Ohio Supreme Court Rules that Nonresident Individual is Not Taxable on Sale of LLC Interest

In a recent decision, Ohio determined that an investor could not be constitutionally taxed on the sale of his intangible investment since the investor was not himself engaged in the business and did not participate in the active day-to-day management of it.

State tax consequences can be significant in the sale of a business and must be considered as part of any deal. Ultimately, a selling investor’s state income tax liability is determined by several factors: whether the transaction is structured as a sale of assets or equity, how the affected states classify and apportion/allocate the gain, whether the investor is an individual or an entity and the investor’s relationship to the business itself.

For example, an asset sale results in a gain to the business itself and is generally allocated/apportioned among all of the states where that business is required to file income/franchise tax returns. An equity sale results in a gain to the investor, which in the case of an individual investor is often specifically allocated to the investor’s state of residence, but in some cases may be allocated/apportioned among the states where the business operates.

Ohio follows the latter view of an equity sale in certain situations. Under what is referred to as Ohio’s “Closely Held Statute,” a nonresident individual owning (at any point during the three-year period ending on the last day of the taxpayer’s tax year) more than 20 percent (equity with voting rights) of a qualifying business must apportion the gain from the sale of its equity to Ohio using an average of that business’ Ohio apportionment fractions for the current and preceding two years. [1] In order to be a qualifying business, any of the following must apply (on at least one day during the three-year period ending on the last day of the taxpayer’s tax year): (i) the business is a pass-through entity, (ii) the equity interests of the business (with voting rights) are owned, directly or indirectly, by five or fewer persons or (iii) one person owns, directly or indirectly, at least 50 percent of the equity interest with voting rights. [2]

However, in a decision issued on May 4, 2016, the Ohio Supreme Court ruled that the Closely Held Statute was unconstitutional as applied to a nonresident investor who sold his 79 percent interest in an LLC doing business in Ohio. [3] In this particular case, the taxpayer was the main owner and a member of the board of managers of the company. He visited the company’s headquarters in Ohio for board meetings and management presentations. His role was as an investor – to buy companies and advise them on how to grow so that he could realize gain on his eventual sale. He was not engaged in the business or in a similar business, and he was not involved in the active, day-to-day management of the business.

The Court recognized the right of Ohio to tax the taxpayer on his share of the income from the business given the business’ connection with Ohio. However, the sale by the taxpayer of his intangible investment in the company is different, and Ohio could not constitutionally tax the investor in this income since he was not engaged in a unitary business with the company – i.e., he was not engaged himself in the business or in a similar business and did not participate in the active day-to-day management of the business. The Court did not strike down the law, since it noted that under other circumstances, Ohio may have the right under the Closely Held Statute to tax a nonresident on the sale of an equity interest in a business conducted in Ohio; it only denied Ohio the right to apply it to the taxpayer under these facts.

Taxpayers that may have reported gains to Ohio under this statute since 2012 may have a potential refund claim and should consult with a tax advisor. This decision draws attention to the important considerations facing business owners who intend to sell a business or similar investment. The rules for allocating and apportioning gains vary by state, with both the structure of the transaction and the investor’s connection to the business impacting the result. Aprio’s SALT practice has experience working with taxpayers who are considering a sale of a business and can assist in navigating the complex state and local tax consequences.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the June 2016 SALT Newsletter. To view the newsletter, click here.

[1] This statute may also apply to estates and trusts.

[2] Ohio Rev. Code Ann. §5747.212.

[3] Corrigan v. Testa, Slip Opinion No. 2016-Ohio-2805 (May 4, 2016).

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.