State income tax on a divestiture gain is allowable

1FAR 31.205-41(b)(2)A tax the sale itself imposes is still unallowable

FAR 31.205-41 makes federal, state and local taxes allowable in general, then lists the taxes that are not. One is a tax in connection with financing or reorganizations, which points to FAR 31.205-27, the cost principle for organization and reorganization costs. The parties agreed that taxes RTX paid directly because of the asset sales were unallowable. In this appeal those were real estate transfer taxes and controlling interest transfer taxes.

The Board read the phrase as one that "implies something broader than simply the taxes specifically imposed on the business reorganization transaction itself", because states and localities tax transactions in more ways than a rule could list. Quoting the Supreme Court in Maracich v. Spears, it added that such "language must have a limit".

Why it matters: a transfer tax, or any other tax that a closing itself triggers, belongs with the unallowable costs of the deal. This decision does not change that.

What to watch: the closing statement. When you buy or sell a business, record every tax the transaction triggers apart from your regular income tax provision, so it comes out of the proposal before an auditor finds it.

2FAR 31.205-41(a)(1) and (b)(2)Income tax on the gain is not a tax on the deal

The government argued that RTX would not have paid these taxes but for the divestitures. RTX answered that its income tax is the product of a whole year of business, not of one transaction. The Board agreed with RTX:

"We hold that income taxes incurred due to the recognition of capital gains, triggered by a business reorganization, are not unallowable"

The reasoning runs on timing, structure and text. On timing, the Board found that "The capital gains, however, accrued, but were not recognized, over some period of years prior to the business reorganization"; the sale only made the tax on them due. The exception has to be read narrowly, "so that it does not swallow-up the general rule in (a)(1) that state taxes are allowable". And the FAR names income taxes where it means them, in the paragraphs on federal income tax and on tax accruals.

It followed the Claims Court's decision in Hercules, Inc. v. United States, 22 Cl. Ct. 301 (1991), which read the rule as reaching transactional taxes, "the imposition of which has nothing to do with income". It did so while noting that decisions of that court do not bind it, and it set aside the government's cases on the phrase because they read other laws.

The test it settled on comes from the Court of Federal Claims' Datamill decision: the phrase "means that there is a direct and causal relationship between two things that are mutually dependent". Income tax fails that test "because income taxes can be due in the absence of a reorganization or there may be no income tax due even with a business reorganization in the event of a capital loss".

Why it matters: state income tax on a gain a divestiture recognizes is judged like any other state income tax. The reorganization exception does not take it out of your rates.

What to watch: your audit. DCAA questioned these costs as reorganization taxes, and the government defended that on a but-for reading. Expect the same position in any audit of a year you sold a business, and answer it with this decision and Hercules.

3The 1997 proposed ruleThe government proposed this rule in 1997 and withdrew it

On September 23, 1997, the FAR councils proposed adding a new category of unallowable tax: "Net increase in taxes incurred by a seller or transferor resulting from a sale or other transfer of ownership of a segment". Their reason was that "the Government should not share in any tax increases resulting from the segment sale or transfer".

Because the proposal said it would add these taxes to the list, the Board read it as a change to the rule, not a clarification of what the rule already meant. On August 12, 1998, the agencies withdrew it, over industry concern that it would "place a significant administrative burden on contractors by requiring them to compute state and local taxes twice".

Why it matters: an argument that the rule already reaches these taxes has to explain why the councils once proposed adding them, and then dropped the idea.

What to watch: the Federal Register. A rule like the 1997 proposal is the one way the answer changes for future years.

4What the Board did not decideWhat RTX left out, and what the Board left open

RTX did not claim all of the tax. When United Technologies spun off Otis and Carrier, businesses the record calls predominantly commercial, RTX excluded the added state income tax from its proposals. For the asset sales, it excluded the share tied to the businesses' commercial work. DCAA objected to the rest, the share tied to government work. In its words, "We consider all costs for these divestitures, including the full amount of taxes paid on the gain of these sales to be within the scope of reorganizations, mergers, and acquisitions".

The Board decided the tax question alone. Having held that the income tax is not a reorganization tax, it did not reach RTX's argument that the divestitures were not reorganizations at all. To settle the Department of Justice's antitrust case, RTX agreed to divest three businesses with significant government work; Project Sky was a sale the government did not require.

Why it matters: whether a divestiture is a reorganization is still open. The costs of planning or carrying out a sale, such as fees for attorneys, brokers and accountants, remain a separate question under FAR 31.205-27.

What to watch: your own exclusions. Keep the workpapers that show how you split a gain between commercial and government work, because that split is the line an auditor will test.

5FAR Overhaul 31.205-41Under the FAR Overhaul, the same words sit at a new number

Since August 4, 2026, Class Deviation 2026-O0032, Revision 1 has told Department of War contracting officers to use the FAR Overhaul's revised Part 31 in place of the codified text. In that text, the reorganization tax the Board read at FAR 31.205-41(b)(2) sits at FAR Overhaul 31.205-41(c)(2), word for word, and the federal income tax and tax accrual paragraphs move with it. Neither the revised part nor the codified section carries the 1997 proposal.

Why it matters: the holding reads onto the new number. Our reading, not a statement by the FAR Council: Part 31 was rewritten without the rule the councils withdrew.

What to watch: which Part 31 your contracting officer applies. A response to a Department of War office cites FAR Overhaul 31.205-41(c)(2) and this decision together.

Documents and data used in this piece

Disclaimer. This piece is commentary on a published decision. It is not legal advice, and it is not a determination about any contractor, cost or contract. Confirm how the decision applies to you with counsel or a government contracts professional. The Board released the decision under a protective order: its dollar amounts are blacked out and four of its 18 pages carry no readable text, so this piece states no amounts. Read the Board's opinion and the class deviation in full.

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