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Subsequent to the Ohio Supreme Court’s (“Court”) decision striking down the Tax Commissioner’s attempt to tax a portion of a nonresident’s gain on the sale of a closely-held Ohio business pursuant to R.C. 5747.212, the Ohio Department of Taxation (“ODT”) issued Information Release 2016-01 (“Release 2016-01"), which raises some planning considerations and potential tax pitfalls for a resident or nonresident’s sale of a business.
In 2002, the Ohio General Assembly enacted R.C. 5747.212, which requires that certain nonresidents apportion to Ohio gains or losses from the sale of debt or equity interests in certain closely-held Ohio businesses. R.C. 5747.212 applies to a twenty percent or greater owner in a pass-through entity; the owner of a qualifying person, defined as any entity other than an individual, an estate, or trust, with five or fewer investors with voting rights; or the owner of a fifty percent or greater interest in a qualifying person. A person can meet the ownership test anytime within the three years prior to the sale of the business. The statute requires that any gain or loss on the sale of the entity be apportioned as business income based on the apportionment factor of the entity for the current and two prior taxable years.
In Corrigan v. Testa, Slip Opinion 2016-OHIO-2805 (May 4, 2016), the Court held that R.C. 5747.212 was unconstitutional as applied to the taxpayer. Mr. Corrigan, a Connecticut resident, owned approximately seventy-nine percent of the equity interests of an Ohio limited liability company (“LLC”). He had traveled to Ohio for board of director meetings and management presentations and had some limited involvement in the business. Mr. Corrigan sold the membership units of the LLC and realized a capital gain. The Tax Commissioner assessed income tax on a portion of the gain. Mr. Corrigan paid the assessed tax and filed a refund claim asserting that applying R.C. 5747.212 to him was unconstitutional and that he should be permitted to allocate the gain entirely outside Ohio (paying no tax to Ohio on the gain).
The Court does not explicitly address whether Mr. Corrigan’s sale of the business was “business” income or “nonbusiness” income. However, the Court held that his gain from the sale of the business was allocable to Mr. Corrigan’s commercial domicile outside of Ohio, which is consistent with the treatment of income characterized as nonbusiness income pursuant to R.C. 5747.20(B)(2)(c). Id. at ¶3.
The Ohio Supreme Court held “that R.C. 5747.212, as applied to Corrigan, violates the Due Process Clause of the Fourteenth Amendment to the United States Constitution.” Id. at ¶ 5 (Emphasis added). The Court focused on the fundamental requirement of the Due Process Clause that there be a link “between the state and the person being taxed as well as between the state and the activity being taxed.” Id. at ¶ 32. Although the LLC whose interests Corrigan sold had availed itself of Ohio’s protections, Mr. Corrigan (as an individual owner of the LLC) did not. The Court stated, at ¶ 36, “In this case, the activity at issue is a transfer of intangible property by a nonresident. Thus, Ohio’s connection is an indirect one, whereas in Agley the activity being taxed was the very income derived from business activity in Ohio. Moreover, although Corrigan’s availment of Ohio’s protections and benefits is clear with respect to the pass-through of [the LLC’s] income to him, Corrigan’s sale of his interest in [the LLC] did not avail him of Ohio’s protections and benefits in any direct way.” Therefore, the Court held that Mr. Corrigan did not owe Ohio tax on the capital gain at issue and was entitled to a refund of the tax he paid.
The Court does state, however, at ¶ 69, “Conceivably, an individual taxpayer might engage in the conduct of a business with or through a corporate entity, and under the MeadWestvaco and Allied-Signal line of cases, the imposition of tax under R.C 5747.212 could be sustained. We therefore decline to hold that R.C. 5747.212 is facially unconstitutional because Corrigan has not demonstrated, as he must, that ‘there exists no circumstances under which the statute would be valid.’ Harrold v. Collier, 107 Ohio St. 3d 44, 2005-Ohio-5334, 836 N.E.2d 1165, ¶ 37. Because there is at least a possibility that the statute could be applied when the unitary-business situation is present, we reject the facial challenge.” Thus, the Court suggests that there may be a factual situation where R.C. 5747.212 would satisfy the Due Process Clause because of the individual’s business relationship with the entity. Although Corrigan was involved to some extent in the operation of the business, the Court did not deem his participation in the operation of the business sufficient to establish a unitary relationship.
Following the decision in Corrigan, ODT issued Release 2016-01. In Release 2016-01, ODT observes that: the decision only applies to R.C. 5747.212, R.C. 5747.212 was unconstitutional as applied to that taxpayer (perhaps not to all others), and the Court found that an ownership interest in a business is an “intangible asset,” which is sitused to the taxpayer’s commercial domicile. The first two observations suggest that ODT takes a narrow view of the Corrigan decision and may still assert that R.C. 5747.212 applies to certain nonresidents on the sale of a business. Release 2016-01 does not describe the situations where it may apply R.C. 5747.212. Release 2016-01 also provides guidance on requesting a refund pursuant to the decision or supplementing an existing appeal for taxpayers challenging the application of R.C. 5747.212.
The most interesting portion of Release 2016-01 is in the last paragraph: “Additionally, to the extent an individual taxpayer recognizes a capital gain relating to the disposition of an interest in a business entity to which R.C. 5747.212 does not apply, that gain is nonbusiness income. Such a gain is allocable to the taxpayer’s state of domicile under R.C. 5747.20(B)(2)(c).” The paragraph then notes that the Ohio Small Business Deduction (“SBD”) and the Ohio Business Income Deduction (“BID”) cannot be applied to gain on the sale of a business, which is considered nonbusiness income. Release 2016-01 does not describe the factual situations when R.C. 5747.212 does not apply. However, R.C. 5747.212 expressly does not apply to residents of Ohio and owners that have less than the minimum ownership interest. Corrigan holds that R.C. 5747.212 does not apply to nonresidents that have the same facts as the taxpayer in Corrigan. Since a nonresident’s domicile would be outside of Ohio, a nonresident with facts similar to those in Corrigan will not be subject to Ohio tax on the gain on the sale of a business. An Ohio resident would, however, be subject to Ohio tax on the entire gain. Release 2016-01 suggests that a resident could not claim the SBD or the BID against the gain on the sale of a business.
On December 28, 2016, the Court issued its decision in T. Ryan Legg Irrevocable Trust v. Testa, Slip Opinion 2016-OHIO-8418, in which it held that a nonresident trust’s sale of a business was properly subject to Ohio tax. Although the Court determined that the trust was a nonresident trust, the Court determined that imposing the Ohio income tax on the trust did not violate the Due Process Clause. The Court distinguished Corrigan, which was relied upon by the trust, based on the fact that the grantor of the trust was a resident of Ohio when the trust was created and was also the founder and manager of the business. Id. at ¶ 67. The Court held that the resident grantor’s “contacts with Ohio and with the business easily justify the imposition of the tax on the trust from the standpoint of due process.” Id. at ¶ 69. The taxpayer has filed a motion for reconsideration of the Court’s decision.
Taken together, the decision in Corrigan and Release 2016-01 provide a framework for tax planning for the sale of a business. Based on the decision in Corrigan, a nonresident is not subject to Ohio tax on the sale of a closely-held business if his/her facts are similar to those in the case. Release 2016-01 suggests that an Ohio resident would be subject to Ohio tax on the entire gain and would not be entitled to the SBD or BID. Although not mentioned in Release 2016-01, an Ohio resident’s gain on the sale of a business would also probably not be eligible for the lower tax rate on business income. Thus, an Ohio resident who sells a closely-held business will pay Ohio tax on the entire gain from the sale at the resident’s marginal rate, while a nonresident owner of the same business would pay no Ohio tax on the gain.
An Ohio resident may consider various planning alternatives to reduce his or her Ohio tax on the sale of a closely-held business. The owner could structure the sale as a sale of assets, which generates business income, and take advantage of the BID and the lower tax rate on business income. Alternatively, based on language in Corrigan and T. Ryan Legg, the gain from the sale of the ownership interest of the business may be treated as business income if the owner of the business actively participated in the operation of the business. Under those facts, the resident owner could also take advantage of the BID and the lower tax rate on business income. If the owner is an Ohio resident, and is not actively engaged in the operation of the business, he or she could consider changing his or her domicile to a lower or no income tax state prior to selling the business.
A nonresident may also have some planning opportunities. For example, a nonresident may consider an asset sale if he/she anticipates a loss on the sale of a business and the nonresident has other income subject to tax in Ohio.
Taxpayers and practitioners should carefully review their facts and the law to determine whether their facts are consistent with Corrigan or whether the gain or loss may be considered business income. They should also consider whether an alternative structure would result in significantly less Ohio tax.
If you have you have any questions about this information release, please contact Debora (Dardinger) McGraw or any other ZHF professional.