state had given the investee business the protection of the laws and various services, sufficient constitutional nexus was found to tax the income from the business, whether at investee or investor level. The Board applied the same reasoning to VAS’s investment in Cloud5, which held the Massachusetts business operations of Thing5, allowing the state to tax the out-of-state VAS or its owners based on the in-state business held by Cloud5.

The Board dismissed the appellant’s argument regarding the distinction between distributive share income and income from the sale of the business (a partnership in this case). VAS had argued that the distinction is crucial because “the activity subject to tax in connection with the Sale Gain was the appellant’s act of selling its interest in Cloud5,” a “discrete act” that “did not provide the requisite minimum connection to Massachusetts or availment of the protections and benefits of Massachusetts law that are required by the United States Constitution,” VAS at 527, because the act of selling the interest had taken place elsewhere, unlike the admittedly taxable distributive share of Cloud5’s business activity income. The Board viewed this distinction as irrelevant under Massachusetts law because the income tax is not a transaction tax and the taxed capital gain results from “the increase in value of the appellant’s interest in Cloud5, which accrued over time through the business activities of the operating entities,” the sale being “simply the event by which” the increase in value over time was realized. VAS at 528.

In the Board’s view, the combination of the investee’s connection to Massachusetts and the absence of a constitutionally meaningful distinction between income from a business sale and operating income from the in-state business, allowed for a determination that Massachusetts had the ability under its own laws and the U.S. Constitution to tax the gain from the sale of Cloud5. Having reached its decision, the Board refrained from discussing questions around the impact of VAS’ status as a holding company. Clearly, though, it did not find the holding company’s existence sufficient to convert the status of the gain from business to nonbusiness income.

In its Application for Direct Appellate Review, VAS objects to the “investee apportionment” analysis, calling it “a brand new constitutional theory of extraterritorial taxation . . . wholly unsupported by any decision of the United States Supreme Court or the courts of Massachusetts.” The taxpayer also argues that its existence as a passive holding company breaks the unity between taxpayer and the Massachusetts operating business due to the absence of the three hallmarks (functional integration, etc.) or an operational function of the investment in Cloud5. This argument is similar to the Idaho decision in Noell. As stated above, the request for appeal was granted and thus the final conclusion is yet to be determined in Massachusetts.


Most of the multi-state tax law evaluating whether a business interest is unitary with its owner and the gain from its sale can be taxed as business income relates to C corporations. Less authority exists related to the sale of a business interest in a pass-through entity by another pass-through entity, particularly where an individual owner or owners had significant ownership and operational connections with one or both entities. As the cases develop, there may be many approaches to the question of when income from the sale of a business, particularly of a pass-through or other closely held entity, may be taxed by a given state.

California, for instance, issued Legal Ruling 2021-01 on October 25, providing an analysis that reaches a conclusion in direct opposition to the Noell decision in Idaho. Based primarily on earlier decisions from the California State Board of Equalization, the Legal Ruling states that “the traditional tests for unity are not an exact fit in the context of pass-through entity holding companies.”[1] Because “holding companies have limited, if any, operations . . . non-traditional factors are more heavily weighted in determining unity.”[2] These factors center around any benefits the operating business derives from the holding company. Additionally, where there is a single operating company and a passive holding company, it is appropriate to look through the holding company to determine whether the operating business is unitary with the holding company’s owner at the time of sale. If so, the mere existence of a holding company will not break that unity.

The Ohio Supreme Court, in Corrigan v. Testa, 149 Ohio St.3d 18 (2016), ¶ 60, “decline[d] to read International Harvester as authorizing the imposition of a tax on the nonresident” investor, indicating Ohio would not allow the use of the investee apportionment methodology used by the Massachusetts Appellate Tax Board in VAS. The Corrigan decision, however, and the T. Ryan Legg[3] decision that followed, both provide for a unitary analysis between the taxpayer and the business that produced the gain, allowing that for an individual who was actively involved in the business up to the time of the sale, the gain would be apportionable business income.

In Ohio, it is an important question, not only in determining taxability for out-of-state taxpayers, but also because, for both out-of-state and in-state taxpayers, the Business Income Deduction and flat 3% tax rate apply only to “business income,” the same concept used in determining whether income is apportionable among states. Taxpayers contemplating the sale of a business should pay particular attention to the treatment of any gain on the sale for state tax purposes. For advice on this and other tax implications of a business sale, contact any ZHF professional at 614-326-1120.



[1] Calif. Franchise Tax Board, Legal Ruling 2021-01 (Oct. 25, 2021) p.7.

[2] Id. p.6

[3]T. Ryan Legg Irrevocable Trust v. Testa, 149 Ohio St.3d 376, 390-91 (2016).

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