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145367-70 - Wheeler Estate v Department of Treasury

Wheeler Estate,
John D. Pirich
June Summers Haas
Nicholas Huzella and Lisa J. Huzella (145368), Patrick Wright and Michaelon Wright (145369) and Thomas R Wheeler and Patsy Wheeler (145370),  
(Appeal from Ct of Appeals)
(Michigan Tax Tribunal)
Department of Treasury,
Kevin T. Smith


The petitioners in this case were shareholders of an S corporation called Electro-Wire Products, which makes electrical systems for Ford Motor Company. Because Ford wanted Electro-Wire to establish a world-wide presence, in 1994, Electro-Wire acquired all the business assets of a German company, Temic Telefunken Kabelsatz, GmbH (TKG) which also manufactured and assembled electrical distribution systems. Two general partnerships were created: (1) an operating company, also named Temic Telefunken Kabelsatz, GmbH, which held all TKG’s purchased assets and (2) a holding company, Electro-Wire Products, GmbH (EWG), which held a 99.5 percent partnership interest in TKG. Electro-Wire held a 99 percent partnership interest in EWG, as well as the remaining 0.5 percent partnership interest in TKG. As an S corporation and two general partnerships, Electro-Wire, EWG, and TKG were flow-through entities for tax purposes, meaning that their income or loss is passed through to their shareholders, who report that income or loss on their individual income tax returns.

In 1994 and 1995, the petitioners received flow-through income from Electro-Wire, which included Electro-Wire’s distributive share of the partnership income from TKG. The petitioners reported this income by treating Electro-Wire and TKG as a unitary business and combining their apportionment factors.
The Michigan Department of Treasury audited the petitioners for those years and sent them a tax bill. The unitary business principle did not apply to individuals under the Michigan Income Tax Act, MCL 206.1 et seq., the treasury department asserted; accordingly, the petitioners should have applied Electro-Wire’s apportionment factors to Electro-Wire’s income alone, independently of TKG.
A Department of Treasury hearing referee concluded that the unitary business principle applied and that the petitioners were entitled to combine the apportionment factors of the S corporation and the German partnerships, but a hearings administrator rejected that recommendation and held that the unitary business principle did not apply in the absence of statutory authorization. The petitioners were ordered to pay $822,460 in taxes, plus a $81,082 penalty and $786,629 in interest.
But the Michigan Tax Tribunal overturned that directive, concluding that the unitary business principle does apply to individual income taxes, including the petitioners’ income from the German partnerships. TKG and Electro-Wire were unitary during the years in question, and the petitioners had properly used the apportionment factors of the entire unitary business to apportion their income to the state of Michigan, the tribunal said.
The Department of Treasury appealed, but in a unanimous published opinion, the Court of Appeals affirmed the tax tribunal’s ruling, saying that the three entities did meet the criteria for a “unitary business.”
The Michigan Income Tax Act provides that income a taxpayer earns in Michigan must be allocated to Michigan for tax purposes. Section 110(1) of the MITA states:
For a resident individual . . . all taxable income from any source whatsoever, except that attributable to another state under sections 111 to 115 and subject to section 255, is allocated to this state. [MCL 206.110(1).]
But if a taxpayer has income from activities in other states as well as Michigan, that income is allocated pursuant to MCL 206.115, which provides:
Before January 1, 2012, 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.
The Michigan Court of Appeals cited the U.S. Supreme Court’s decision in Allied-Signal, Inc v Div of Taxation Director, 504 US 768 (1992). Recognizing that some multistate businesses cannot allocate their income to specific states, the Court held that the “unitary business principle” allows states to tax multistate businesses “on an apportionable share of the multistate business carried on in part in the taxing State.” In order to exercise multi-state apportionment under the unitary business principle, there must “be some sharing or exchange of value not capable of precise identification or measurement – beyond the mere flow of funds arising out of a passive investment or a distinct business operation – which renders formula apportionment a reasonable method of taxation,” the Allied-Signal Court stated.
In applying the unitary business principle to this case, the Michigan Court of Appeals looked to two recent Court of Appeal decisions: Preston v Dep’t of Treasury, 292 Mich App 728 (2011), and Malpass v Dep’t of Treasury, 295 Mich App 263 (2012).
In Preston, the taxpayer sought to offset gains earned by his Michigan nursing homes with losses suffered by out-of-state businesses. The Michigan nursing homes were owned by one of 22 lower-level partnerships; the remaining partnerships operated nursing homes outside Michigan. All 22 partnerships distributed their gains and losses to a higher-level partnership, which owned 99 percent of the lower-level partnerships and distributed their combined income to the taxpayer. The Court of Appeals held in that case that the high-level partnership operated the lower-level partnerships as a unitary business and that the taxpayer was entitled to apportion that income.
But in Malpass, the Court of Appeals reached a different result. In that case, the taxpayers owned two separate S corporations, one operating in Michigan and one operating in Oklahoma, and filed tax returns seeking to treat them as a unitary business. The Malpass court said that the S corporations had many characteristics of a unitary business, but rejected the taxpayers’ application of the unitary business principle, saying that the S corporations were “separate and legally distinct business entities, and nothing in the ITA allows for combined-entity reporting.”
In this case, the facts “are more analogous to those of Preston than Malpass,” the Court of Appeals ruled. “TKG is 99 percent owned by EWG, which is in turn 99.5 percent owned by Electro-Wire. Electro-Wire and TKG are not ‘separate and legally distinct business entities,’ but stand in what amounts to a parent/subsidiary relationship. Like Preston, the income to petitioners flowed through one source, in this case Electro-Wire, and not through two separate sources as in Malpass. Therefore, Electro-Wire and TKG should be permitted to avail themselves of multistate apportionment under the ITA.”
The Court of Appeals rejected the Department of Treasury’s argument that the ITA excludes foreign entities from consideration as part of a unitary business. “Pursuant to MCL 206.103, ‘[a]ny taxpayer having income from business activity which is taxable both within and without this state . . . shall allocate and apportion his net income as provided in this part,’” the appellate panel explained. “State” is defined under MCL 206.20 as ‘any state of the United States, the District of Columbia, the Commonwealth of Puerto Rico, any territory or possession of the United States, and any foreign country, or political subdivision, thereof’. (Emphasis added.)” Under that “plain language,” and the language of other sections of the ITA in effect during the years at issue, “unitary, international businesses [were required] to include international apportionment factors in the calculation of property, payroll, and sales factors,” the Court of Appeals declared. “Therefore, because the ITA does not exclude foreign entities from consideration under the [unitary business principle], the Tax Tribunal did not err by granting summary disposition to petitioners.”
Moreover, the Tax Tribunal did not err by finding that Electro-Wire and TKG constituted a unitary business, the Court of Appeals said. “This Court utilizes a five-factor test … as follows: (1) economic realities; (2) functional integration; (3) centralized management; (4) economies of scale, and (5) substantial mutual interdependence. Petitioners submitted unrebutted evidence to the Tax Tribunal to establish each of these five criteria, and the Tax Tribunal concluded that petitioners had established at least four, and possibly all five, of the relevant factors.”
The “economic realities” factor was satisfied, the panel said, because the “regularly conducted activities” of Electro-Wire and TKG were not only related, but identical, although “the only requirement is that the underlying businesses be related to each other.” The petitioners also showed that the businesses were functionally integrated because Electro-Wire provided support services for TKG and managed its business activities. Businesses need not “be 100 percent integrated in order to classify them as unitary,” the appellate panel observed. The third factor, centralized management, was met by “unrebutted evidence that TKG’s overall management decisions were centralized and directed by Electro-Wire managers in North America and that Electro-Wire hired and fired all TKG officers and managers … the only requirement … is centralized management, not complete management.” The petitioners satisfied the fourth factor, economies of scale, by presenting “unrebutted evidence of economic benefits generated by the combination of Electro-Wire and TKG, such as an expanded customer base, sharing of unique and proprietary processes, and improved financing terms.” Finally, as to the “substantial mutual interdependence” factor, the petitioners had submitted “unrebutted evidence that acquiring TKG was essential for Electro-Wire to remain a supplier for Ford and that remaining a supplier for Ford was essential to Electro-Wire’s survival.”
The Court of Appeals also rejected the treasury department’s contention that the petitioners should pay a 10 percent penalty for negligent failure to pay taxes. Under MCL 205.23(3), if any part of a tax deficiency is the result of negligence, a penalty of $10 or 10 percent of the deficiency, whichever is greater, plus interest is added to the deficiency – but the statue also provides that the penalty is waived if a taxpayer demonstrates that the tax deficiency resulted from reasonable cause. “Reasonable cause is generally deemed to exist when there is an honest difference of opinion with regard to the effect or application of the law,” the Court of Appeals observed. The petitioners based their tax returns on earlier Court of Appeals decisions, as well as “numerous” U.S. Supreme Court decisions, so that “substantial legal foundation” – plus the fact that the petitioners had prevailed on several levels in the tax appeal process – “underscores the reasonableness of their legal position.”
The Department of Treasury appealed. In an October 4, 2012 order, the Supreme Court granted leave to appeal, directing that this case would be “argued and submitted to the Court together with the cases of Tad Malpass v Department of Treasury.”