Subject: Business v. Nonbusiness Income and the Lenox
Tax: Corporate Income and Franchise Taxes
Law: G.S. 105-130.4; Lenox, Inc. v. Tolson
Issued By: Corporate, Excise, and Insurance Tax Division
Date: November 20, 2001
This Directive addresses the decision of the North Carolina Supreme
Court in Lenox, Inc. v. Tolson, 353 N.C. 659, 548 S.E.2d
513 (2001), and its effect on the determination of whether income
is business or nonbusiness. If you have questions about this Directive,
you may call the Corporate, Excise, and Insurance Tax Division
of the North Carolina Department of Revenue at (919) 733-8510.
You may also write to the Division at P.O. Box 871, Raleigh, N.C.
Business v. Nonbusiness Income
A corporation with income from sources both within and outside
of North Carolina is required to allocate and apportion its total
net income or loss to North Carolina. The corporation apportions
its business income among all states in which the corporation
transacts business in accordance with the statutory apportionment
formula under G.S. 105-130.4. The corporation allocates its nonbusiness
income in accordance with the provisions of G.S. 105-130.4(d)
G.S. 105-130.4(a)(1) sets out two separate, independent tests
for determining whether income is classified as business income
- the transactional test and the functional test. If either test
is satisfied, the income is considered business income. All income
that is not business income is nonbusiness income under G.S. 105-130.4(a)(5).
Income satisfies the transactional test if it arises from transactions
and activity in the regular course of the corporation's trade
or business. In Polaroid Corp. v. Offerman, 349 N.C. 290,
507 S.E.2d 284 (1998), cert. denied, 526 U.S. 1098, 143
L. Ed. 2d 671 (1999), the North Carolina Supreme Court held that
the frequency and regularity of similar transactions, the former
practices of the business, and the corporation's subsequent use
of the income are all factors to be considered in determining
whether income meets the transactional test.
Income satisfies the functional test if it is from tangible or
intangible property and the acquisition, management, and/or disposition
of the property constitute integral parts of the corporation's
regular trade or business operations. In Polaroid, the
Court stated that the extraordinary nature or infrequency of the
transaction is irrelevant. If the asset or property was integral
to the corporation's regular trade or business, income resulting
from the acquisition, management, and/or disposition of that asset
or property constitutes business income regardless of how that
income is received.
The Lenox Case
Lenox is a New Jersey-based corporation that operates in many
states, including North Carolina. It is engaged in the business
of manufacturing and selling various consumer products. In 1970,
Lenox established its ArtCarved subsidiary division to manufacture
and sell fine jewelry. ArtCarved's principal place of business
was in New York and it was a functionally and financially distinct
division of Lenox. In 1988, Lenox liquidated ArtCarved by selling
all of ArtCarved's assets, thereby terminating Lenox's involvement
in the fine jewelry business. Lenox did not reinvest any of the
proceeds from the liquidation in its ongoing business; instead,
Lenox distributed the liquidation proceeds in their entirety to
its parent company and sole shareholder.
Lenox classified the gain from the sale as nonbusiness income
and allocated the income to New Jersey, its commercial domicile.
The North Carolina Department of Revenue reclassified the income
as business income and apportioned it to North Carolina, resulting
in additional corporate income tax. Lenox paid the additional
tax under protest and filed suit to recover the tax. A Granville
County judge ruled in favor of the State in 1999 but his decision
was reversed by a divided Court of Appeals in 2000. The State
appealed the decision to the North Carolina Supreme Court.
In the majority decision, the North Carolina Supreme Court held
that Lenox's gain from the liquidation of its ArtCarved division
is nonbusiness income. The Court stated that when a "transaction
involves a complete or partial liquidation and cessation of a
company's particular line of business, and the proceeds are distributed
to shareholders rather than reinvested in the company, any gain
or loss generated from that transaction is nonbusiness income
under the functional test."
The Court in Lenox concluded that the sale of ArtCarved's assets
was not an integral part of Lenox's regular trade or business.
In reaching this conclusion, the Court disavowed its statement
in Polaroid that the extraordinary nature or infrequency
of a transaction is irrelevant and declared, instead, that the
extraordinary nature or infrequency of the transaction is relevant
when using the functional test for determining whether income
is business income. The Court noted that partial or complete liquidations
are extraordinary events rather than recurring transactions and
that liquidation is a way to stop doing business rather than further
the business. The Court found that the liquidation of the ArtCarved
division was a liquidation in cessation of business and was not
an integral part of Lenox's regular trade or business. In support
of this finding, the Court noted that Lenox did not use any of
the liquidation proceeds in its remaining, ongoing business and
that none of Lenox's remaining businesses involved fine jewelry
or similar products.
Application of the Lenox Decision
Gain or loss from a company's disposition of real or tangible
property is classified as nonbusiness income and is allocated
to the situs of the property if both of the conditions listed
below apply. Gain or loss from a disposition that does not meet
both conditions is classified as business income and is subject
to apportionment. The conditions are:
The Lenox decision supersedes the application of administrative
rule 17 NCAC 5C .0703, Business and Nonbusiness Income, to dispositions
that meet the conditions set out above. The Department plans to
amend the rule to reflect the Lenox decision.
- The disposition is the liquidation of a separate and distinct
line of business of the company and results in the cessation
of that line of business.
- The company distributes all of the proceeds of the liquidation
to its shareholders and does not reinvest any of the proceeds
in the company.
on: 10/31/07 03:36:02 PM.