Retroactive state tax legislation and interpretations: Ohio update

Editor: Brian Myers, CPA

Taxpayers and advisers bristle at the notion that a state or local governing body can push through legislation reinterpreting the past. Taxpayers annually in good faith invest significant time and resources analyzing their multistate activities, the corresponding tax statutes and regulations, relevant policy documents, and recent rulings or litigation affecting their tax responsibilities. Rarely does retroactive tax legislation benefit a broad group of taxpayers; more often, it creates uncertainty and financial hardship for taxpayers. Even more astounding is that retroactive interpretations and legislation can create significant exposures for business owners years after selling their business.

Retroactive tax legislation dates to the early 1900s, when Congress passed the first income tax with the 1913 Revenue Act, P.L. 63–16, which was not signed until October 1913 by President Woodrow Wilson. During the 1930s the Supreme Court heard several retroactive tax cases, and the Court upheld retroactive tax legislation in nearly each decision. During this time, the Court adopted a standard of a retroactive tax law being unconstitutional if its application “is so harsh and oppressive as to transgress the constitutional limitation” of due process under the 14th Amendment.¹ The Supreme Court again addressed the constitutionality of retroactive tax legislation in 1994. In Carlton, the Court unanimously held that retroactive tax laws did not violate the constitutional prohibition on ex post facto legislation, provided their retroactive application was “supported by a legitimate legislative purpose furthered by rational means.”²

At issue in Carlton was whether a retroactive estate tax law change violated the taxpayer’s due–process rights. In holding that it did not, the Court noted that the provision as originally enacted was intended to create an incentive for stockholders to sell their companies to their employees, but the absence of a decedent–stock–ownership requirement resulted in the deduction’s broad availability to virtually any estate, at an estimated loss to the government of up to $7 billion in anticipated revenues. “Thus, Congress undoubtedly intended the amendment to correct what it reasonably viewed as a mistake in the original provision,” the Court stated.³ The Court added that the amendment’s retroactive application was rationally related to its legitimate purpose, since Congress acted promptly in proposing the amendment within a few months of its original enactment. The Court therefore upheld the retroactive tax legislation, declaring it was enacted for a “legitimate legislative purpose furthered by rational means” and that the legislature “acted promptly and established only a modest period of retroactivity.”⁴ Justice Sandra Day O’Connor concurred in Carlton,as the retroactive period was only one year, but stated that periods greater than that would raise “serious constitutional questions” under the Due Process Clause of the Fifth Amendment.

This column discusses Ohio’s 2022 retroactive tax legislation, its impact on existing law, and how this clarifying legislation affected taxpayers who sold their business years prior to the law’s enactment.⁵ The Ohio Constitution, Article II, Section 28, states, “The general assembly shall have no power to pass retroactive laws, or laws impairing the obligation of contracts; but may, by general laws, authorize courts to carry into effect, upon such terms as shall be just and equitable, the manifest intention of parties, and officers, by curing omissions, defects, and errors, in instruments and proceedings, arising out of their want of conformity with the laws of this state.”

The clarifying legislation

Ohio passed the 2022 law to clarify that “business income” includes sales of equity interests when (1) the sale is treated as the sale of assets for federal income tax purposes; or (2) the seller “materially participated” (as defined in federal Temp. Regs. Sec. 1.469–5T) in the activities of the business during the tax year of the sale or any of the five tax years prior to the sale.⁶

The bill’s first provision clarified the state’s conformity with federal laws allowing for qualifying equity sales to be treated as sales of assets. In practice, Ohio had traditionally conformed to the federal income tax treatment of Internal Revenue Code Secs. 338(h)(10) and 336(e), even for sales of single–member limited liability company (LLC) interests. Ohio began to question the state’s conformity only after the Department of Taxation’s loss in the Corrigan decision (described below).⁷

The bill’s second provision created a standard to evaluate when an owner’s activities would lead to the owner’s sale of equity being classified as business income. Ohio law retroactively and prospectively will evaluate an owner’s material participation in the business pursuant to the federal regulation’s set of seven material–participation provisions, which includes such considerations as whether an owner participates in the activity for more than 500 hours during the year or the owner’s activity is on a regular, continuous, and substantial basis during the year.⁸

Ohio described the legislation as a curative measure to clarify existing law and stated that the legislation would be applied retroactively to all open audits, petitions for reassessment, refund applications, and even pending appeals.⁹ While the first measure does appear to clarify Ohio’s conformity with federal laws, the second measure is questionable as to whether the material–participation standard is new or clarifying when Ohio considers whether unity exists for an owner selling their equity interest.

Ohio’s history of taxing equity sales

For more than 20 years, Ohio business income has included gain or loss from transactions, activities, and sources in the regular course of a trade or business; from real, tangible, 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; as well as income, including gain or loss, from a partial or complete liquidation of a business, including gain or loss from the sale or other disposition of goodwill or equity of a business.¹⁰ Nonbusiness income, on the other hand, has been defined as all income other than business income.¹¹

The clarifying legislation was in response to an Ohio Court decision six years prior. In 2016, the taxpayer in Corrigan successfully challenged the constitutionality of Ohio Rev. Code Section 5747.212, which taxed nonresident owners selling equity of businesses operating in Ohio.¹² Rev. Code Section 5747.212 provides that an investor that directly or indirectly owns 20% of a passthrough entity during the current or any of the two preceding tax years must apportion any income, including gain or loss, realized from each sale, exchange, or other disposition of an equity interest.¹³ In Corrigan, Ohio recast intangible income traditionally sourced to a taxpayer’s state of domicile as apportionable business income.

Patton R. Corrigan, a Connecticut resident, owned 79.29% of an LLC operating in Ohio. Corrigan’s stance was that his activities were limited to that of an investor; he sat on the LLC’s board of managers and visited Ohio for board meetings, but he did not participate in the day–to–day management of the business. The Ohio Department of Taxation did not pursue the extent of Corrigan’s activities with the business but instead relied on a plain reading of Rev. Code Section 5747.212(B) that each entity “shall apportion any income, including gain or loss, realized from each sale, exchange, or other disposition of a debt or equity interest.”

Ultimately, the Supreme Court of Ohio concluded that Ohio’s law was unconstitutional — but only as applied to Corrigan’s facts. The court’s decision followed the traditional position that a gain derived from the sale of equity was an intangible asset that should be classified as nonbusiness income allocable to the taxpayer’s state of domicile. The court was worried that taxpayers may try to argue the reverse, that a sale of assets should now be recharacterized as a sale of equity. The court left a few breadcrumbs within the notes of its decision, implying it might have ruled differently had the department shown that Corrigan’s activities rose to a unitary level with the business.

Shortly after this decision, the Ohio Department of Taxation issued an information release offering guidance to nonresident taxpayers who filed Ohio returns apportioning their intangible gain under Rev. Code Section 5747.212 on requesting refunds.¹⁴ The department instead began targeting Ohio residents who sold equity. Ohio residents have always been required to report all taxable income. However, beginning in 2013, Ohio had begun offering the business income deduction (BID) on business income received from passthrough entities.¹⁵ Ohio’s 2016 top personal tax rate at the time of the Corrigan decision was nearly 5%.¹⁶ Ohio’s eligible BID income was subject to lower tax rates; currently, the first $250,000 of qualifying BID income is taxed at 0%, and any additional business income above that is taxed at a reduced 3%.¹⁷ However, at the same time the department began accepting refund claims on Ohio income tax paid on equity sales by nonresidents, it began assessing Ohio residents with equity sales at the higher 5% nonbusiness income tax rate.

2024 taxpayer challenge

During May 2024, Garry Rayant and Kathy Fields filed an appeal with the Ohio Board of Tax Appeals regarding the constitutionality of Rev. Code Section 5747.212 as applied to their facts, pursuant to the Corrigan decision.¹⁸ The taxpayers were California residents who during 2018 sold a 25% interest in their skin care products business that also had operations in Ohio. The taxpayers originally apportioned the gain on their equity sale to Ohio pursuant to Rev. Code Section 5747.212 but applied Ohio’s higher nonbusiness income tax rate.

The taxpayers subsequently filed a refund claim requesting an Ohio tax refund of $719,492, reflecting an allocation of the intangible gain to their state of domicile, California. While not clearly documented in the case files, it is plausible the taxpayers came across the department’s Corrigan guidance on how to request a refund on intangible equity sales. In March 2024, the Ohio tax commissioner issued a final determination partially denying the taxpayers’ 2018 refund claim. The tax commissioner found the capital gain should be apportioned to Ohio but at the lower BID rate, which amounted to a refund of $31,178.¹⁹

The tax commissioner based her determination on the presumption that Rev. Code Section 5747.212 was constitutional as applied to the taxpayers’ facts. Further, the tax commissioner stated that even if Rev. Code Section 5747.212 was found to be unconstitutional, the taxpayers’ 2018 gains would be apportioned pursuant to Rev. Code Section 5747.01(B), due to Ohio’s clarifying legislation signed in June 2022. The department documented that Fields materially participated in the company’s day–to–day management by continuing to develop products and acting as a spokesperson for the business.

Tax practitioners were closely watching to see how the Board of Tax Appeals would rule in the first constitutional challenge since the enactment of Ohio’s clarifying retroactive legislation. While the Department of Taxation lacks jurisdiction to determine a statute’s constitutionality, would the Board of Tax Appeals provide any meaningful guidance on its constitutionality? Unfortunately, the board closed the docket in October 2024 after the taxpayers and the tax commissioner agreed to a settlement. While the terms of the settlement are unknown, questions remain as to whether Ohio’s retroactive legislation could endure a future due–process challenge similar to Carlton. Would the U.S. Supreme Court similarly view Ohio’s 2022 legislation as timely and for the purpose of merely correcting the state’s original tax provisions on equity sales?

Many Ohio resident sellers with audits and appeals in process during fall 2022 were grateful to see their cases resolved favorably through Ohio’s application of the lower BID tax rates on their capital gains. But many nonresident taxpayers, like Rayant and Fields, instead faced a harsh reality that Ohio would seek to tax the gain on their equity sales occurring in prior years. Even more problematic is that Ohio’s clarifying legislation created additional business income considerations that sellers likely did not even know to consider previously. For example, Rev. Code Section 5747.212 addresses 20%-and–greater owners of a business. Pre–Corrigan, the Department of Taxation classified all capital gains received pursuant to this section as business income subject to the lower BID rates. However, what is not apparent is whether Ohio will continue that practice or if the Department of Taxation will begin evaluating whether an owner is unitary with the business to avail themselves of the lower BID rates. The new material–participation standard was included in the definition of “business income” at Rev. Code Section 5747.01(B), which led to the question of whether Ohio will pursue less–than–20% nonresident owners to tax their Ohio capital gains on an equity sale.

Hindsight less than golden

During a transaction, sellers have a short window to evaluate the tax consequences of an equity or asset sale. Frequently, a buyer will negotiate reimbursing a seller for certain tax costs associated with a buyer’s preferred transaction structure. However, when tax laws and interpretations change post–transaction, sellers of a business are often the most vulnerable, as they are unable to go back in time to rewrite transaction terms. Taxpayers on either side of a transaction are unable to adequately plan for statutory changes that have simply not yet occurred. However, could we see parties to a transaction consider incorporating terms that allow for reimbursement of additional tax costs, such as when a regulatory body audits and disagrees with a seller’s commonly accepted tax position during the statutory lookback period?

The Corrigan decision encouraged residents and nonresidents alike to closely evaluate their agreement terms and related tax risks. Some Ohio residents even moved to another state in an attempt to avoid Ohio’s tax on their capital gain altogether. But no taxpayer can prepare for the financial impacts of legislation occurring years after an income event. Taxpayers may have reinvested these funds in a new business or perhaps used their gains to pay down existing debt. Retroactive legislation to allow for reduced taxes or to expand exemptions is considered reasonable, but passing legislation that imposes “harsh and oppressive” tax consequences on taxpayers with transactions occurring in the past is an intolerable practice.

Footnotes

¹Welch v. Henry, 305 U.S. 134 (1938).

²Carlton, 512 U.S. 26 (1994).

³Id.

⁴Id.

⁵Ohio Amended S.B. 246, H.B. 515, 134th General Assembly.

⁶Ohio Rev. Code §5747.01(B).

⁷Corrigan v. Testa, 149 Ohio St. 3d 18, 2016-Ohio-2805.

⁸Temp. Regs. Secs. 1.469-5T(a)(1) and (7).

⁹Ohio Legislative Service Commission, “Final Fiscal Note & Local Impact Statement,” H.B. 515 (June 14, 2022).

¹⁰Ohio Rev. Code §5747.01(B).

¹¹Ohio Rev. Code §5747.01(C).

¹²Corrigan v. Testa, 149 Ohio St. 3d 18, 2016-Ohio-2805.

¹³Important note: Ohio will also pursue qualifying owners of closely held corporations, defined as an entity having five or fewer owners or when one person owns 50% or more of an entity’s equity with voting rights.

¹⁴Ohio Department of Taxation, IT 2016-01 (Oct. 7, 2016).

¹⁵Ohio H.B. 59, 130th General Assembly.

¹⁶Ohio personal income tax, 2016—2018, graduated top rate 4.997%.

¹⁷Ohio Rev. Code §5747.01(A)(28).

¹⁸Rayant, No. 2024-477 (Ohio Board of Tax Appeals 4/3/24) (final determination).

¹⁹Id. The final determination stated the Ohio refund was issued in April 2020.

Contributors

Hannah M. Prengler, CPA, is a state and local tax partner with Cohen & Co Advisory LLC. Brian Myers, CPA, is a partner at Crowe LLP in Indianapolis. Prengler is a member, and Myers is chair, of the AICPA State and Local Taxation Technical Resource Panel. For more information about this column, contact thetaxadviser@aicpa.org.