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144430-2 - Malpass v Department of Treasury

Tad Malpass and Brenda L. Malpass,
Nicole L. Mazzocco
(Appeal from Ct of Appeals)
(Ct of Claims -
Manderfield, P)
Department of Treasury
Scott L. Damich


​The plaintiffs, members of the Malpass family, own and control two Michigan companies: East Jordan Iron Works, which operates an iron foundry in East Jordan, Michigan, and Ardmore Foundry, Inc. which operates a foundry and distribution center in Oklahoma. East Jordan Iron Works’ resident agent, corporate offices, and principal place of business are located at 301 Spring Street, East Jordan, Michigan; Ardmore’s resident agent is also located at this address.

The two companies are subchapter S corporations, which mean that neither pays federal income taxes. Instead, their income or loss is passed through to their shareholders, who report that income or loss on their individual income tax returns.

When the plaintiffs initially filed their individual Michigan tax returns for 2001, 2002, and 2003, they treated the business income from East Jordan and Ardmore as from two separate businesses. The plaintiffs attributed the business income from East Jordan to Michigan, and included it as income on their returns; they attributed losses from Ardmore to Oklahoma, and added those losses back into their adjusted gross income for Michigan individual income tax purposes. Mich Admin Code, R 206.12(20) provides that “Distributive income from a subchapter S corporation not allocated or apportioned to Michigan may be claimed as a subtraction from adjusted gross income. Conversely, losses not allocated or apportioned to Michigan shall be added to adjusted gross income.”

But later, the plaintiffs filed amended individual returns for the same years, treating East Jordan and Ardmore as a unitary business, offsetting East Jordan’s gains with Ardmore’s losses and applying the Michigan apportionment factors to both companies. Based on these amended returns, the plaintiffs sought refunds totaling over $1 million.

The Michigan Department of Treasury denied the plaintiffs’ amended returns; the plaintiffs appealed to the Court of Claims. The Department of Treasury moved for summary disposition, arguing that the Michigan Income Tax Act, MCL 206.1 et seq., does not allow the unitary business principle to be applied to individual income tax situations. Under the ITA, the plaintiffs were not permitted to use a combined filing method based on the unitary business principle, the department contended.

The plaintiffs countered with their own motion for summary disposition; they argued that East Jordan and Ardmore are a unitary business. In support, the plaintiffs offered an affidavit from East Jordan’s treasurer, in which he attested that the two companies constituted a unitary business.

The Court of Claims ruled in the plaintiffs’ favor, holding that East Jordan and Ardmore were a unitary business and that the plaintiffs were entitled to a tax refund. The court held that the unitary business principle is recognized in Michigan law and applies to Michigan income tax filings. Although the Legislature had not explicitly referred to the unitary business principle in the ITA, it nonetheless incorporated the principle into the act, the Court of Claims reasoned. The court cited MCL 206.110(1), which provides, “For a resident individual . . . all taxable income from any source whatsoever, except that attributable to another state under [MCL 206.111 to MCL 206.115] and subject to [MCL 206.255], is allocated to this state.” Moreover, MCL 206.115 provides, “All business income, other than income from transportation services shall be apportioned to this state by multiplying the income by a fraction, the numerator of which is the property factor plus the payroll factor plus the sales factor, and the denominator of which is 3.”

Taking MCL 206.110 and MCL 206.115 together, the court stated: “Clearly, based on the plain language set forth in Sections 110 and 115, the Michigan Legislature has adopted the unitary business principle, because it has chosen to require the apportionment of all business income according to a statutory formula.” MCL 206.115 does not distinguish between unitary and nonunitary businesses, but the ITA’s apportionment formula could only be constitutionally applied to a unitary business, the Court of Claims said.

But the Court of Appeals reversed, holding that the Court of Claims erred in allowing the plaintiffs to combine their business income from the two companies for the purposes of MCL 206.115. “There is no provision in the ITA that allows individuals to combine their business income from separate businesses and then use a combined apportionment formula on the total,” the appellate court declared. “[A]llowing the plaintiffs to combine all their business income from separate entities and then apportion it based on the apportionment factors, or alternately requiring other similarly situated taxpayers to do so whether or not the result would be favorable to them, would raise due process concerns and cause the ITA to be applied inconsistently.”

Under the Due Process and the Commerce Clauses of the Constitution, a state may not, when imposing an income-based tax, “tax value earned outside its borders,” the appellate panel noted. Accordingly, states are permitted to tax multistate businesses “on an apportionable share of the multistate business carried on in part in the taxing State,” the Court of Appeals explained, citing the U.S. Supreme Court’s decision in Allied-Signal v Director, Division of Taxation, 504 US 768 (1992). “This is known as the ‘unitary business principle.’”

In determining whether companies constitute a “unitary business,” courts consider five factors: 1) economic realities, 2) functional integration, 3) centralized management, 4) economies of scale, and 5) substantial mutual interdependence, the panel explained. The Court of Appeals acknowledged that, based on the treasurer’s affidavit, the two companies “have many characteristics of a unitary business. However, they remain separate and legally distinct business entities, and nothing in the ITA allows for combined-entity reporting.” The court noted, among other matters, that Ardmore’s stock was not owned by East Jordan, but by members of the Malpass family.

The Court of Claims interpreted “all business income” in MCL 206.115 to mean “that all business income, no matter what the source, must be added together and then apportioned by the apportionment factors,” the Court of Appeals said. The Court of Claims correctly recognized that this approach would violate the constitutional prohibition against a state taxing income earned outside its borders – unless companies in different states were operating in a unitary fashion. Accordingly, the Court of Claims reasoned, the legislature must have intended to incorporate the unitary business principle into the statute.

But, “[w]hile this approach may be constitutionally permissible, it would cause MCL 206.115 to be applied inconsistently with respect to different taxpayers … For example, a petitioner who holds interests in multiple separate entities could attempt, on one hand, to exclude his or her out-of-state businesses that turn a profit from inclusion and apportionment, while arguing on the other hand that the petitioner’s other out-of-state businesses that post a loss should be included and apportioned to his or her advantage.” The Court of Claims approach would probably lead to “arbitrary decisions and unnecessarily protracted litigation,” the Court of Appeals opined.

“[A] consistent approach would be to apportion all business income at the entity level. That way, if the business conducts multistate activity, the income will be apportioned accordingly. If the business has no nexus to Michigan, none of that income will be attributed to Michigan because its property factor, payroll factor, and sales factor will all be zero,” the panel stated.

Michigan treasury regulations call for business income to be “allocated or apportioned to the state in which the activity took place,” the Court of Appeals said, citing Mich Admin Code Rule 206.12(3). “Therefore, if a resident earns business income that is derived from another state, it is allocated to that state. However, if the business income is attributable to Michigan and one or more other states, Rule 206.12(4) requires that it be apportioned as calculated by the formula in MCL 206.115.”

The income from Ardmore, including its losses, must be attributed to Oklahoma “in which the activity took place,” the panel reasoned. “Because the losses sustained by Ardmore are not attributable to Michigan, they are not allocated or apportioned to Michigan and are added back to plaintiffs’ adjusted gross income.”

The plaintiffs appealed. In an order dated October 4, 2012, the Supreme Court granted leave to appeal, ordering the case to be argued and submitted with Wheeler Estate v Department of Treasury.