Effective in 2015, Ohio enhanced its already favorable small business deduction (SBD) available to individual business owners. The deduction can be very beneficial, yet many taxpayers are failing to take advantage of the tax savings opportunity offered by Ohio to small business owners. This is primarily because the deduction sounds too good to be true and many taxpayers do not realize that, while it is termed a "small business" deduction, larger business owners may avail themselves of it as well.
The changes made to the law in 2015 are aimed at simplifying the calculation and increasing the deduction available to taxpayers. An individual business owner can deduct 75% of his or her first $250,000 of business income (up to $187,500) reported on the Ohio individual income tax return and then apply a graduated tax rate capped at 3% on business income over the SBD amount. Nonbusiness income is taxed at the standard Ohio graduated rates capped at 4.997%. For tax years 2016 and thereafter, the Ohio SBD is available for 100% of the first $250,000 of business income for single taxpayers and married taxpayers filing jointly. Amounts over $250,000 are taxed at a flat 3% rate. For taxpayers whose filing status is married filing separately, the $250,000 is reduced to $125,000.
The History of the Ohio Small Business Deduction
Ohio first enacted the SBD for tax year 2013. In tax years 2013 and 2014, the SBD was applied to a taxpayer's apportioned Ohio business net income (business income is defined below). For 2013, the deduction was 50% of the first $250,000 of apportioned business income (up to $125,000). For 2014, the deduction was 75% of the first $250,000 of apportioned business income (up to $187,500). Similar to current law, these amounts were halved for taxpayers whose filing status was married filing separately.
Historically, each source of business income needed to be apportioned on a business-by-business basis and reported on a separate SBD form to take the SBD on the Ohio individual income tax return. This was time-consuming and required Ohio taxpayers to request information on the three-factor apportionment amounts for each eligible business interest. Business income (remaining after applying the SBD) and all nonbusiness income were taxed at the standard Ohio graduated rate.
The SBD also required that the Ohio bonus and Sec. 179 depreciation add-backs and subtractions as well as federal deductions to adjusted gross income (AGI) attributable to business income, including self-employment taxes, self-employment health insurance, and retirement contribution deductions, be separately reported by entity and apportioned on each separate SBD form. This was cumbersome as tax preparers many times did not receive all of this information sorted out on an entity-by-entity basis. Individuals who directly or indirectly through a tiered structure own at least a 20% interest in profits or capital of a passthrough entity (C corporations are not eligible) may also include their wages and guaranteed payments from that passthrough entity in the SBD calculation. The indirect ownership only included ownership through a tiered entity structure and did not include constructive ownership from family members via attribution or husband-and-wife attribution.
Ohio Rev. Code Section 5747.01(B) defines business income as:
[I]ncome, including gain or loss, arising from transactions, activities, and sources in the regular course of a trade or business and . . . [that] includes income, gain, or loss from real property, tangible property, and intangible property if the acquisition, rental, management, and disposition of the property constitute integral parts of the regular course of a trade or business operation. "Business income" includes income, including gain or loss, from a partial or complete liquidation of a business, including, but not limited to, gain or loss from the sale or other disposition of goodwill.
Ohio Rev. Code Section 5747.01(C) defines nonbusiness income as:
[A]ll income other than business income and may include, but is not limited to, compensation, rents and royalties from real or tangible personal property, capital gains, interest, dividends and distributions, patent or copyright royalties, or lottery winnings, prizes, and awards.
In the Ohio Supreme Court case of Kemppel v. Zaino, 91 Ohio St. 3d 420 (2001), the court provided two tests to identify business income: (1) the transactional test,which looked at the nature, frequency, and regularity of the transactions being tested,and (2) the functional test, which looked at whether the transactions being tested were an integral part of the business.
The Current Tax Regime
Starting with tax year 2015, to claim the SBD on an individual tax return, the taxpayer must include a two-page Form IT-BUS, Business Income Schedule, instead of preparing and attaching the one-page SBD form for each investment. The SBD now is based on all business income, not exclusively Ohio apportioned income. Therefore, residents no longer need to apportion their business income when calculating the deduction, which means more taxpayers may take advantage of the deduction, and the deduction will likely increase for taxpayers with businesses that operate both in and outside of Ohio. Net business income that is included in the SBD calculation now is taxed at the graduated business income rate capped at 3%, not to exceed the Ohio income tax base. The most difficult piece of the calculation is determining whether a source of income is business or nonbusiness income.
Compensation and guaranteed payments received by 20%-or-more owners of passthrough entities (which excludes C corporations) are still considered business income and eligible for both the SBD and the business income tax rate, which can be a significant tax savings.
Ohio also eliminated the Ohio bonus and Sec. 179 depreciation add-back and subtractions as well as federal deductions for AGI including self-employment taxes, self-employment health insurance, and retirement contribution deductions attributable to business income from the Ohio SBD calculation. These items are considered nonbusiness income (loss) and taxed at the standard graduated rate, which is capped at 4.997% for 2015. While it is a favorable change that taxpayers deduct future subtractions related to prior years' depreciation add-backs against nonbusiness income, which is taxed at the higher individual rates, future add-backs are also taxed at the higher tax rate, which will likely be derived from business income entities.
Common Misconceptions
The authors often find taxpayers who have not availed themselves of the SBD on their Ohio income tax returns. While it is human nature to second-guess something that sounds too good to be true, especially when it comes to taxes, many taxpayers do not realize they, too, are eligible for this deduction or just do not take the time to prepare the necessary form, as they believe the tax savings are minimal. Effective with the 2015 changes, the SBD has become a significant item of tax savings for Ohio taxpayers. Taxpayers who failed to claim the deduction on their originally filed returns should give serious thought to filing amended returns to claim the benefit for all three years that the SBD has been in existence in some form.
A few of the most common reasons taxpayers fail to take full advantage of the Ohio SBD are set forth below:
"I don't consider myself a 'small' business; therefore, I likely don't qualify": While the deduction contains the term "small business," there is no limit on gross receipts or assets that the entity can have. As such, the owners of any passthrough entity that issues a federal Schedule K-1 and reports income from a trade or business, or any business activity included on an individual taxpayer's federal Schedule C, Profit or Loss From Business, or Schedule E, Supplemental Income or Loss, will likely be eligible for the deduction (in 2013 and 2014) and the deduction and lower tax rate for tax years 2015 and following.
"I am a nonresident, so I likely don't qualify for the Ohio SBD": The deduction can be taken by not only Ohio residents on all their business income received, but also by Ohio nonresidents and part-year residents on their Ohio business income subject to tax in the state.
"I was included in an Ohio composite return filed on my behalf by a passthrough entity, so I already received my deduction": While electing to be included in the composite tax return in most states makes financial sense, taxpayers could be missing out on the lucrative tax savings available in Ohio. A passthrough entity cannot deduct the SBD on a composite tax return filed on a taxpayer's behalf, and the SBD cannot be claimed on any other nonindividual tax return, such as a trust return and even a nonresident withholding return.
It is important to note that the Ohio nonresident passthrough and trust withholding tax rate for individuals is 5% for 2015 with no proposed plans to reduce it. The Ohio composite income tax rate is also a flat 4.997% for 2015. As such, if an individual taxpayer has been included in a composite return or had withholding performed by a passthrough entity, he or she is likely paying more Ohio taxes than needed. Ohio nonresidents may claim the deduction by filing personally, even if they are already included on an Ohio composite tax return, and calculating the Ohio SBD available and then applying the 3% graduated tax rate to all Ohio-sourced business income. This is most beneficial to taxpayers who reside in a state that does not impose a personal income tax or imposes an income tax rate that is less than 5%.
"I do not own more than 20% of a passthrough entity, so I do not qualify": Many taxpayers, including Ohio residents, have not taken the SBD because upon reading the SBD form, they thought they must own 20% or more of the passthrough entity to qualify for the deduction. But that is not what the law provides. The law only limits the deduction of compensation and guaranteed payments by 20%-or-more owners. Taxpayers who own less than 20% are still eligible to claim the SBD on qualifying business income.
Another common oversight related to 20%-or-more passthrough business owners is when ownership changes during the tax year. Individual owners may meet the "at least 20% ownership test" anytime during the tax year and, currently, there is not a set number of days or amount of time during the calendar year that an owner needs to meet the test. If an individual owner meets the ownership test at any point during the calendar year, the individual's entire year of compensation or guaranteed payments may qualify as business income.
EditorNotes
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.
