Directive CD-01-1

Subject: Business v. Nonbusiness Income and the Lenox Decision
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
Number: CD-01-1

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 Tax Division of the North Carolina Department of Revenue at 919-814-1163. You may also write to the Division at P.O. Box 871, Raleigh, N.C. 27602-0871.

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) through (h).

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 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.

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.