The Ohio Department of Taxation (“ODT”) has revealed that ODT has been issuing refunds to nonresidents who sold a business interest and had originally reported the gain as business income taxable to Ohio. Speaking at last week’s virtual Ohio Business Tax Conference, ODT officials indicated that it would comply with the Ohio Supreme Court’s decision in Corrigan v. Testa, 149 Ohio St.3d 18, 2016-Ohio-2805, that nonresidents do not owe Ohio tax on capital gains obtained by the sale of business interests. Nonresidents that paid Ohio tax on the sale of a business interest should consider whether a refund opportunity may be available for prior years. Generally, the statute of limitations (“SOL”) for refunds has not yet expired on calendar years 2016 and later years, although the SOL may be open in earlier years if the taxpayer signed a waiver, is under audit, or has an active appeal pending.
Statute Violates Due Process for Nonresident Investor
In Corrigan v. Testa, the Ohio Supreme Court held “that R.C. 5747.212, as applied to Mr. Corrigan, violates the Due Process Clause of the Fourteenth Amendment to the United States Constitution.” Id. at ¶ 5. 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 interest Mr. 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 did 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 Mr. Corrigan was involved to some extent in the operation of the business, the Court suggests that his participation in the operation of the business was not sufficient to establish a unitary relationship.
Taxpayer’s Management of the Business Likely Important
The Ohio Supreme Court’s subsequent decision to allow the taxation of the gain on the sale of a business in T. Ryan Legg Irrevocable Trust v. Testa, 149 Ohio St.3d 376, 2016-Ohio-8418 (“T. Ryan Legg”), indicates that a taxpayer that was involved in the active management of a business may be considered unitary with the business such that the gain on the sale would be considered business income apportionable to Ohio. In comparing the facts to those in Corrigan, the Court noted that the grantor was a resident at the time he contributed the shares to the trust and that “Moreover, unlike Corrigan, Legg was a founder and manager of the business of the pass-through entity—a material distinction, see Corrigan at ¶ 68 (finding the tax unconstitutional as applied to Corrigan ‘in light of the absence of any assertion or finding that Corrigan’s own activities amounted to a unitary business with that of Mansfield Plumbing’).” Id. at ¶ 67 (Emphasis Added.) Thus, unlike the investor in Corrigan, the decision in T. Ryan Legg suggests (but does not directly conclude) that Ohio could tax an owner that was actively involved in the management of the business, if the transaction was the sale of the business ownership interest.
Refund Opportunities
It is not entirely clear how broadly the decision in Corrigan will be applied. Nonresidents who, like Mr. Corrigan, are investors and were not involved in the day-to-day dealings of the business should be eligible for refunds. The impact of the language in T. Ryan Legg is less clear. Nonresidents, who, like Mr. Legg, were involved in the day-to-day dealings of the business, may be deemed to have a unitary relationship that satisfies the Due Process Clause, allowing the gain on the sale of a business interest to be taxed in Ohio in a manner similar to apportionable business income. Because the answer is less clear if the taxpayer was involved in the day-to-day management of the business, a discussion on the best strategy to preserve the taxpayer’s rights to a refund should be completed.
There is an additional situation where nonresidents may be eligible for Ohio tax refunds: if the sale of a business interest was treated as an asset sale for federal income tax purposes. Some examples include the sale of a disregarded entity, a sale that includes an I.R.C. 338(h)(10) election, or a sale that includes an I.R.C. 754 election, which are considered to be the sale of business assets for federal income tax purposes, rather than the sale of a business interest. ODT has indicated that it will not treat these types of transactions as the sale of assets for purposes of the definition of “business income.” Instead, ODT is treating these transactions as the sale of a business interest. Of course, before filing refunds, taxpayers and their advisors should consider the factual situation and the taxpayer’s relationship with the business (i.e., investor versus actively involved in the business) as described above.
Future Sale Transactions & Planning: The Paradox of Domicile
When assisting with a future sale of a business interest, taxpayers and their advisors should fully analyze and consider nature of the transaction, the taxpayer’s relationship with the business, and the treatment of various transaction types under Ohio’s tax law. For instance, in light of ODT’s recent interpretations, resident taxpayers may want to consider whether changing their domicile to outside Ohio before selling their business would position them for greater Ohio tax savings.
Another problem is that a paradox of sorts can result when some sellers are residents, while others are nonresidents of Ohio. Careful planning and analysis must be performed so that all parties understand the potential for some forms of a sale to favor one seller over another.
Zaino Hall & Farrin LLC professionals have advised many business owners regarding R.C. 5747.212 and related planning. We would be happy to further discuss your particular facts and circumstances and how these latest developments may impact you or your clients.
If you would like to discuss any income tax refund opportunities, please contact Debora (Dardinger) McGraw or any other ZHF professional.