At first glance, the distinction between "business income" and "nonbusiness" income appears unequivocal. Recent case law followed by an ambiguous technical memorandum, however, created uncertainty among the legal and accounting communities. The distinction is crucial, as the maximum Ohio tax rate for business income is 3% whereas the nonbusiness income tax rate is capped at 4.997%.
Section 5747.01(B) of the Revised Code defines business income as comprised of "income, including gain or loss from a partial or complete liquidation of a business, including but not limited to gain or loss from the sale or other disposition of goodwill." (emphasis added). Conversely, nonbusiness income includes "compensation, rents and royalties from real or tangible personal property, capital gains, interest, dividends and distributions, patent or copyright royalties, or lottery winnings, prizes and awards." Section 5747.212 requires certain nonresident investors to apportion capital gains to the situs of the earnings.
In Corrigan v. Testa, the State of Ohio asserted that section 5747.212 provided jurisdiction to tax the gain produced by a nonresident's sale of an equity interest. The nonresident taxpayer in Corrigan sold an equity interest in an LLC, which conducted a portion of its business in Ohio. The sale of the intangible business interest produced approximately $27 million of capital gain, which the taxpayer treated as nonbusiness income lacking nexus to Ohio. The Ohio Department of Taxation ("Department") subsequently issued a tax liability assessment of approximately $675,000. The taxpayer paid a portion of the liability and unsuccessfully filed a refund claim with the tax commissioner. Despite a petition to the Ohio Board of Tax Appeals ("BTA"), the appellate tribunal affirmed the tax commissioner's determination. On appeal, The Supreme Court of Ohio reversed the BTA's decision on grounds that section 5747.212, as applied to the taxpayer, violated the Due Process Clause of the 14th Amendment. Siding with the taxpayer, the Supreme Court employed a traditional personal jurisdiction analysis and concluded the Department lacked sufficient contacts to support the assessment, which therefore violated the Due Process Clause of the 14th Amendment.
In response to Corrigan, the Department issued IT 2016-01 - Guidance Relating to an Equity Investor's Apportionment of a Gain from the Sale of a Closely-Held Business. IT 2016-01 specifically states:
Additionally, to the extent an individual taxpayer recognizes a capital gain relating to the disposition of an interest in a business entity to which R.C. 5747.212 does not apply, that gain is nonbusiness income. Such a gain is allocable to the taxpayer's state of domicile under R.C. 5747.20(B)(2)(c)."
Although this guidance provides insight to nonresidents, it compounds the issues for Ohio residents who are contemplating the sale of a business. For instance, since Ohio law does not provide the flexibility of federal tax laws to electively treat the sale of stock as an asset sale for tax purposes (e.g. 338 election), there is an additional benefit from structuring a sale as an asset disposition. Specifically a transaction structured as an asset sale constitutes a liquidation in the traditional sense, thereby producing business income or loss at the 3% rate. Conversely, a stock sale similar to the Corrigan transaction may trigger the 4.997% nonbusiness income tax rate, as the transfer of an intangible ownership interest produces capital gains, and therefore nonbusiness income. In both instances, whether a stock sale treated as an asset sale by election or a traditional asset sale in form, the seller is disposing of the entire enterprise in a single transaction. As the Department asserted in Corrigan, despite having similar economic substance, the distinction between an equity transfer and an asset sale emphasizes form over substance. Stated differently, how does one reconcile the fact that the lower 3% tax rate applies to gains resulting from an asset sale whereas the gains resulting from an equity ownership transfer are taxed at the higher 4.997% rate? Consequently, don't be surprised to see an increase in business sales structured as asset liquidations within the immediate future.
1 R.C. §5747.02(A)(3) - (4).
2 Id. at §5747.01(C).
3 Corrigan v. Testa, Slip Opinion No. 2016-Ohio 2805, ¶45.
4 Id. at ¶6 - 9.
5 Id. at ¶9.
6 Id. at ¶10.
7 Id. at ¶11.
8 Id. at ¶12 - 14.
9 Id. at ¶71.
10 Id. at ¶18.
11 Section 338 of the Internal Revenue Code permits certain stock purchases to be treated as an asset sale for federal income tax purposes.
12 Corrigan at ¶ 62.