Business Income Definition Provides Planning Opportunities
Editors note: Portions of this Buzz relating to the exclusion to eligible business income pertaining to legal and lobbying services have been superseded. For more information please see The Ohio Legislature Repeals the Exclusion of Ohio Law and Lobbying Businesses from Ohio Business Income Deduction
Ohio personal income is taxed at the state level at the highest marginal rate of 4.797% in 2019. To the extent the income meets the definition of "business income," the income qualifies for the business income deduction ("BID") of $125,000 individually ($250,000 for married filing jointly) and the remaining business income above those levels is taxed at a reduced rate of 3% (a 1.797% reduction from the highest marginal rate of 4.797%). Thus, the ability to characterize income as "business income" can provide a significant reduction in the income tax liability of an individual.
We have previously written about planning opportunities available to owners of businesses that may divest their ownership interest. See: Corrigan Decision Suggests Sale of an Ohio Business May Have Tax Pitfalls and Should Business Owners Be Penalized for Staying Ohio Residents? A Review of Ohio Law. This SALT Buzz discusses some of the planning opportunities that exist with respect to ongoing operations.
The Definition of Business and Nonbusiness Income in Ohio
The term "business income" is used nationally in many state's statutes to describe the type of income that can be taxed across multiple states, often referred to as apportionable income. The definition that applies for purposes of the Ohio personal income tax is as follows:
(B) "Business income" means income, including gain or loss, arising from transactions, activities, and sources in the regular course of a trade or business and includes income, gain, or loss from real property, tangible property, and intangible property if the acquisition, rental, management, and disposition of the property constitute integral parts of the regular course of a trade or business operation. "Business income" includes income, including gain or loss, from a partial or complete liquidation of a business, including, but not limited to, gain or loss from the sale or other disposition of goodwill. R.C. 5747.01(B).
Alternatively, income that does not meet the definition of "business income" is considered "nonbusiness income," which is allocated to and taxed in one state. " 'Nonbusiness income' means all income other than business income and may include, but is not limited to, compensation, rents and royalties from real or tangible personal property, capital gains, interest, dividends and distributions, patent or copyright royalties, or lottery winnings, prizes, and awards." R.C. 5747.01(C).
Outside of the treatment of the sale of a business, there is little judicial authority in Ohio interpreting the definition of "business income." As a general rule, most of the income of a business is considered "business income." Historically, the Ohio Department of Taxation ("ODT") has taken a broad view of the definition of "business income."
Ohio Business Income Definition and the Lower Rate Generally
In 2013, the Ohio legislature first enacted the small business income tax deduction ("SBID"). The amount of the deduction was increased over several years and the deduction was renamed the BID. In 2015, the Ohio legislature also enacted a lower tax rate of 3% (versus 4.995% at the time) on business income above the BID of $125,000 individually ($250,000 for married filing jointly). The Ohio legislature's continued goal was to stimulate business and investment in Ohio. The BID and lower tax rate on business income also help create a more level playing field between C corporations, which pay the Commercial Activity Tax ("CAT") but are not subject to an income tax, and pass-through entities and sole proprietors, which pay both the CAT and the personal income tax.
In general, taxpayers want Ohio-sourced income to be considered "business Income" and, therefore, eligible for the BID and the lower flat rate. Schedule C (sole proprietorships), Schedule E (rental income), and distributive shares of income on a Schedule K-1 from an entity treated as a partnership for federal income tax purposes is generally treated as "business income."
Income such as interest, dividends, and capital gains are typically considered nonbusiness income as described in R.C. 5747.01(C), unless it is part of an ongoing business. While not required, ODT typically treats distributive share income on a Schedule K-1 as business income. Thus, where the assets generating interest, dividends, and capital gains are located in a pass-through entity operating a business and the income is included as distributive share on a Schedule K-1, ODT typically treats such amounts as business income eligible for the BID and lower rate. The assets could be owned directly by the individual and the income still considered business income but from a practical perspective, ODT is more likely to initially deny the BID and the taxpayer will likely be required to provide evidence that the assets and income are business income.
An example would be where an individual that has a sale of a business and uses the proceeds to create a significant portfolio of investment assets from which the individual plans to fund additional businesses and uses the funds in new and existing businesses. The individual would have a good argument that any income that is generated is business income but the return will likely be flagged in the ODT computer system. Thus, an Ohio resident may find it advantageous to have a portfolio used to fund existing and future businesses housed within a pass-through entity.
Planning for a non-Ohio resident is a little more complicated. Assuming the resident is in a low or no tax resident state, a non-Ohio resident usually wants non-Ohio based income to be considered non-business income allocable outside of Ohio. Thus, a non-Ohio resident may want to own the investment portfolio directly and keep the assets unrelated to his businesses so that the income is treated as non-business income allocable outside of Ohio.
Definitional Changes for 2020 and Later Years
Effective for tax year 2020, the BID and lower rate only applies to “eligible business income.” “Eligible business income” is defined to mean business income excluding income from a trade or business that performs either or both of the following:
(a) Legal services provided by an active attorney admitted to the practice of law in this state or by an attorney registered for corporate counsel status under section 6 of rule VI of the Ohio supreme court rules for the government of the bar of Ohio;
(b) Executive agency lobbying activity, retirement system lobbying activity, or actively advocating by a person required to register with the joint legislative ethics committee under section 101.78, 101.92, or 121.62 of the Revised Code.
Nothing in the statutory language requires that the primary activity of the trade or business be the provision of legal or lobbying services, or that it derives income from such activity. While it is our understanding that the limitation was intended to only impact law firms and lobbying firms, the language could be read to eliminate the BID for any businesses that have in-house legal counsel or uses a lobbyist, including manufacturers, retailers, accountants, and other service providers. Thus, most closely-held businesses (i.e., those that do not operate as a C corporation) should consider the impact of the legislative change. ODT has not yet provided guidance on how the legislative changes will be applied.
On October 10, 2019, the Ohio House Finance Committee passed an amendment to House Bill 26 that would effectively repeal the changes applicable in 2020 (i.e., allow the BID and lower tax rate to Ohio licensed attorney services and Ohio registered lobbying services). If the Ohio House and Senate approve House Bill 26 and the governor signs the bill into law with the amendment intact, the following section will be inapplicable.
Non-Legal Services Example
Since the Ohio-licensed attorney services and Ohio lobbying services are "tainted" services and statutorily ineligible for the BID and the lower rate, various planning opportunities may be helpful and should be considered. If it fits within the business context, it may be helpful to isolate the "tainted" services from goods and services that are eligible for the BID and the lower rate. For example, businesses that have a combination of Ohio-licensed attorney legal services and non-legal services may consider separating out the non-legal services into a different, separately owned legal entity. To the extent expenses can be justifiably applied to the "tainted" services, that would help reduce the income that is subject to the higher rate and does not qualify for the BID. The BID and the lower rate would be applied to the income from the non-legal services. The Ohio-licensed legal and lobbying services would not "taint" the other qualifying services.
Non-Ohio Registered Legislative Services Example
Another potential planning opportunity would be separating the Ohio-registered services that do not qualify for the BID and the lower rate from the non-Ohio registered services. For example, a lobbying firm may provide non-Ohio legislative services, such as legislative efforts at the national level, lobbying services outside of Ohio, or services in Ohio that do not require a registration or reporting with the Ohio legislative ethics committee. Assuming it makes sense within the business context, the Ohio registered lobbying services could be segregated and performed by a separate legal entity. The non-Ohio registered services would be eligible for the BID and lower tax rate in Ohio.
Non-Ohio Licensed Legal Services Example
Similarly, a national law firm that provides Ohio-licensed attorney legal services and legal services licensed by other states may consider segregating the legal services licensed by other states to allow the income to be eligible for the BID and the lower tax rate in Ohio. Depending on the firm's profile, it may be able to structure to avoid the personal income tax altogether on the non-Ohio licensed attorney legal services. Another option for consideration is whether certain services really require an Ohio-licensed attorney or whether the services could be provided by a non-Ohio licensed attorney, thereby qualifying for the BID and the lower tax rate. Interestingly, the new law does not treat legal services provided in Ohio by a non-Ohio licensed attorney that has filed a motion for pro hac vice as "tainted" services, ineligible for the BID or the lower tax rate. A motion for pro hac vice allows a non-Ohio licensed attorney to practice law in Ohio in a specific case.
Ohio Registered Corporate Counsel Example
A strange aspect of the new law is that legal services by an Ohio registered corporate counsel appear to be "tainted" services. The new law does not explain how to measure these legal services since a corporate counsel would not typically have income included in its employer's taxable income. Thus, it is unclear whether the law intends to treat the amount the employer deducted as the corporate counsel's wages as not qualifying because the statute does not contain such language or use some other income in the employer's income. Wages were never eligible for the BID or the lower rate so the corporate counsel's personal income tax should not be impacted by the new law. One reading of the statutory language would be that all the income of a business with an Ohio registered corporate counsel is not eligible for the BID or the lower rate, which would cover a lot of Ohio based closely-held businesses. Another alternative reading would be that this portion of the statute does not apply to most businesses with an Ohio registered corporate counsel because there is no income from such legal services in the employer's income. Absent any clarifying guidance, closely-held companies should consider separating their Ohio registered corporate counsel into a separate legal entity similar to the other examples described above.
Planning Considerations Generally
Absent a legislative change or a narrow interpretation of the new law, a whole host of other planning opportunities may be available. For example, does it make sense for the legal entity with the Ohio-licensed or registered "tainted" services to be a C corporation that is not subject to the personal income tax? Traditionally, closely-held businesses avoided the double taxation issue associated with C corporations but the lowering of the federal corporate rate and the additional Ohio personal income tax applied to pass-through entities (but not C corporations) may be a sufficient economic driver to change the paradigm, particularly in businesses that issue very little dividends.
There are various business and tax implications that should be considered, many of which will vary depending on the business, and businesses should carefully review the business and the law before implementing any planning. For example, it is important that any restructuring or planning be consistent with the business objectives. There are also many practical considerations. For example, if the Ohio and non-Ohio operations utilize shared operating, administrative, and/or management functions, it may be important for performance and bonus purposes how those costs are recorded. However, payments between pass-through entities may be subject to addbacks in Ohio and other states. Likewise, it is important to consider federal income and estate taxes, FICA and Medicaid taxes, the impact on unemployment tax and other Ohio taxes, Ohio municipal income tax, and non-Ohio taxes.