Tax planning is often a vital consideration in an exit strategy for business owners. While most business advisors factor in federal income tax consequences when analyzing transaction structures, state income tax consequences seldom take center stage. Nevertheless, state income taxes can pose a significant tax burden for business owners upon exit and should be analyzed when contemplating transaction structures.
Practically, Ohio state income tax liability is based on several factors, including the taxpayer's residency and the categorization of the income. Importantly, there are two major categories of income: business and nonbusiness income.1 Business income generally includes income derived in the "regular course of a trade or business." Nonbusiness income is broadly defined to include "all income other than business income." Resident taxpayers benefit significantly from having their income qualify as business income because the income is taxed at a flat 3% rate and is eligible for the Ohio Business Income Deduction (a potential $250,000 deduction for taxpayers filing jointly and $125,000 for single filers); nonbusiness income is taxed at ordinary progressive state income tax rates. Nonresident taxpayers, however, will typically seek to categorize their income as nonbusiness income to try to avoid the Ohio state income tax altogether.
With this in mind, business advisors representing sellers in a transaction involving either an Ohio entity or an Ohio resident should consider whether their client would benefit from categorizing the proceeds as business income.
Categorizing income before HB 515
The methodology utilized by the Ohio Department of Taxation (the "Department") for categorizing proceeds derived from the sale of business interests in the state has caused taxpayers significant headache over the past few years.
As a result of Ohio jurisprudence (e.g., Kemppel v. Zaino2) and actions taken by the Ohio General Assembly (e.g., 2002 Senate Bill 261), there seemed to be a workable definition of business income for business advisors to utilize in analyzing the state income tax consequences of transaction structures. However, in late 2016 (following the Corrigan v. Testa3 decision), the Ohio Department of Taxation issued Information Release IT 2016-01 which arguably misinterpreted the court's analysis in Corrigan and, as a result, broadly concluded that the sale of an equity interest to which ORC § 5747.212 does not apply always generates nonbusiness income. As a result, the Department began to broadly categorize business interest (i.e., equity) sales as nonbusiness income without considering the true form and nuance of the transaction, such as whether the transaction was structured for federal income tax purposes as a sale of assets under Internal Revenue Code § 338(h)(10) or § 336(e) and whether the sale was of a single-member LLC.
The impact of HB 515
On June 24, 2022, Governor Mike DeWine signed House Bill ("HB") 515 into law. Among other things, HB 515 revises the definition of business income to clarify that the "sale of an equity or ownership interest in a business" is business income under ORC 5747.01(B). For purposes of determining when a "sale of an equity or ownership interest in a business" occurs, the General Assembly directs taxpayers and the Department to look to (1) whether the "sale is treated for federal income tax purposes as the sale of assets" and/or (2) whether the "seller materially participated in the activities of the business during the taxable year in which the sale occurs or during any of the five preceding taxable years", as determined applying the Regulations in 26 C.F.R. 1.469-5T (the "Material Participation Regulations").
The practical impact of HB 515's revisions to the definition of business income and whether the changes are favorable to a taxpayer depends on the particular taxpayer's situation.
For resident taxpayers who structure their business exit utilizing IRC § 338(h)(10) or § 336(e) elections or sell ownership of a single-member LLC, the changes in HB 515 are welcome and have been long awaited because the federal tax treatment of the transaction should be respected by the state. As a result, these taxpayers will be able to take advantage of the Business Income Deduction and the lesser tax rate applicable to business income. However, these transaction structures will now also subject nonresidents to Ohio tax given the categorization of the proceeds as business income.
Since nonresidents are only subject to Ohio's income tax on their income apportioned to the state, it is important for nonresidents to understand when the sale of a business interest in Ohio creates business income. There are a few factors to consider. First, HB 515 does not explicitly impact the applicability of ORC § 5747.212 to the business income analysis. That section provides guidance for apportioning a nonresident investor's income (including proceeds from the sale of the equity interest) to Ohio where the nonresident owns 20% or more of the company's voting rights during any time in the preceding three years. Therefore, nonresident investors who surpass the 20% equity threshold should continue to analyze the applicability of ORC § 5747.212. Second, if the nonresident investor is not subject to ORC § 5747.212 given the investor's ownership percentage, the investor should analyze whether he materially participated in the business under the Material Participation Regulations. If so, the proceeds from the sale of the business interest would be categorized as business income given the changes in HB 515; if not, the proceeds would be nonbusiness income. The Material Participation Regulations set forth seven situations to consider when determining whether the material participation threshold has been met. These factors should help provide some guidance for taxpayers when they categorize sale proceeds. It will be important to track how the Department will implement the Material Participation Regulations in its business income analysis.
The changes made by HB 515 are effective September 21, 2022 and will apply to any petition for reassessment, appeal, or refund application that is pending on or after such date.
The clarifications offered by House Bill 515 will hopefully clear up the Department's confusion and help taxpayers both correctly categorize their proceeds from the sale of a business interest and defend their asserted positions in audits. Taxpayers who have recently sold an equity interest and reported the proceeds as nonbusiness income for Ohio state income tax purposes should consider the changes made by HB 515 and consult their tax advisors as to whether there may be grounds for filing a refund claim prior to September 21, 2022 to preserve a refund claim. Similarly, nonresidents who receive letters from the Department following the sale of an equity interest should consult their tax advisors to ensure proper treatment of the proceeds.
For questions or assistance with the topics discussed in this brief article, please contact T.W. Langevin, Eddie Rivin, Mark Sims, or another KMK Law attorney.
1 See ORC 5747.01(B) and (C).
2 Kemppel v. Zaino, 91 Ohio St. 3d 420, 423 (2001).
3 Corrigan v. Testa, 149 Ohio St. 3d 18, 23 (2016).
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.