Ohio cannot tax nonresident's income from the sale of intangible asset
State lacks jurisdiction under due process clause
TAX ALERT |
On May 4, 2016, the Supreme Court of Ohio issued its decision in Corrigan v. Testa, holding that the state’s utilization of the income sourcing provisions under O.R.C. 5747.212 to tax a nonresident individual on the sale of his ownership interest in a limited liability company that did business in Ohio violated the due process clause of the United States Constitution.
Mr. Corrigan is a nonresident Ohio taxpayer who owned a 79.29 percent ownership interest in Mansfield Plumbing, L.L.C., a pass-through entity engaged in the production of sanitary ware, which was headquartered in Ohio, owned plants in Texas and California, and did business throughout the United States and many foreign countries. As a member of Mansfield Plumbing’s board of managers, Mr. Corrigan spent more than 100 hours per year at the business’ Ohio headquarters for board meetings and presentations, but left the day-to-day management of the company to employees of the business. In 2004, Mr. Corrigan sold his entire interest in Mansfield Plumbing to a third party, Ceramicorp, Inc., and realized approximately $27 million in gain. In filing his Ohio nonresident personal income tax return for tax year 2004, Mr. Corrigan treated the entire amount of this gain as allocable outside Ohio on the grounds that the gain from his sale of his intangible ownership interest in Mansfield Plumbing should be sourced solely to his state of residence.
The Ohio Department of Taxation audited Mr. Corrigan’s 2004 return, and determined that he had failed to source any of the gain from the sale of his ownership interest in Mansfield Plumbing to the state, as required under O.R.C. 5747.212. O.R.C. 5747.212 provides that capital gain realized by a nonresident individual owner of a 20 percent or greater interest in a pass-through entity (or closely held C corporation) during a three-year period including the taxable year of the disposition was apportionable for individual income tax purposes to Ohio based on the percentage of the entity’s business conducted in the state during the three-year testing period. Recalculating tax due based upon the apportionment percentages computed under this provision, the department assessed Mr. Corrigan approximately $847,000 in additional 2004 tax and interest. Mr. Corrigan paid the state $100,000, and then subsequently filed a refund claim, arguing that the amount had been paid in error because the assessment violated both the due process clause and the commerce clause of the United States Constitution.
The department rejected Mr. Corrigan’s claim, and he appealed to the Ohio Board of Tax Appeals (BTA), raising the same constitutional arguments. The BTA affirmed the decision of the department, noting in its decision that it lacked the jurisdiction to declare the application of O.R.C. 5747.212 to Mr. Corrigan unconstitutional and that it could make no findings in relation to that claim other than to acknowledge it. Mr. Corrigan subsequently appealed to the Supreme Court of Ohio, continuing to seek relief on constitutional grounds.
The Supreme Court of Ohio held in favor of Mr. Corrigan, reversed the decisions of the BTA and department, and ordered the department to pay Mr. Corrigan’s refund claim. In reaching this holding, the court noted that, under the due process clause of the United States Constitution, the department could not impose a tax on Mr. Corrigan unless it had the requisite jurisdictional connection to both Mr. Corrigan and the activity the state sought to tax. The court found that, while the state clearly had jurisdiction over Mr. Corrigan based on his activities within the state, it did not have jurisdiction over Mr. Corrigan’s sale of his ownership interest in Mansfield Plumbing because the intangible property sold was located at Mr. Corrigan’s state of residence and the transaction did not involve the purposeful availment of Ohio’s market as required under the due process clause. In reaching this conclusion, the court soundly rejected the department’s argument that purposeful availment was established by the fact that some portion of the value of Mr. Corrigan’s ownership interest had been generated by Mansfield Plumbing’s business activities within the state, and clearly distinguished between the taxability of activities of a business within the state and activities of a nonresident owner outside of the state. Because the Supreme Court of Ohio decided the case on due process grounds, it did not address Mr. Corrigan’s commerce clause arguments.
Nonresident individuals that have paid Ohio personal income tax on gain from the sale of an ownership interest in a pass-through entity because of the application of O.R.C. 5747.212 should review this decision and consider filing a refund claim. Additionally, individuals paying personal income tax as nonresidents in other states with similar laws that impose tax on income from sales of intangible property should review the reasoning behind the Supreme Court of Ohio’s decision and consider whether filing a similar refund claim under the due process clause would make sense in those jurisdictions.