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California SBE Characterizes Gain from "Deemed" Sale of Goodwill as Business Income

In In re Appeal of Imperial, Inc., Case Nos. 472648; 477927 (July 13, 2010), the California State Board of Equalization (SBE) ruled that gain from the sale of stock sold pursuant to an

In In re Appeal of Imperial, Inc., Case Nos. 472648; 477927 (July 13, 2010), the California State Board of Equalization (SBE) ruled that gain from the sale of stock sold pursuant to an IRC § 338(h)(10) election constituted business income. Imperial, Inc., a Wisconsin S corporation, entered into an acquisition agreement with an unrelated buyer, whereby Imperial’s shareholders received cash for their shares. The stock sale was treated as an asset sale for income tax purposes as a result of the IRC § 338(h)(10) election, and as a consequence, the sale was deemed to trigger gain on the sale of goodwill.

Imperial argued that the gain on goodwill constituted nonbusiness income and should be allocated to Wisconsin, where Imperial was headquartered, whereas the Franchise Tax Board argued that the gain was business income under the business income functional test.

Under California law, gains realized upon the termination of a business are treated as business income if: 

  1. The taxpayer has sufficient control over the income-producing property; and 
  2. The taxpayer’s control and use of the property is integral to the taxpayer’s regular trade or business operations.

The SBE noted that Imperial’s goodwill was an asset that was created, managed and disposed of by Imperial in the day-to-day operations of its business from 1959 until the sale in 2003, and that more than 50% of the goodwill’s value was attributable to Imperial’s customer base, trade names and internally developed software. The SBE concluded that Imperial’s goodwill represented the residual value of Imperial’s business operations as a going concern after its “hard” assets were valued. The SBE also determined that the goodwill was essential to the viable conduct of its business. For these reasons, the SBE found that both prongs of the functional test were satisfied. 

The SBE next addressed whether the gross receipts from the sale were excludable from the company’s California sales factor under the incidental or occasional sale exception pursuant to California Regulation 25137(c)(1)(A). The taxpayer sought to include the receipts from the sale of goodwill because it would have reduced its California sales factor. The SBE held that excluding the amount associated with the sale of goodwill was justified because the sale created a substantial amount of gross receipts (more than 60%) relative to the taxpayer’s total gross receipts for the year.

The Imperial decision is consistent with the Oregon Tax Court’s analysis of an IRC § 338(h)(10) sale in Centurytel, Inc. v. Dep’t of Revenue, No. TC 4826 (Or. T.C. August 9, 2010) (see SALT Shaker, Vol. 1, No. 9, pp. 2-3). In each of these cases, the tribunal analyzed the character of the transaction based upon the deemed asset sale created by the federal income tax election.

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