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July 23, 2024
2024-1424

Taxpayers appeal Ohio Department of Taxation decision that capital gains are apportionable business income

A California couple has appealed an Ohio Department of Taxation (Department) denial1 of their refund claim for income tax paid on capital gains from the sale of 25% of their interest in a company that conducts business in Ohio.

Background

The taxpayers, California residents who filed their joint Ohio 2018 nonresident income tax return reporting apportioned capital gains from the sale of 25% of their interest in a skincare product company, filed a refund claim asserting the gain was allocable nonbusiness income. The Department granted a refund on the rate differential after determining the gain qualified for Ohio's business income deduction and the corresponding 3% flat rate on business income,2 but denied a full refund after concluding the gain was subject to apportionment under Ohio Rev. Code 5747.212.

The Department's determination effectively overrode the Ohio Revised Code's normal sourcing of capital gains (i.e., to a nonresident's state of domicile) and required apportionment of the gain based on a three-year average of the investee entity's apportionment factors if the investor owned a 20%-or-greater interest in the entity during the current and two preceding tax years. The taxpayers appealed the denial of their refund claim to the Department's Office of Appeals.

Gain is apportionable business income

On appeal, the taxpayers argued Ohio Rev. Code 5747.212 is unconstitutional as applied to them, citing the Ohio Supreme Court's (court) decision in Corrigan v. Testa, 149 Ohio St.3d 18 (Ohio 2016).3 The Department noted, however, that the court held the statute was unconstitutional as applied to the taxpayer in Corrigan but not on its face. The Department noted it does not have jurisdiction to determine a statute's constitutionality and presumed Ohio Rev. Code 5747.212 is constitutional before distinguishing the taxpayer's facts from those reviewed in Corrigan.4 In Corrigan, the taxpayer was an investor who was not involved in the active company management. In this case, both taxpayers were members of the board, and one of them founded the company, developed its products, acted as a company spokesperson, and is featured prominently on the company's website.

The Department further observed that the taxpayers reported the income they received from the company as nonpassive income on their federal income tax return. The Department concluded the income was subject to apportionment under Ohio Rev. Code 5747.01(B)'s definition of "business income," which was modified in 2022 by House Bill 515,5 to clarify the conditions under which income from the sale of an ownership interest in a business, such as a partnership or limited liability company, would qualify as business income for individual income tax purposes. HB 515 was remedial in nature and applied retroactively to codify two conditions under which the sale of an ownership interest in a business will be considered business income: (1) the transaction is treated as an asset sale for federal income tax purposes, and (2) the seller materially participates (as described in Treas. Reg. Section 1.469-5T) in the activities of the business during the tax year in which the sale occurs or during any of the five preceding tax years. The taxpayers had acknowledged that they spent enough time with the business to be considered materially participating.

Implications

The taxpayers appealed the Department's determination to the Ohio Board of Tax Appeals; a hearing is scheduled on January 20, 2025.

In the wake of the Corrigan decision, the Department had been pursuing Ohio residents who had claimed the Business Income Deduction on gains from sales of businesses on the ground that the gains were nonbusiness income. HB 515 was enacted to clarify that sales of businesses will be treated as business income under certain circumstances. Nonresidents who, relying on Corrigan, are considering the treatment of their transactions should consider how HB 515 changes to the definition of business income, as well as Ohio Rev. Code 5747.212 and the T. Ryan Legg Irrevocble Tr. Decision may apply.

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Endnotes

1 Garry A. Rayant & Kathy A. Fields, Final Determination - Refund Claim No. 0044350439 (Ohio Dept. of Taxn. March 28, 2024), appeal filed, Appeal Number 477 (Ohio Bd. Tax App. filed on May 24, 2024).

2 Ohio Rev. Code 5747.01(A)(28) allows individuals to deduct the first $250,000 of business income ($125,000 for spouses filing separate returns) using the business income deduction. For business income above $250,000, a flat 3% rate applies. See Ohio Rev. Code 5747.02(A)(4). Nonbusiness income, on the other hand, is entirely taxable and subject to individual income tax rates, which are somewhat higher (the top marginal rate for 2024 is 3.5%).

3 In Corrigan, the court held that applying Ohio Rev. Code 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. See Tax Alert 2016-0859 .

4 The Department concluded that the taxpayers' facts aligned more with those in T. Ryan Legg Irrevocable Tr. v. Testa, 149 Ohio St.3d 376 (2016), where the Ohio Supreme Court held that Ohio Rev. Code 5747.212 was constitutional as applied to a founder, manager and 50% owner of an entity who sold its interest as a nonresident.

5 See Tax Alert 2022-0991.

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State and Local Taxation

Published by NTD’s Tax Technical Knowledge Services group; Chris DeZinno, legal editor
 

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