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December 8, 2010

Each year, many taxpayers file inaccurate corporate income tax returns in separate-reporting jurisdictions because they do not consider the unitary business principle applicable to those states.

Although you may find this revelation shocking, the simple fact is that all states are unitary states. In other words, all states must abide by the unitary business principle in administering their corporate income tax regimes. While it is true that unity is most often associated with states that have adopted a combined-reporting regime, such as California and Illinois, the unitary business principle is also applicable (and important) in states with a separate-company reporting system. This edition of Tax Advisor Weekly highlights a selection of the notable, and sometimes overlooked, impacts of unitary relationships in traditional separate-reporting states.

The Unitary Business Principle, Broadly
One of the fundamental constitutional limitations on state corporate income taxation is that a state may not tax a corporation's income unless there is "some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax." In the case of multistate corporations, it is often difficult to determine what activities have the requisite "minimum connection" with the taxing state, and may therefore be subject to tax. In addressing this issue, the U.S. Supreme Court has formulated the unitary business principle, described in Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980), as "the linchpin of apportionability in the field of state income taxation . . . ." As the Court recently held, a state may "tax an apportioned share of the value generated by the intrastate and extrastate activities of a multistate enterprise if those activities form part of a ‘unitary business.'"

The Court has adopted several tests for determining whether a unitary business exists. Notably, in Mobil, the Court described a unitary business as one characterized by "functional integration, centralization of management, and economies of scale." In Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983), the Court held that "the prerequisite to a constitutionally acceptable finding of a unitary business is a flow of value, not a flow of goods."

Application of the Unitary Business Principle in Separate-Reporting Jurisdictions
In the words of Vince Lombardi, "the achievements of an organization are the results of the combined effort of each individual." And indeed, the unitary business principle is most commonly applied by taxpayers in the context of determining the members of their combined corporate income tax filing group, due in no small part to the complexity of corporate organizational structures. However, as mentioned above, often overlooked is the very real impact of the unitary business principle in separate-reporting jurisdictions.

State Treatment of Non-Unitary Partnerships
One way in which the unitary business principle may impact a taxpayer in a separate-reporting state involves the treatment of partnership income and apportionment factors. Some separate-reporting states provide specific guidance on how income and apportionment factors of a partnership are treated by a corporate partner. This treatment varies depending on whether the partnership and corporate partner constitute a unitary business.

Generally speaking, if a corporate partner and its partnership are part of a unitary business, partner-level apportionment should be used. Under partner-level apportionment, the corporate partner would include its distributive share of the partnership's income and apportionment factors with its own, and would then apportion its business income to the given state based on the combined income and apportionment amounts.

If, on the other hand, the corporate partner and partnership are not part of a unitary business, partnership-level apportionment is generally used to calculate the corporate partner's income apportioned to a given state. This means that the partnership's income attributable to a state is separately apportioned using only its income and apportionment factors. The corporate partner then receives its distributive share of this apportioned income, which is added to its own business income apportioned to the state (which was calculated using only the corporate partner's apportionment factors).

These two methods of accounting for partnership income can result in wildly different state taxable income amounts, depending on the taxpayer's specific facts, and should be considered in all instances in which the taxpayer believes it may have income from non-unitary partnerships.

Multiple Unitary Businesses, One Corporate Bucket?
But what about a separate-company taxpayer that has no flow-through entity ownership interests whatsoever and is a true standalone entity? Certainly, in such a case the unitary business principle would be rendered moot, right?

As Lee Corso would say: "Not so fast, my friend!"

The unitary business principle is absolutely relevant, even in the true single-entity context. For example, when a single taxpayer has multiple divisions engaged in "unrelated business activities" that constitute "discrete business enterprises," those divisions may constitute multiple non-unitary lines of business. If so, a taxpayer could potentially be leaving money on the table if it files a separate-company return treating its non-unitary divisions as one unitary business.

For instance, assume that Company A has two divisions, Red Division and Green Division, both doing business in State X, among other states. Also assume that neither division generated any nonbusiness income for State X purposes. If the two divisions constitute a unitary business, the income and apportionment factors of the two divisions would simply be combined to determine Company A's income apportioned to the state.

However, if the two divisions are non-unitary, Red and Green Division would separately apportion their income to State X. That is, Red Division would multiply its State X income by its State X apportionment to calculate its State X taxable income. Green Division would do the same with its own State X income and apportionment factors. Company A's state taxable income would be the resultant sum of the taxable income amounts.

Properly apportioning could lead to favorable State X tax results for Taxpayer A. By way of example, assume that Red Division generated 1 percent of Company A's income and had high State X apportionment, while Green Division generated 99 percent of Company A's income and had very low State X apportionment. If the relative magnitude of Red and Green Division's underlying state apportionment factors were similar, properly apportioning its income to State X would result in state tax savings for Company A.

Be mindful that the tax result is highly dependent on the specific facts of the taxpayer at issue, which should be examined carefully to ensure proper treatment. Additionally, a state's corporate income tax forms are generally drafted to address the more-common scenario of a single taxpayer with a single unitary business. Therefore, those forms may not necessarily lend themselves to proper apportionment of income in situations like those described above. However, the mechanics of a state's forms are not controlling when they conflict with proper application of the relevant law.

Has Gore Eviscerated the Unitary Principle in Maryland?
W.L. Gore & Associates, Inc. v. Comptroller of the Treasury, Nos. 07-IN-OO-0084, -0085, -0086, 2010 Md. Tax LEXIS 3, a recent Maryland Tax Court decision from November 2010, appears at first blush to add an unexpected wrinkle to the unitary business principle analysis that must be conducted in a separate-reporting state. In this case, Gore Enterprises, Inc. (GEH) and Future Value, Inc. (FVI) were Delaware holding companies and wholly owned subsidiaries of W.L. Gore & Associates, Inc. While W.L. Gore had a physical presence in Maryland, GEH and FVI had no physical presence in the state. The state contended that GEH and FVI were required to file Maryland income tax returns and pay tax on royalty and interest income on a modified apportionment formula. The royalty income earned by GEH was generated by the Maryland manufacture of products by W.L. Gore and the subsequent sale of goods to Maryland customers. Additionally, the interest income earned by FVI was directly connected to the ordinary business operations of W.L. Gore conducted in Maryland.

The issue before the court was whether GEH and FVI, with no physical presence in Maryland, could be constitutionally subjected to Maryland's corporate income tax because of W.L. Gore's physical presence and activities in the state. In answering this question, the court stated that, "Maryland courts have consistently concluded that the basis of a nexus sufficient to justify taxation is the economic reality of the fact that the parent's business in Maryland was what produced the income of the subsidiary... Thus, the resolution of this case depends on whether GEH and FVI as out-of-state affiliates had real economic substance as business entities separate from W.L. Gore." In an attempt to determine whether GEH and FVI had economic substance, the court in W.L. Gore & Associates, Inc. applied the following unitary analysis: "This Court's previous interpretation of the facts support [sic] the Comptroller's position that GEH and FVI were engaged in a unitary business with W.L. Gore and are not separate business entities." Since the court held that GEH and FVI lacked economic substance and were not separate business entities, it held that substantial nexus existed between GEH and FVI with the state of Maryland.

In essence, the court in W.L. Gore & Associates found that the intangible holding companies had nexus to Maryland based on a complete lack of economic substance apart from W.L. Gore. However, a unitary business principle analysis was used, at least in part, to determine this lack of separate existence. Therefore, taxpayers should be wary of states, such as Maryland, attempting to use the unitary "analysis" in the W.L. Gore & Associates case as a standalone reason for nexus to the state, particularly in the absence of a similar lack of economic substance.

Alvarez & Marsal Taxand Says:
Bear in mind that the unitary business principle is neither synonymous with nor inseparable from combined reporting. Indeed, there are many instances in addition to those noted above where the unitary business principle must be applied in separate-reporting states, and the failure to do so could result in incorrect returns being filed. Further, staying vigilant should serve as a shield against unfair state taxation of non-unitary income, lest state taxing authorities use the unitary business principle as a sword - or, more accurately, as a blunt instrument - to draw more of your company's income into their state.


Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992), citing Miller Bros. Co. v. Maryland, 347 U.S. 340 (1954).

MeadWestvaco Corp. v. Illinois Dep't of Revenue, 553 U.S. 16 (2008), citing Hunt-Wesson, Inc. v. Franchise Tax Bd. of Cal., 528 U.S. 458 (2000).

See Exxon Corp. v. Dep't of Revenue, 447 U.S. 207 (1980). In Exxon, the U.S. Supreme Court held that a wholly owned subsidiary of Exxon Corp.'s marketing, refining and exploration/production divisions constituted a single functionally integrated business. However, when a company's divisions are not functionally integrated or otherwise do not satisfy the tests for unity, those divisions may constitute separate, non-unitary lines of business - e.g., Tex. Comptroller's Decision No. 43,881 (July 12, 2006).

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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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