What is Material Participation?
Material Participation in Dispute for Business Income on Sale of a Business
As previously reported, Ohio Governor Mike DeWine signed Substitute House Bill 515 (“H.B. 515”) on June 24, 2022, providing a needed clarification of the definition of “business income” as applied to the sale of an equity or ownership interest in a business in Ohio’s personal income tax law. Cases recently appealed to the Ohio Board of Tax Appeals (the “Board”) consider the law change but a review of the law is helpful.
“Business Income” Definition
“Business income” is defined at Revised Code (“R.C.”) 5747.01(B) and serves several functions under Ohio income tax law. With its opposite, “nonbusiness income,” it is used to determine whether a certain source of income is apportionable among states or must be allocated to a specific state. Income that qualifies as business income is apportioned while nonbusiness income, “all income other than business income” per R.C. 5747.02(C), is allocated.
Clarification of the law became necessary when it became apparent that different readings of the “business income” definition were leading to disputes between the Ohio Department of Taxation (the “Department”) and many taxpayers whose income included a gain from the sale of a business. The debate over this issue was discussed in an earlier SALT Buzz, Unraveling the Ohio Taxation of a Sale of a Business Interest Under Current and Future Law. In short, the Department considered most gains from the sale of a business to be nonbusiness income, while many taxpayers and their advisors disagreed. From a practical perspective, the Department’s position resulted in a resident’s gain on the sale of an equity or ownership interest in a business not qualifying for the business income deduction or the lower tax rate on business income.
H.B. 515 added the wording, “or the sale of an equity or ownership interest in a business” to the definition of “Business income.” The definition of that phrase, also added by H.B. 515, made it clear that a qualifying equity sale also includes any sale in which the seller materially participated in the business during the taxable year that includes the sale or any of the five taxable years preceding the sale. The requirement of material participation, defined by reference to 26 C.F.R. 1.469-5T, for an equity sale limits the concept’s applicability to those business owners who were deeply involved with the business being sold, as opposed to those who were merely investors in the business. A mere investor’s gain on the sale of his or her interest in a business is nonbusiness income under H.B. 515’s clarification.
In May of 2023, two seemingly related taxpayers filed Notices of Appeal at the Board regarding the material participation standard set forth in H.B. 515. Dean T. And Carol J. Mueller v. Harris, No. 2023-685 and Scott C. Mueller v. Harris, No. 2023-686. The taxpayer in the first case, Dean Mueller, was the president of the tire company that was sold. The taxpayer in the second case, Scott Mueller was the Chief Executive Officer. The taxpayers submitted Schedule K-1 forms reflecting guaranteed payments, an excerpt from the company’s operating agreement and a “secretary’s certificate” listing their respective titles, and a log of badge swipes into the company’s office. The latter seemingly was intended to show hours worked, which is one of the facts considered in 26 C.F. R. 1.469-5T. The Final Determination issued by the Department argues that none of the information provided specified duties, hours, or any specific role at the company. It is unclear whether the badge swipes supported the taxpayer working greater than 500 hours for any of the years but the Department rejected the badge swipe logs as not being indicative of material participation.
In these cases, the Department hasn’t issued a specific list of information that would be sufficient to support material participation, stating that the information may vary by taxpayer. In general, the Department has required or requested more support in most cases. Based on discussions with Department personnel, the Department has indicated that a letter or summary outlining the taxpayer’s facts and how they are applied under the law would be helpful. While it is often difficult to evaluate a case based on the public information available (e.g., the Notice of Appeal and Final Determination), it does appear that the taxpayers materially participated. We theorize that additional supporting information could have been provided (and may still be provided even in settlement) supporting their role and/or hours worked. These two cases underscore the importance of trying to take full advantage of all administrative hearings and working through supporting information with the Department at the appeals division, the level below the Board, as well as providing multiple documents in support of material participation under 26 C.F.R. 1.469-5T.
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