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ODT program seeks information on Schedule D gains listed as business income

Written on May 1, 2020

By Debora D. McGraw, CPA, JD, LLM

The Ohio Department of Taxation’s (ODT) personal income tax (PIT) unit sent hundreds of letters in the last few months seeking information on federal Schedule D gains that were listed as “Business Income” on the PIT return Form IT BUS.

“Business Income” is eligible for the Business Income Deduction (BID) and the lower flat tax rate on business income. The Schedule D portion of a taxpayer’s federal income tax return, Form 1040, contains information on the capital gains and losses claimed by the taxpayer, including sales of business interests. ODT seeks factual information, explanations of each transaction that generated the capital gain/loss, and explanations of why the capital gain is business income. In some cases, such as certain sales of business assets, ODT may be satisfied that the income has been properly characterized on the Form IT BUS. In many instances, additional discussion and analysis will likely be required.

In Corrigan v. Testa, 149 Ohio St.3d 18 (2016), the Ohio Supreme Court determined that the application of R.C. 5747.212 to treat the sale of a limited liability company (LLC) as “business income” was unconstitutional because the taxpayer’s lack of a unitary relationship with the business resulted in insufficient contacts between the gain from the disposition and the state of Ohio as required to satisfy the Due Process Clause. Mr. Corrigan was deemed an "investor" and nonresidents with similar facts will probably not pay Ohio tax on similar gains. Whether the character of the gain is business or nonbusiness income is less clear if the nonresident was actively involved in the business. ODT's letter is intended to capture these factual differences.

The letters are likely to be an issue for Ohio residents that sell an ownership interest in a business. Although the decision in Corrigan only applies to nonresidents, ODT has stated “[t]o the extent an individual taxpayer recognizes a capital gain relating to the disposition of an interest in a business entity  that gain is generally nonbusiness income. A nonbusiness gain is allocable to the taxpayer’s state of domicile since this gain is considered nonbusiness income, it is not eligible for Ohio’s Small Business Deduction for tax years 2013 and 2014, or Ohio’s Business Income Deduction for tax years 2015 and forward.”  Information Release 2016-01. The practical implication of this paragraph is that ODT believes that the gain realized when a resident sells a business interest will generally be considered nonbusiness income and not entitled to the BID. Although not mentioned in the Information Release, the gain would also be ineligible for the lower tax rate on business income. In some situations where the resident was actively involved in the business, the gain may be treated as business income eligible for the BID and lower tax rate.

ODT has indicated that it will treat a sale of a disregarded entity or an IRC Sec. 338(h)(10) election as the sale of a business interest likely resulting in the gain being nonbusiness income ineligible for the BID and lower tax rate. See FAQ #14 under “Income – Business Income and the Business Income Deduction.”

Accountants and other advisers working with taxpayers that receive the notices should analyze this area carefully and should consider seeking the advice of legal counsel. Accountants and other advisers are also cautioned to be careful of the procedural issues related to such notices. For example, depending on the type of notice being sent, the matter may be transferred to the Appeals Division of ODT upon the receipt of additional information. While a non-attorney can represent a taxpayer at the Appeals Division, in order to be successful, the representative must persuasively summarize the legal arguments. It is also important that all legal arguments are raised at the Appeals Division or the taxpayer will be prevented from raising an argument at the Ohio Board of Tax Appeals. This procedural rule is particularly important in situations like the sale of a business interest described above where the law is uncertain. Likewise, failure to respond to an ODT letter in a timely manner may result in ODT issuing an assessment and/or an assessment becoming final.

Debora D. McGraw, CPA, JD, LLM, is a member at Zaino, Hall & Farrin LLC in Columbus.