Imagine that you are an owner of a business. The business is a LLC, meaning that it “passes-through” its income to its owners, who in turn take their share of the business income, include it with their own income, and pay tax on the agglomeration.
You own 79.29% of the business. It has headquarters in Perrysville, Ohio, owns plants in Texas and California, and does business in all states.
The business has made a couple of bucks. It has allowed you a life of leisure. You fly-in for occasional Board meetings in northern Ohio, but you otherwise hire people to run the business for you. You have golf elsewhere to attend to.
You sold the business. More specifically, you sold the stock in the business. Your gain was over $27 million.
Then you received a notice from Ohio. They congratulated you on your good fortune and … oh, by the way … would you send them approximately $675,000?
Here is a key fact: you do not live in Ohio. You are not a resident. You fly in and fly out for the meetings.
Why does Ohio think it should receive a vig?
Because the business did business in Ohio. Some of its sales, its payroll and its assets were in Ohio.
Cannot argue with that.
Except “the business” did not sell anything. It still has its sales, its payroll and its assets. What you sold were your shares in the business, which is not the same as the business itself.
Seems to you that Ohio should test at your level and not at the business level: are you an Ohio resident? Are you not? Is there yet another way that Ohio can get to you personally?
You bet, said Ohio. Try this remarkable stretch of the English language on for size:
ORC 5747.212 (B) A taxpayer, directly or indirectly, owning at any time during the three-year period ending on the last day of the taxpayer's taxable year at least twenty per cent of the equity voting rights of a section 5747.212 entity shall apportion any income, including gain or loss, realized from each sale, exchange, or other disposition of a debt or equity interest in that entity as prescribed in this section. For such purposes, in lieu of using the method prescribed by sections 5747.20 and5747.21 of the Revised Code, the investor shall apportion the income using the average of the section 5747.212 entity's apportionment fractions otherwise applicable under section 5733.05, 5733.056, or 5747.21 of the Revised Code for the current and two preceding taxable years. If the section 5747.212 entity was not in business for one or more of those years, each year that the entity was not in business shall be excluded in determining the average.
Ohio is saying that it will substitute the business apportionment factors (sales, payroll and property) for yours. It will do this for the immediately preceding three years, take the average and drag you down with it.
Begone with thy spurious nonresidency, ye festering cur!
To be fair, I get it. If the business itself had sold the assets, there is no question that Ohio would have gotten its share. Why then is it a different result if one sells shares in the business rather than the underlying assets themselves? That is just smoke and mirrors, form over substance, putting jelly on bread before the peanut butter.
Well, for one reason: because form matters all over the place in the tax Code. Try claiming a $1,000 charitable deduction without getting a “magic letter” from the charity; or deducting auto expenses without keeping a mileage log; or claiming a child as a dependent when you paid everything for the child – but the divorce agreement says your spouse gets the deduction this year. Yeah, try arguing smoke and mirrors, form and substance and see how far it gets you.
But it’s not fair ….
Which can join the list of everything that is not fair: it’s not fair that Firefly was cancelled after one season; it’s not fair that there aren’t microwave fireplaces; it’s not fair that we cannot wear capes at work.
Take a number.
Our protagonist had a couple of nickels ($27 million worth, if I recall) to protest. He paid a portion of the tax and immediately filed a refund claim for the same amount.
The Ohio tax commissioner denied the claim.
COMMENT: No one could have seen that coming.
The taxpayer appealed to the Ohio Board of Tax Appeals, which ruled in favor of the Tax Commissioner.
The taxpayer then appealed to the Ohio Supreme Court.
He presented a Due Process argument under the U.S. Constitution.
And the Ohio Supreme Court decided that Ohio had violated Due Process by conflating our protagonist with a company he owned shares in. One was a human being. The other was a piece of paper filed in Columbus.
The taxpayer won.
But the Court backed-off immediately, making the following points:
(1) The decision applied only to this specific taxpayer; one was not to extrapolate the Court’s decision;
(2) The Court night have decided differently if the taxpayer had enough activity in his own name to find a “unitary relationship” with the business being sold; and
(3) The statute could still be valid if applied to another taxpayer with different facts.
Points (1) and (3) can apply to just about any tax case.
Point (2) is interesting. The phrase “unitary relationship” simply means that our protagonist did not do enough in Ohio to take-on the tax aroma of the company itself. Make him an officer and I suspect you have a different answer. Heck, I suspect that one Board meeting a year would save him but five would doom him. Who knows until a Court tells us?
With that you see tax law in the making.
By the way, if this is you – or someone you know – you may want to check-out the case for yourself: Corrigan v Testa. Someone may have a few tax dollars coming back.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.