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On May 4, 2016, the Ohio Supreme Court (Court) issued its unanimous decision in Corrigan v. Testa,¹ holding that the application of R.C. 5747.212 to a nonresident's capital gain from his sale of ownership interests in a limited liability company that was doing business in Ohio violated the Due Process Clause. In reaching this conclusion, the Court reversed a decision by the Ohio Board of Tax Appeals (Board) upholding the application of the statute and remanded the matter to the Ohio Tax Commissioner for a grant of refund to the taxpayer. The decision is significant in that it is one of very few state court decisions to address the state personal income tax treatment of gain on the sale of equity interests in a pass-through entity (e.g., partnership, LLC). The decision seems to uphold the view that pass-through entity equity interests should be treated as the sale of intangible property whose gain is generally sourced to and, in the case of a sale by an individual, is subject only to tax in the state of residence of the seller and not as gain from the sale of the underlying assets of the pass-through entity.

In 2000, Mr. Patton Corrigan (Corrigan) acquired a 79.29% interest in Mansfield Plumbing, LLC (the LLC), a multistate business that produced sanitary ware with a headquarters location in Ohio and plants in California and Texas. Corrigan was a member of the LLC's board of managers and visited its Ohio headquarters for board meetings and other matters. Corrigan's involvement was as an investor providing financing and strategic expertise with a view to growing the company for eventual sale to a third party. Corrigan's involvement amounted to about 100 hours per year; the day-to-day management of the LLC was conducted by the company's officers and managers.

In 2004, Corrigan sold his interests in the LLC to a third party and realized a capital gain of $27.5 million. When he filed his 2004 Ohio nonresident income tax return, he allocated the entire gain outside of Ohio since he was at that time domiciled in Connecticut. The Ohio Department of Taxation (Department) subsequently issued an assessment of tax and interest in the amount of $850,000). Corrigan paid $100,000 of the assessment and requested a refund, which the Department denied. Corrigan appealed the decision to the Board, which upheld the Department's decision, acknowledging that it had no authority to consider Corrigan's constitutional challenges to the statute. He subsequently appealed the Board's decision to the Court.

At issue is the application of R.C. 5747.212, which, as amended in 2002 and for the year at issue, provided:

A pass-through entity investor that owns, directly or indirectly, at least 20% of the pass-through entity at any time during the current [tax] year or either of the two preceding [tax] years shall apportion any income, including gain or loss, realized from the sale, exchange, or other disposition of a debt or equity interest in the entity as prescribed in this section. For such purposes, in lieu of using the method prescribed by sections 5747.20 and 5747.21 of the Revised Code, the investor shall apportion the income using the average of the pass-through entity's apportionment fractions otherwise applicable under section 5747.21 of the Revised Code for the current and two preceding [tax] years. If the pass-through entity was not in business for one or more of those years, each year that the entity was not in business shall be excluded in determining the average.

In effect, R.C. 5747.212 overrides the Ohio Revised Code's normal sourcing of a capital gain (i.e.,to a nonresident's state of domicile) and requires apportionment of the gain based on a three-year average of the investee entity's apportionment factors if the investor has owned a 20% or greater interest in the investee entity during the current and two preceding tax years.

The Court distinguished the two types of income received by Corrigan, that is, distributive share income and the capital gain on his sale of the equity interests in the LLC. Citing Shaffer v. Heitner² and Agley v. Tracy,³ the Court concluded that Ohio could tax Corrigan's distributive share of the LLC's income. The distributive share income was generated by Ohio business activity and Corrigan's decision to invest in the investee entity using corporate structures in Ohio and making federal pass-through entity elections satisfied the "purposeful availment" criterion of the tests applied under the Due Process Clause. The Court concluded that the activity being taxed was the "very income derived from business activity in Ohio." With regard to the capital gain on the sale of the equity interests in the LLC, the Court noted that it was generated by a transfer of intangible property (i.e., Corrigan's interests in the LLC) that was owned by a nonresident. Corrigan's sale of his interest in the investee entity "did not avail him of Ohio's protections and benefits in any way." Accordingly, the Court concluded that Agley did not extend to the capital gain income because Ohio's connection with the capital gain was indirect.

The Court analyzed precedents from the US Supreme Court (USSC) and other state courts that the Department argued in support of its position. The Court reviewed the application of Wisconsin v. J.C. Penney Co.,⁴ International Harvester Co. v. Wisconsin,⁵ and MeadWestvaco v. Illinois Dep't. of Rev.,⁶ and concluded that those cases did not speak to the imposition of an investee-apportioned tax on the gain realized by a nonresident investor. Since the foregoing was a question "unanswered" by the USSC, the Court could not conclude that they supported the application of R.C. 5747.212 to Corrigan's capital gain. Likewise, the Court reviewed Johnson v. Collector of Revenue,⁷ and Couchot v. State Lottery Comm'n.,⁸ and concluded that they did not support the application of R.C. 5747.212. The Court also discussed Allied-Signal, Inc. v. Comm'r. of Fin.,⁹ in which a state court upheld New York City's imposition of tax on a nonresident's parent corporation's capital gain from the sale of an interest in a subsidiary. The Court declined, however, to give that decision any weight in light of the absence of USSC authorities as previously discussed.

The Court then dismissed the Department's argument that it should be permissible to apportion the "economically equivalent situation" of a capital gain from the sale of ownership interests since it would have been permissible to apportion a capital gain from a sale of assets. In support of this argument, the Department relied on R.C. 5747.01(B), which includes in the definition of "business income" the gain or loss from a partial or complete liquidation of a business, including goodwill. The Court concluded that the distinction between two different methods of achieving the same economic result did not elevate form over substance because economic equivalence does not mean that jurisdictional limitations lack their own substantive importance. The Court then went on to note that such an argument can "cut both ways" (i.e., one could also argue that, if the sale of assets in liquidation of a business is in substance the same as the sale of stock in the corporation, "Ohio cannot constitutionally treat the gain from the asset sale as apportionable" income.)

Finally, the Court concluded that R.C. 5747.212 was not facially invalid under the Due Process Clause because Corrigan did not demonstrate that there were no circumstances under which the provisions would be valid. Thus, the Court did not strike down the statute as constitutionally invalid under the Due Process clause but only as it applied to Corrigan. Since the Court disposed of Corrigan's appeal on Due Process grounds as applied, it did not address his Commerce Clause claims.

Implications

The Court's decision seems to indicate that unitary principles should apply when determining whether to apportion income. Taxpayers who have applied R.C. 5747.212 in past years should consider their facts in light of filing amended returns and refund claims with Ohio. Ohio has a four-year statute of limitations, with extended 2011 returns still open until October 15, 2016. This also marks the second opinion in the past year when the Court has struck down under the Due Process clause a taxing statute (the other being the City of Cleveland's apportionment ordinance as applied to NFL football players in Hillenmeyer¹⁰). While the courts have frequently looked to the Commerce Clause to address state tax matters, the Court's willingness to address taxpayer Due Process claims is an interesting development to continue to follow.

This decision also calls into question whether other states may tax a nonresident on gain from the sale of an interest in a flow-through entity that owns underlying assets in the putative taxing state. Finally, the decision could open the door for courts to address the taxability of interests in flow-through entities in which state partnership or LLC law applies the entity, as opposed to the aggregate, theory of partnerships.

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ENDNOTES

¹ Corrigan v. Testa, Slip Opinion No. 2016-Ohio-2805 (2016).

² Shaffer v. Heitner, 433 U.S. 186 (1977).

³Agley v. Tracy, 87 Ohio St.3d 265. In Agley, the Court upheld the assessment of tax on a nonresident's distributive share income from S corporations doing business in Ohio. The Court concluded that the nonresident shareholders, through their S corporations, purposefully availed themselves of Ohio's benefits, protections and opportunities by receiving income from the S corporations.

⁴ Wisconsin v. J.C. Penney Co., 311 U.S. 435 (1940).

⁵ International Harvester Co. v. Wisconsin, 322 U.S. 435 (1944).

⁶ MeadWestvaco v. Illinois Dep't. of Rev., 553 U.S. 16 (2008).

⁷ Johnson v. Collector of Revenue, 246 La. 540 (1964) (nonresident taxed on capital gain when he or she received property with a Louisiana situs).

⁸ Couchot v. State Lottery Comm'n., 74 Ohio St.3d 417 (1996) (nonresident taxed on Ohio lottery winnings from ticket purchased in Ohio).

⁹ Allied-Signal, Inc. v. Comm'r. of Fin., 79 N.Y.2d 73 (1991).

¹⁰ Hillenmeyer v. Cleveland Bd. of Rev., 144 Ohio St.3d 165, 2015-Ohio-1623, 41 N.E.3d 1164 (2015).