Earlier this year we reported on a Massachusetts case where a court, (wrongly, we think), determined that a nonresident taxpayer could be taxed on the sale of stock in a business that he founded and ran in the state. Turns out this issue might be contagious……a few months ago, Ohio successfully made a similar argument. In a Final Determination issued on March 28, 2024, the Ohio Tax Commissioner denied Claimants Dr. Garry Rayant and Dr. Kathy Fields’s $719,492 refund application filed with their amended 2018 Ohio tax return. The Claimants sold 25% of their interest in Rodan & Fields, a skincare products company, and originally apportioned their resulting capital gain income to Ohio in calculating their Ohio nonresident credit. On their amended return, however, they allocated this capital gain income to California, increased their nonresident credit, and claimed a refund.
On their original return, the Claimants apportioned the income to Ohio under § 5747.212 of Ohio’s Revised Code, which according to the Tax Commissioner “requires a taxpayer to apportion income from the sale of [their] equity interest, using the entity’s apportionment ratio, if the taxpayer owns at least 20% of the entity at any time during the three-year period ending on the last day of the taxpayer’s taxable year.” But now the Claimants argue that § 5747.212 is unconstitutional as applied to them under Corrigan v. Testa, 149 Ohio St.3d 18 (Ohio 2016), and contend that they should have instead allocated the income to California as nonbusiness income under § 5747.20.
Our team wrote an article on Corrigan v. Testa back in 2016 after that case was decided. As outlined there, the Supreme Court of Ohio determined that Ohio could not tax Mr. Corrigan’s capital gain income from the sale of his 80% interest in an LLC doing business in Ohio, as it held that “R.C. 5747.212 as applied to [Mr.] Corrigan, violates the Due Process Clause of the Fourteenth Amendment to the United States Constitution.” Corrigan, 149 Ohio St.3d at 19. The court cited the “bedrock principle” of the Due Process Clause, which is that “a [s]tate may not tax value earned outside its borders,” and found that Ohio’s assessment of tax could not “be sustained under the basic due-process test for the exercise of proper tax jurisdiction.” Id at 21-22 (citation omitted).
But here, the Ohio Tax Commissioner was not persuaded by Dr. Rayant and Dr. Fields’s argument, initially stating that “the Tax Commissioner lacks jurisdiction to determine a statute’s constitutionality,” that “legislative enactments of the Ohio General Assembly are entitled to a strong presumption of constitutionality,” and that “[t]he Ohio Supreme Court . . . adheres to the presumption the Tax Commissioner’s application of state tax laws is constitutional.” And with regard to Corrigan specifically, the Commissioner explained that while § 5747.212 was found to be unconstitutional as applied to Mr. Corrigan, it was not found to be unconstitutional on its face, and therefore the Commissioner viewed “the holding in Corrigan [to have] no bearing on this matter.” Thus, the Commissioner concluded that “R.C. 5747.212 is presumed constitutional and . . . was properly applied to the [C]laimants’ capital gains, as reflected on their original return.”
The Tax Commissioner stated that the facts in the two cases are “materially different,” as the taxpayers had different relationships with their respective companies. While Mr. Corrigan was “an investor who was not involved in the active management of his company,” Dr. Fields founded Rodan & Fields, “developed products for the company, acted as a spokesperson for the company, . . . is featured prominently on the company’s website,” and was an active investor. Additionally, the Claimants were board members before and after the sale and received a large guaranteed payment from Rodan & Fields.
Furthermore, the Commissioner explained that “even if R.C. 5747.212 is unconstitutional as applied to the [C]laimants, the capital gain at issue is business income . . . and thus would be subject to apportionment . . . .” Ohio modified its definition of “business income” in 2022 to include “the sale of an equity or ownership interest in a business,” which includes “a sale treated for federal income tax purposes as an asset sale, or . . . a sale where the seller materially participated, as described in 26 C.F.R. 1.469-5T, in the business during the year of the sale or during any of the five preceding years.” The Commissioner then cited most of the facts identified above describing the Claimants’ relationship with Rodan & Fields in finding that the Claimants “materially participated” in the company and that, therefore, the gain from the sale of their interest is business income and subject to apportionment under this reasoning as well.
Is this a sign of things to come? Will we see more states jumping on this bandwagon? New York, the nationwide leader in chasing after nonresidents, has not yet gone as far as Ohio and Massachusetts by directly taxing a nonresident’s intangible income in a typical business sale. But they seem to be inching in that direction. State law already requires the allocation of gain from the sale of an entity interest where the entity’s assets are comprised of significant real property. N.Y. Tax Law § 631(b)(1)(A)(1). Also, recent legislation (covered in Noonan’s Notes) requires the apportionment of gain from the sale of partnership interests in certain situations as well. So, taxpayers and their advisors need to be on the lookout—states are getting more aggressive with nonresidents, especially those states that are losing taxpayers in droves!
