Unraveling the Ohio taxation of a sale of a business interest under current and future law

Unraveling the Ohio taxation of a sale of a business interest under current and future law

By Debora Dardinger McGraw, CPA, JD, LLM

There is an ongoing debate in Ohio regarding whether the sale of a business interest, such as a stock sale or sale of a partnership or membership interest, generates business income or nonbusiness income for purposes of determining the tax due on an individual owner.

An individual that is an Ohio resident at the time of sale generally wants the gain to be considered business income in Ohio because a resident is taxed at 100% of their income and a business gain will be eligible for the business income deduction and the lower tax rate on business income, which has historically been an approximately 1.8% difference and represents a 1% difference in 2021 and later years. A nonresident wants the gain to be considered nonbusiness income in Ohio because nonresidents would not generally be subject to Ohio tax on the sale.

Because of this dichotomy, recent audit activity and litigation has been focused on residents and whether the gain on the sale is subject to a significantly higher amount of tax. The Ohio Department of Taxation sent information requests and audited 200+ individual taxpayers that sold business interests. In many cases, assessments were issued and the taxpayers are at various levels of appeal. Only in a few rare fact patterns has ODT been willing to drop the audit or assessment. For sales transactions in 2020 and prior years, there are opportunities for taxpayers to settle or continue their appeals until the issue is resolved legislatively (both Senate Bill 247 and House Bill 515 are currently pending) or through litigation. Sales transactions in 2021 and later years also have this option but also have various planning options available and, in 2026 and later years, deductions may also be available, described below.

On Oct. 28, 2021, a hearing was held at the Ohio Board of Tax Appeals in Linehan v. McClain, Ohio BTA No. 2020-430. The BTA is a tribunal that is the first level of appeal after the exhaustion of appeals at ODT of an assessment or denial of a refund. The BTA cannot decide constitutional issues. Any decision by the BTA in tax commissioner cases, such as individual income tax matters, are appealable by either party to the Ohio Supreme Court or to a local court of appeals.

The Linehan case is the first case at the BTA involving an Ohio resident that sold a business interest that considers whether the gain is business income or nonbusiness income. The parties will brief the case and then the BTA will render adecision. It will take a year or more before a decision is issuedby the BTA. The BTA’s decision will likely be appealed to theSupreme Court, which could take another few years. Thereis one other case on the business income topic pendingat the BTA and many others still at ODT audit and appealsdivision levels. There are also some variations on the issue –including legal sales treated as asset sales for federal incometax purposes and situations where a legal entity (versus theultimate individual owner) sold the business interest at issue– that may require litigation of additional fact patterns and theresult may vary depending on the fact pattern.

Sales of business interests in calendar year 2026 and later years

Am. Sub. H.B. 110, the state’s two-year operating budget,changed the tax brackets and reduced the highest marginaltax rate from 4.797% to 3.99% effective for calendar year2021 and later years. The maximum rate a resident wouldbe taxed on a nonbusiness capital gain starting in calendaryear 2021 is now reduced by approximately 1%. Thus, thetax differential on gains from the sale of a business interestdrops to an approximately 1% difference. The budget bill alsoprovided two important deductions for the sale of a business,but these two provisions only apply in calendar year 2026 andlater years.

Venture capital gain deduction: The budget bill adopted anew venture capital gains deduction. To qualify for the VCdeduction a taxpayer must invest in an “Ohio venture capitaloperating company” (OVCOC). The VC deduction equals100% of the capital gain received by the taxpayer in thetaxable year from the OVCOC attributable to the company’sinvestments in Ohio businesses during the period for whichthe company was an OVCOC plus 50% of the company’sinvestments in all other businesses during the same period.

While “venture capital operating company” is defined byreference to federal tax regulations, the attainment of the “Ohio” prefix requires certification by the Ohio Director of Development that the company has met various requirements, including the management or capital commitments of at least $50 million in active assets and the Ohio residency of at least two-thirds of its managing and general partners. The OVCOC will have to apply to the DOD for certified OVCOC status. To be considered an “Ohio business,” the business must be headquartered in Ohio and must employ more than half its full-time workforce in the state, measured on an annual basis. The VC deduction will require annual reporting by the OVCOC on forms to be submitted to both the DOD and the tax commissioner. The DOD will be able to issue a certificate qualifying the company as an OVCOC, stating what portion of the OVCOC’s investments were in Ohio companies, and providing what percentage of gains or of distributed equity interests or securities is attributable to each qualified investor in the OVCOC. A copy of this certificate would be necessary to claim the VC deduction.

The VC deduction only applies to the sale of a business interest; it does not apply to transactions treated as asset sales for legal purposes and potentially not to transactions treated as asset sales for federal income tax purposes (e.g., sale of a disregarded entity, an IRC 338(h)(10) election, etc.). The difference in Ohio tax could be whether the highest tax rate of 3.99% applies or whether no Ohio tax applies to the sale of a business. The various requirements (i.e., certification from DOD, investment of $1 million or more) will likely limit the qualifying transactions to an exceedingly small group of sales transactions.

Even where the VC deduction applies to a transaction, the provisions may not apply to the portion of the gain on the sale of a business interest that is recharacterized as ordinary income due to the federal hot asset and depreciation recapture rules, which in some factual situations can be a significant portion of the gain. Thus, sellers attempting to take advantage of the VC deduction should carefully evaluate their facts and compliance on an ongoing basis and particularly in structuring the sales transaction.

Qualifying capital gain deduction: Another new deduction available in taxable years 2026 and later years was added for capital gains from the sale of a business interest. The qualifying capital gain deduction equals the lower of the “qualifying capital gain” or “deductible payroll.” Qualifying capital gain means a capital gain resulting from the sale of an interest in an entity reported for the taxable year as reported for federal income tax purposes, to the extent not otherwise deducted or excluded in computing federal or Ohio adjusted gross income, provided that all three of the following conditions are met:

1. The selling taxpayer either:

a. Materially participated (as defined in federal regulations 26 CFR 1.469-5T (a)(1), (2), (3), (4) or (7)) in the sold entity for the five years immediately preceding the time of sale; or

b. Directly or indirectly invested at least $1 million in the entity;

2. The entity is incorporated, registered, or organized in Ohio during the five years immediately preceding the sale; and

3. The entity is headquartered in Ohio during the five yearsimmediately preceding the sale.

A limitation placed on qualifying payroll is that it does notinclude amounts paid to the taxpayer or the taxpayer’sspouse, parents, grandparents, children, or grandchildren.

If a taxpayer has multiple capital gains from the sale ofinterests in different entities during the taxable year, eachcapital gain must meet the requirements to be classified asa “qualifying capital gain.” The lesser of the qualified capitalgain or deductible payroll is determined on an entity-by-entitybasis. The deduction amounts related to each entity wouldthen be aggregated to determine the total qualifying capitalgain deduction allowed. By limiting the qualifying capitalgain deduction to the lesser of the qualifying capital gain ordeductible payroll, the provision is intended to keep the taxbenefit from becoming out of proportion to the number ofjobs created by the business. Lower payroll would amount toa smaller credit unless the gain amount is already smaller thanthe deductible payroll.

The qualifying capital gain deduction may apply to moretransactions than the VC deduction because it does notrequire certification in earlier years, but the payroll limitationand the $1 million investment will likely limit its application.The qualifying capital gain deduction also only applies to thesale of a business interest (not the legal sale of assets) andmay not apply to any portion of the gain that is recognizedor recharacterized as ordinary income for federal income taxpurposes. Thus, sellers attempting to take advantage of thequalifying capital gain deduction should carefully evaluatetheir facts on an ongoing basis and particularly in structuringa sales transaction.

Sales of business interests by a resident in calendar years2021 to 2025 and sales in 2026 or later years where gain isnot offset by deductions

As described above, the tax differential in calendar years2021 and later years between business and nonbusinessincome, such as the gain on the sale of a business interest, will be reduced to 1%. Thus, there should be less Ohio tax at issue on the sale of a business.

In situations where a resident is selling a business interest in calendar years 2021 through 2025 there are several planning options available. If the timing works, a seller may try to take advantage of the change in law in calendar year 2026 and later years and try to either push the sale date to those years or structure the sale to be recognized for federal and Ohio income tax purposes in those later years.

There are other options, which could also apply to sales of business interest in 2026 and later calendar years where the gain is not offset by the deductions described above. The sale could be structured such that all or some of the sale is a legal sale of assets, which ODT agrees qualifies as business income. If the sale of a business interest is necessary and the seller has to remain an Ohio resident, the seller should explore various planning options and the impact of the ongoing litigation and pending legislation. It may also make sense to negotiate the additional cost in the price of the deal. All these options are complicated and there are important legal and federal income tax implications that should also be evaluated as part of the process.

Another option is to become a resident in a no-tax state before the sale. A change in residency has recently been simplified by changes to Ohio’s bright-line residency law, but advanced planning is prudent and should not be contemplated lightly. Further, it is important that sellers of businesses understand the potential risks that ODT may take a different position in some factual situations or may change its position in later years.

Conclusion

Like a ball of yarn, the taxation of the sale of a business has become incredibly complex in Ohio. It is important that potential sellers work with their tax advisors to thoroughly understand the ramifications of a sale and the statutory or planning options available.

Debora Dardinger McGraw, CPA, JD, LLM, is a member of the tax and legislative affairs groups at Zaino, Hall & Farrin, LLC in Columbus.