Medicine Shoppe's income subject to Missouri taxation

The Missouri Supreme Court handed down an important and instructive decision on April 9. In Medicine Shoppe International v. Director of Revenue, the court considered the income from franchise activities and held that revenue generated from activities both in this state and another state are subject to Missouri taxation on an apportioned basis.

The decision may have an impact on Missouri corporations which engage in commercial activities outside the borders of the state.

Medicine Shoppe International franchises retail pharmacies throughout the country, while providing start-up loans, technical and business advice, and real estate location assistance to new franchisees.

The company is located in St. Louis and almost all of its employees work in the state.

The company earns about 7 percent of its income from loan origination fees and interest to out-of-state franchisees.

In 1993, the company filed its state income tax return and designated the income earned from out of state franchisees as non-Missouri source income.

The Director of Revenue disagreed.

Section 143.451 requires a Missouri corporation to include in income all income earned from sources within the state.

It also requires all income derived from transacting business partly done in the state and partly done in another state to be reported as income subject to Missouri taxation.

The taxable portion is based on a formula that apportions the earnings between that amount earned inside the state and that amount earned outside the state.

Medicine Shoppe International claimed that all interest income from out-of-state franchisees should be excluded from taxation in the state. The Missouri Supreme Court on appeal reviewed the basis for determining what income the state may tax.

First, the income must have some contact with the state of Missouri.

The state cannot tax income wholly derived from out of state operations because it would violate the due process clause of the United States Constitution.

For income earned partly in the state and partly outside, Missouri may tax a fairly apportioned amount of the income.

Second, the court also considered the amount of the control of the management of the company within the state, and the extent of the activity or effort expended in the state.

Finally, the court reviewed whether the activity was passive or active.

In this case, the court noted that the corporation had its central office in the state and operated the loan program as a component of its regular business.

The company maintained significant influence over the franchisees located out of state and thus had sufficient control.

In addition, the activity was not a passive one, but one that required marketing, accounting, financing, advertising and loan servicing.

Sufficient activities in the state were thus found to impose tax liability on the income derived from out-of-state franchisees.

The Missouri Supreme Court's analysis would seem to require companies to consider carefully their activities carried on partly within the state and partly outside the state with respect to taxation. It might be possible in some instances to structure transactions to minimize the corporate state tax liability.

(Stephen F. Aton is a Springfield attorney practicing in the areas of corporate law and taxation, and estate planning.)