There is an ongoing debate in Ohio regarding whether the sale of a business interest, such as a stock sale or sale of a partnership or membership interest, generates business income or nonbusiness income for purposes of determining the tax due on an individual owner. The question becomes more complex depending on a whole host of factors, including whether the person is a resident or nonresident, the individual’s relationship with the entity, whether the transaction was treated as an asset sale for federal income tax purposes, and whether the sale was by a legal entity other than an individual. Finally, the area is further complicated based on differences in the law depending on the calendar year in which the sale occurred/occurs. Specifically, several provisions in Am. Sub. H.B. 110 (the “Budget Bill” or “Bill”), the state’s two-year operating budget, signed by Governor DeWine on July 1, 2021, provide additional considerations for those planning for the sale of a business interest in calendar year 2026 and later years. This SALT Buzz focuses on the Ohio individual income tax considerations of the sale of a business interest with a specific focus on the differences depending on the calendar year of the sale and the new law.
Sales of Business Interest Before Calendar Year 2026
A. Past Sales of Business Interests by a Resident
This firm has drafted several SALT buzzes describing the ongoing debate in Ohio on whether the sale of a business interest is business income.[1] For an individual that is an Ohio resident at the time of sale, the taxpayer generally wants the gain to be considered business income in Ohio because a resident is taxed at 100% of his/her income and, if the gain is business income, it will be eligible for the business income deduction (“BID”) and the lower tax rate on business income, which has historically been an approximately 1.8% difference. A nonresident typically wants the gain to be considered nonbusiness income in Ohio because nonresidents would not be subject to Ohio tax on the sale.
Because of this dichotomy, the recent audit activity and litigation has been focused on residents and whether the gain on the sale is subject to a significantly higher amount of tax. We previously described the Ohio Department of Taxation’s (“ODT’s) audit program and the identification and audit of 200+ individual taxpayers that sold business interests.[2] That debate is ongoing. As described above, there are variations depending on the individual’s relationship with the entity, whether the transaction was treated as an asset sale for federal income tax purposes, and whether a legal entity sold the interest rather than an individual. Only in a few rare fact patterns has ODT been willing to drop the audit and/or assessment. There are opportunities for taxpayers to settle or continue their appeals until the issue is resolved legislatively or through litigation. Both the legislative and litigation efforts are ongoing, and the final resolution may vary depending on the fact pattern.
In terms of litigation, on October 28th, 2021 a hearing was held at the Ohio Board of Tax Appeals (“Board”) in Linehan v. McClain, Ohio Board of Tax Appeals No. 2020-430. The Board is a tribunal that is the first level of appeal after the exhaustion of any appeals at ODT of an issuance of an assessment or denial of a refund by ODT. The Board cannot decide constitutional issues. Any decision by the Board in Tax Commissioner cases, such as individual income tax matters, are appealable by either party to the Ohio Supreme Court or to a local Court of Appeals.
The Linehan case is the first matter at the Board involving an Ohio resident that sold a business interest that considers whether the gain is business income or nonbusiness income. The parties need to brief the case and then the Board will render a decision. Thus, it will likely take a year or more before a decision is issued by the Board. Because of the broad importance of the issue, the Board’s decision will likely be appealed to the Ohio Supreme Court, which could take another few years. There is at least one other case on the business income topic pending at the Board and many others still at ODT audit and appeals division levels. There are also some variations on the issue, including legal sales treated as asset sales for federal income tax purposes and situations where a legal entity (versus the ultimate individual owner) sold the business interest at issue, that may require litigation of additional fact patterns.
B. Future Sales of Business Interests By a Resident in Calendar Year 2021 to 2025
There was a legislative effort during the Budget Bill to clarify the law and resolve the current controversy so that residents were entitled to the BID and lower tax rate on business income on certain sales of business interests, including on prior sales transactions. The General Assembly ultimately enacted provisions that will likely reduce or eliminate the tax burden on some sales of business interests starting in calendar year 2026, which are discussed below.
The General Assembly also changed the tax brackets, reducing the highest marginal tax rate from 4.797% to 3.99% effective for all of calendar year 2021 and later years. The maximum rate a resident would be taxed on a nonbusiness capital gain starting in calendar year 2021 is now reduced by approximately 1%. The issue remains whether the gain on the sale of a business interest is eligible for the BID and the lower tax rate on business income. However, due to the reduction in the maximum rate, the difference in the tax rate applied to business and non-business income drops to an approximately 1% difference (3.99% maximum rate on nonbusiness income versus the 3% tax rate on business income).
While the legislative efforts are still ongoing in the form of stand-alone legislation, the purported cost of clarifying language may be an obstacle to passage. It is important that the General Assembly continue to hear from constituents on this matter, particularly when a seller is contemplating becoming a nonresident, since such a move may result in the seller investing the proceeds in a non-Ohio business versus staying in Ohio and continuing to invest in Ohio businesses.
Residents that are contemplating a sale before calendar year 2026 have a few options. One option is to structure the sale such that all or some of the sale is a legal sale of assets, which ODT agrees qualifies as business income. If the sale of a business interest is necessary and the seller has to remain an Ohio resident, the seller should explore various planning options and the impact of the ongoing litigation. If the timing works, a seller may try to take advantage of the change in law effective in calendar year 2026 and later years and try to either push the sale date to those years or potentially structure the sale to be recognized for federal and Ohio income tax purposes in those later years. It should be noted that at least one of the newly-enacted provisions would require that the entity take action now to secure tax benefits in the future. It may also make sense to negotiate the additional cost in the price of the deal. All these options are very complicated and there are important legal and federal income tax implications that should also be evaluated as part of the process.
Another option is to become a nonresident before the sale. A change in residency has recently been simplified by changes to Ohio’s bright-line residency law, but advanced planning is prudent and should not be contemplated lightly. Further, it is important that sellers of businesses understand the potential risks that ODT may take a different position in some factual situations or may change its position in later years. It is also important to talk through the tax return filings and the positions to be claimed on the return and whether there are options to minimize risk.
Sales of Business Interests in Calendar Year 2026 and Later Years
As described above, the Budget Bill reduced the highest marginal tax rate potentially applied to the sale of a business interest in calendar year 2021 and later years. The Budget Bill also provided two important exclusions for the sale of a business, but it is important to remember that those two provisions only apply in calendar year 2026 and later years. It is also important to remember that a future General Assembly or administration could seek to repeal those provisions before they become effective.
A. Venture Capital Gain Deduction
In an effort to incentivize Ohio business investment, the Budget Bill adopted a new venture capital gains deduction.[3] This new deduction would not be available until taxable years beginning in or after 2026 and would only apply to gain recognized on the sale of a business interest (not a sale of assets).
To qualify for this deduction a taxpayer must invest in an “Ohio venture capital operating company” (“OVCOC”). The deduction equals one hundred percent of the capital gain received by the taxpayer in the taxable year from the Ohio venture capital operating company attributable to the company’s investments in Ohio businesses during the period for which the company was an Ohio venture capital operating company plus fifty percent of the company’s investments in all other businesses during the same period.
While “venture capital operating company” is defined by reference to federal tax regulations that established venture capital entities, the attainment of the “Ohio” prefix requires certification by the Director of Development that the company has met various requirements, including the management or capital commitments of at least $50 million in active assets and the Ohio residency of at least two-thirds of its managing and general partners. The venture capital operating company will have to apply to the Director of Development for certified OVCOC status and must report to the Director of Development each year it seeks to maintain that status.
To be considered an “Ohio business,” the business must be headquartered in Ohio and must employ more than half its full-time workforce in the state, measured on an annual basis.
The new deduction will require annual reporting by the OVCOC on forms to be submitted to both the Director of Development and the Ohio Tax Commissioner. The reporting will allow the Director and Tax Commissioner to determine the portion of the year that the OVCOC qualified as such, as well as the investments that qualify as Ohio companies, and the name, social security number or FEIN, and ownership percentage of each person with a qualifying interest in the company. As a result of this reporting, the Director of Development will be able to issue a certificate qualifying the company as an OVCOC for the year or a portion thereof, stating what portion of the OVCOC’s investments were in Ohio companies, and providing what percentage of gains or of distributed equity interests or securities is attributable to each qualified investor in the OVCOC. Distributed interests would qualify for the deduction once sold by the distributee and income is recognized from their disposition. A copy of this certificate would be given by the OVCOC to each qualified investor, along with any other documentation needed to compute the venture capital gains deduction. In a manner more commonly associated with tax credits, the certificate would be necessary to claim the new deduction.
The venture capital gain deduction only applies to the sale of a business interest, such as the sale of a partnership interest, S or C corporation stock, or a membership interest in a limited liability company (“LLC”). The provisions do not appear to apply to transactions treated as asset sales for legal purposes and potentially do not apply to transactions treated as asset sales for federal income tax purposes (e.g., sale of a disregarded entity, an IRC 338(h)(10) election, etc.). The difference in Ohio tax could be whether the highest tax rate of 3.99% applies or whether no Ohio tax applies to the sale of a business. Thus, if the venture capital deduction applies to a transaction, it may provide a significant Ohio tax benefit.
As described above, however, the deduction may not apply to a lot of sales transactions. There are a number of requirements that must be met for the taxpayer to avail itself of this deduction, including the taxpayer has to obtain certification, the business has to be headquartered in Ohio, the business must have $50 million in active assets (which is a significant threshold), the business must maintain significant Ohio payroll numbers, etc. These requirements will likely limit the qualifying transactions to a very small group of sales transactions.
Likewise, even where the venture capital gain deduction applies to a transaction, the provisions may not apply to the portion of the gain on the sale of a business interest that is recharacterized as ordinary income due to the federal hot asset and depreciation recapture rules, which in some factual situations can be a significant portion of the gain. Thus, sellers attempting to take advantage of the venture capital gain deduction should carefully evaluate their facts and compliance on an ongoing basis and particularly in structuring the sales transaction.
B. Qualifying Capital Gain Deduction
Another new deduction was added for capital gains from the sale of a business interest that may be more broadly available because it does not require prior certification of the business. The deduction equals the lower of the “qualifying capital gain” or “deductible payroll.”[4] Similar to the above Venture Capital Gain Deduction, this new deduction would not be available until taxable years beginning in or after 2026.
Qualifying capital gain means a capital gain resulting from the sale of an interest in an entity reported for the taxable year as reported for federal income tax purposes, to the extent not otherwise deducted or excluded in computing federal or Ohio adjusted gross income (“AGI”), provided that all three of the following conditions are met:
(a) The selling taxpayer either:
1. materially participated (as defined in federal regulations 26 CFR 1.469-5T (a)(1), (2), (3), (4) or (7) in the sold entity for the five years immediately preceding the time of sale; or
2. directly or indirectly invested at least $1 million in the entity;
(b) The entity is incorporated, registered, or organized in Ohio during the five years immediately preceding the sale; and
(c) The entity is headquartered in Ohio during the five years immediately preceding the sale.
Deductible payroll is the amount of compensation used to determine the entity’s withholding tax obligations (“qualifying payroll”), multiplied by the percentage of the interest in the entity the taxpayer sold. The period specified for the calculation of the qualifying payroll differs depending on whether the selling taxpayer was a material participant or an investor as defined in (a) above. For the seller who materially participated in the entity, “deductible payroll” is the payroll for the five calendar years immediately preceding the time of sale (i.e., the same period during which the seller is required to have materially participated). For the seller who made an investment of $1 million or greater in the entity, the period is the investment period. This period may be shorter than the five years immediately preceding the sale but may not be longer. Another limitation placed on qualifying payroll is that it does not include amounts paid to the taxpayer or the taxpayer’s spouse, parents, grandparents, children, or grandchildren.
If a taxpayer has multiple capital gains from the sale of interests in different entities during the taxable year, each capital gain must meet the requirements to be classified as a “qualifying capital gain” as discussed above. The lesser of the qualified capital gain or deductible payroll is determined on an entity-by-entity basis. The deduction amounts related to each entity would then be aggregated to determine the total deduction allowed.
By limiting the deduction to the lesser of the qualifying capital gain or deductible payroll, the provision is intended to keep the tax benefit from becoming out of proportion to the number of jobs created by the business. Lower payroll would amount to a smaller credit unless the gain amount is already smaller than the deductible payroll.
The qualifying capital gain deduction may apply to more transactions than the venture capital gain deduction because it does not require certification in earlier years. However, the payroll limitation and the $1 million investment will likely limit its application. Like the venture capital gain deduction, the qualifying capital gain deduction also only applies to the sale of a business interest (not the legal sale of assets) and may not apply to any portion of the gain that is recharacterized as ordinary income for federal income tax purposes. Thus, sellers attempting to take advantage of the venture capital gain deduction should carefully evaluate their facts and compliance on an ongoing basis and particularly in structuring the sales transaction.
C. Gain Recognized Outside the Deductions
As outlined above, a lot of sales transactions in 2026 and later calendar years may not qualify for either deduction. Further, the facts may be such that all or some of the gain is not offset by the deduction either due to statutory limitations, the federal character of the income, etc. In these situations, it makes sense to evaluate other options such as structuring the sale as a sale of assets or restructuring to maximize the use of the deduction.
Another option is to consider becoming a resident of a no-tax state before the sale. A change in residency has recently been simplified by changes to Ohio’s bright-line residency law, but advanced planning is prudent and should not be contemplated lightly. Further, it is important that sellers of businesses understand the potential risks that ODT may take a different position in some factual situations or may change its position in later years.
Conclusion
Like a ball of yarn, the taxation of the sale of a business has become incredibly complex in Ohio. It is important that potential sellers work with their tax advisors to thoroughly understand the ramifications of a sale and the statutory or planning options available.
If you would like to discuss this area, please contact Debora (Dardinger) McGraw or any other ZHF professional.
[1] Corrigan Decision Suggests Sale of an Ohio Business May Have Tax Pitfalls, February 5, 2017;
Business Income Definition Provides Planning Opportunities, October 10, 2019; ODT May Issue Refunds to Nonresidents Who Sold a Business Interest and Paid Ohio Tax on the Gain, February 10, 2021.
[2] Ohio Department of Taxation Program Seeks Information on Schedule D Gains Listed as Business Income, February 13, 2020.
[3] The definitions for this deduction are primarily contained in new R.C. 122.851. See also new R.C. 5747.01(A)(35).
[4] See new R.C. 5747.79 which describes the credit. See also R.C. 5747.01(A)(34).