What Is Nonbusiness Income for State Tax Purposes?

For state tax purposes, income is categorized in a way that determines how and where it is taxed. One category is nonbusiness income, which includes all income that does not arise from a taxpayer’s primary business activities. This distinction is important for individuals and businesses with financial activities in multiple states. Classifying income correctly is the first step in determining which state has the right to tax it, preventing the over-taxation of multistate income.

Defining Nonbusiness Income

The framework for this distinction comes from the Uniform Division of Income for Tax Purposes Act (UDITPA), though its application varies by state. The original UDITPA model uses two tests to distinguish between business and nonbusiness income. The classification is not based on labels like “interest” or “rent,” but on the income’s relationship to the business operations.

The first of these is the Transactional Test. This test examines whether the income arises from transactions and activities that occur in the regular course of the taxpayer’s trade or business. For example, if a clothing retailer sells its inventory, the income is business income. If that same retailer sells a delivery truck, the income might not meet the transactional test, as selling vehicles is not its primary business activity.

The second standard is the Functional Test. This test classifies income as business income if it comes from property where the acquisition, management, and disposition of that property are integral parts of the taxpayer’s regular business operations. For instance, a manufacturing company that temporarily invests its excess working capital in short-term securities may find the interest earned is business income. This is because the management of working capital is an integral part of the company’s overall operations.

Many states have adopted a broader definition of business income linked to the unitary business principle. Under this principle, income is considered business income if it serves an operational function rather than a passive investment function. This can result in gains from selling a business division or interest from working capital being classified as business income, even if they do not meet the transactional test. The result is a complex set of rules that varies by state.

Common Types of Nonbusiness Income

Several types of income are frequently classified as nonbusiness because they are disconnected from a company’s main operational activities. Interest and dividend income from a passive investment portfolio is a common example. For a company that manufactures furniture, earning dividends from holding stock in a technology firm is not part of its regular course of business, and this income would likely be classified as nonbusiness.

Capital gains from the sale of certain assets also fall into the nonbusiness category. This occurs when a business sells property that was not used in its core operations. For instance, if a restaurant chain sells a parcel of land it held for a future but now-canceled expansion project, the gain from that sale is often considered nonbusiness income.

Rents and royalties can be a source of nonbusiness income when the property generating the income is not used in the taxpayer’s primary business. For example, a business may own an office building, use several floors for its operations, and rent the remaining floors to other tenants. The rental income from the leased floors may be classified as nonbusiness, as being a commercial landlord is not the company’s primary trade.

State Tax Treatment and Reporting

The distinction between business and nonbusiness income governs how states tax income for multistate entities. The principle for nonbusiness income is allocation, which is the process of assigning 100% of a specific item of nonbusiness income to a single state. This prevents multiple states from taxing the same nonbusiness income and ensures a clear connection between the income and the taxing state.

The state to which nonbusiness income is allocated depends on the type of income and the taxpayer’s connection to that state. For individuals, income like interest, dividends, and capital gains from intangible property is allocated to their state of residence. For businesses, this income is allocated to their “commercial domicile,” which is the principal place from which the business is managed. For income from tangible property, such as rental income, the income is allocated to the state where the property is physically located.

This treatment contrasts sharply with how business income is handled. Business income is subject to apportionment, where a taxpayer’s total business income is divided among the states in which it operates using a formula. This formula considers the proportion of a company’s property, payroll, and sales within each state.