On June 24, 2022, Ohio Gov. Mike DeWine signed House Bill 515 (HB 515), which clarifies two situations in which the sale of an equity or ownership interest in a business will be considered business income. The bill will become effective on Sept. 21, 2022. This article supplements our priorarticlediscussing the clarifying language of HB 515.
The passage of HB 515 will clear up significant uncertainty about when the sale of an equity or ownership interest is considered nonbusiness income or business income and will likely begin to impact pending cases in Ohio.
Equity Sales Clarified by HB 515
The first situation HB 515 clarifies is the state tax treatment of equity sales that are treated as a sale of assets for federal income tax purposes. This covers cases where there is a legal sale of stock that is treated as a sale of assets for federal income tax purposes under Internal Revenue Code (I.R.C.) Sections 338(h)(10) and 336(e). It also covers situations where there is a sale of a disregarded single member LLC interest, which is treated as a sale of assets for federal income tax purposes. Each of these transactional structures are common because they enable the buyer to purchase equity while receiving a step up in the basis of the underlying assets.
In the course of audits, the Ohio Department of Taxation (the Department) has taken the position that these types of transactions generate nonbusiness income because there is a sale of equity. The Department has often been unwilling to look underneath the surface of a state law sale of equity to see what the tax law consequences of that sale should be. This has created much confusion for taxpayers and tax practitioners alike who look to the federal tax code as a starting point for whether a transaction is considered a sale of assets or sale of equity. By ignoring the federal tax implications, the Department has effectively created a separate tax classification system whereby a sale of assets under federal tax law can be regarded as a sale of equity under state tax law.
The second situation addressed by HB 515 provides clarity for business owners who materially participate in the underlying business. HB 515 leverages the federal standards for "material participation" from the rules under Treas. Reg. 1.469-5T. A taxpayer is deemed to materially participate in an activity if their activity in the operation of the business is regular, continuous, and substantial.1The regulations then provide seven specific ways in which a taxpayer can establish material participation in an activity.2
The federal material participation standards are extensive and fact specific, which is a stark difference from the current common law standards as to whether or not a taxpayer had a unitary business relationship with the business being sold.
Differing Implications of HB 515 for Residents and Non-Residents
The clarification of income from the sale of a business as "business income" or "nonbusiness income" is important for taxpayers and has differing impacts for residents versus nonresidents. Residents of Ohio pay Ohio income taxes on their worldwide income, subject to certain credits for taxes paid to other jurisdictions. Nonresidents only pay taxes on business income or income that is otherwise earned in Ohio.
For Ohio residents, sales of an equity or ownership interest being taxed as business income will mean that the residents are subject to tax at the more favorable business income tax rate and eligible for the Ohio business income tax deduction ("BID"). The BID permits joint-filing taxpayers to deduct the first $250,000 ($125,000 for single filers or in the case of spouses filing separately) of business income with any income above this amount being subject to the flat 3% business income tax rate.3
For nonresidents, HB 515 will have no impact on their Ohio tax burden in some cases but has an uncertain impact in other situations. There are two situations in which nonresident treatment remains unchanged by HB 515. First, under Ohio Revised Code (O.R.C.) § 5474.212, nonresidents may still be subject to business income tax on a portion of their gain from the sale of interests in a closely held business or pass-through entity. This special rule generally applies to owners with a 20% or more interest in a closely-held pass-through business with five or fewer owners. Gain from the sale of a business interest in these circumstances is considered business income eligible for the BID but, unlike business income generally, the nonresidents' gain is apportioned based on the business' activity in the state over the preceding three years.4This differs from the apportionment of other business income, which is based on the taxpayer's activity in the state over the taxable year.5Second, pursuant to the Ohio Supreme Court's ruling inCorrigan, nonresident taxpayers who are not in a unitary business relationship cannot have income apportioned to Ohio.6
But some uncertainty still remains regarding whether the Department will alter its treatment of nonresidents in certain situations in light of HB 515. First, where a nonresident taxpayer is not subject to O.R.C. § 5474.212, but is in a unitary business relationship with a business in Ohio, the Department has historically not apportioned income to Ohio. Second, it has been the Department's position that where a taxpayer is subject to O.R.C. § 5474.212 they are eligible for the BID. It is unclear whether the Department will change its position regarding these two nonresident taxpayer scenarios. If the Department changes its position in either of these situations, it may result in an increased tax burden to the taxpayer unless the additional Ohio tax can be credited against an income tax in the taxpayer's home state that is at the same or a higher rate.
HB 515 states that it is intended to be remedial and clarify existing law. Thus, changes should apply to any audits, refund applications, petitions for reassessment, and appeals pending on or after the bill's 90-day effective date (Sept. 21, 2022).
Potential Refund Opportunities
It is worth noting that the deadline to file an amended return and refund claim in Ohio isfouryearsfrom the date the return was filed or required to be filed, whichever is later.7To the extent that HB 515 might be found to modify existing law, especially if the modification is not in the taxpayer's favor, the change would probably apply only to the current or future open tax years.8For nonresidents, there still would be the additional requirement of a unitary business relationship to make the sale taxable by Ohio, if at all, underCorrigan.9
Therefore, taxpayers who recently sold an equity or ownership interest in which they "materially participated" or where the sale was treated as a sale of assets under federal law should consider filing protective refund claims for the BID and any delta between nonbusiness and business income taxes they may have paid.10Filing these protective claims will allow taxpayers to be certain the statute of limitations does not expire.
If you have any questions about HB 515 and its implications, please contact any of the authors or other attorneys in Taft'sTaxpractice.
1 I.R.C. § 469(h)(1).
2 Treas. Reg. §§ 1.469-5T(a)(1)-(7).
3 O.R.C. §§ 5747.01(A)(28), 5747.02(A)(4).
4 O.R.C. § 5747.212.
5 O.R.C. §§ 5747.21; 5733.05(B)(2).
6 SeeCorrigan v. Testa, 149 Ohio St.3d 18 (2016), holding that a nonresident's income from the sale of an Ohio business was not taxable under O.R.C. § 5747.212 because the particular nonresident's connection to Ohio was insufficient to establish nexus with Ohio under the Due Process Clause of the Fourteenth Amendment to the United States Constitution.
7 O.R.C. § 5747.13(A).
8 See Lakengren, Inc. v. Kosydar, 44 Ohio St. 2d 199 (1975) (holding that a change in the income tax law is not unconstitutionally retroactive if it applies to an open tax year).
9 See Corrigan v. Testa, 2016-Ohio-2805, ¶ 69, 149 Ohio St. 3d 18, 33, 73 N.E.3d 381, 396 (The Ohio Supreme Court left open the possibility that a nonresident who is active in the day-to-day activities of a business could be subject to Ohio tax. Corrigan was found to be merely engaged in stewardship activities, which did not create a sufficient connection to Ohio for taxation. However, the Court only found O.R.C. § 5747.212 unconstitutional as applied to Corrigan, stating that "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.").
10 See Linehan v. McClain, BTA 2020-430 (pending appeal filed by the taxpayer in response to the Ohio Tax Commissioners Final Determination denying their refund claim for the BID in association with the sale of a membership interest in a business).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.