Business vs. Business Income: Categorization of Income from Sale of Equity Interests | Keating Muething & Klekamp PLL

[co-author: Ken McQueen]

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 rarely take center stage. However, state income taxes can pose a significant tax burden for business owners after exit and should be analyzed when considering transaction structures.

In practice, Ohio state income tax liability is based on several factors, including the taxpayer’s residence and income classification. Most importantly, there are two main categories of income: business and non-business income.[1] Business income generally includes income derived in the “ordinary course of a trade or business.” Business income is broadly defined to include “all income other than business income”. Resident taxpayers benefit significantly from qualifying their income as business income because the income is taxed at a flat rate of 3% and is eligible for the Ohio business income deduction (a potential deduction of $250,000 for taxpayers filing jointly and $125,000 per single filer); Non-business income is taxed at ordinary progressive state income tax rates. However, non-resident taxpayers will typically seek to categorize their income as non-business income in an attempt to avoid Ohio state income tax.

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 income as business income.

Income categorization prior to HB 515

The methodology used by the Ohio Department of Taxation (the “Department”) for categorizing income derived from the sale of business interests in the state has caused taxpayers a significant headache in recent years.

As a result of Ohio jurisprudence (e.g, Campbell v. Zaino[2]) and actions taken by the Ohio General Assembly (eg, Senate Bill 261 of 2002), there appeared to be a workable definition of business income for business advisors to use in analyzing the income tax consequences state of transaction structures. However, at the end of 2016 (after Corrigan v. HEAD[3] decision), the Ohio Department of Taxation issued IT Information Notice 2016-01, which arguably misrepresented 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 interests (vizcapital) sales as non-business income without regard to the true form and nuance of the transaction, such as if 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 if the sale was to a single member LLC.

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 consider (1) whether “the sale is treated for federal income tax purposes as a sale of assets ” and/or (2) if “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 by applying the regulations at 26 CFR 1.469-5T ( “Regulations of material participation”).

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 individual taxpayer’s situation.

For resident taxpayers who structure their business exit using IRC § 338(h)(10) or § 336(e) elections or sell ownership of a single-member LLC, the changes in HB 515 are welcome and expected by long because the federal tax treatment of the transaction must be respected by the state. As a result, these taxpayers will be able to benefit from the business income deduction and the lower tax rate applicable to business income. However, these transaction structures will now also subject nonresidents to Ohio tax given the income’s categorization as business income.

Since nonresidents are only subject to Ohio income tax on their in-state distributed income, it is important for nonresidents to understand when the sale of a business interest in Ohio creates business income. There are several factors to consider. First, HB 515 does not explicitly affect the applicability of ORC § 5747.212 in the business income analysis. This section provides guidance on the allocation of a nonresident investor’s income (including income from the sale of an equity interest) in Ohio where the nonresident owns 20% or more of the company’s voting rights at any time in the three years previous. Therefore, nonresident investors who exceed the 20% net 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 must analyze whether he has 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 income would be non-business income. The material participation regulations provide for seven situations to be considered when determining whether the material participation threshold has been met. These factors should help provide some guidance to taxpayers when they categorize sale proceeds. It will be important to track how the Department will apply the Material Participation Regulations to the business income analysis.

What else?

The changes made by HB 515 take effect on September 21, 2022 and will apply to any petition for reconsideration, appeal, or refund application that is pending on or after that date.

The clarifications provided by House Bill 515 will hopefully clear up the Department’s confusion and help taxpayers correctly categorize their income 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 with their advisors. their tax returns if there may be grounds for filing a refund claim before September 21, 2022 to save a refund claim. Similarly, non-residents who receive letters from the Department following the sale of an equity interest should consult their tax advisors to ensure the appropriate treatment of the proceeds.

[1] Look ORC 5747.01 (B) and (C).

[2] Campbell v. Zaino91 Ohio St. 3d 420, 423 (2001).

[3] Corrigan v. HEAD149 Ohio St. 3d 18, 23 (2016).

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