Constitutional Limitations on State Taxing Authority: The Capital Gain Controversy of Ohio Pass-Through Entity Interests of Nonresidents November 28, 2016

By Jonathan C. Wolnik

corrigan-v-testa_v5“No principle is better settled than that the power of a state, even its power of taxation, in respect to property, is limited to such as within its jurisdiction.”  –The Supreme Court of Ohio

Certainly the above statement presents a powerful limitation on the taxing authority of a state.  These words have often been repeated throughout Ohio case law and appeared yet again in Corrigan v. Testa, a case that limited an Ohio tax statute’s reach beyond state borders.

Corrigan v. Testa presents the plight of a Connecticut investor who owned the majority controlling interest in an Ohio-based limited liability company.  The taxpayer, Patton Corrigan, sold his interest in 2004 which produced a capital gain of $27.5 million.  Because Corrigan was not domiciled in Ohio, his tax return allocated the entire gain outside of the Buckeye State, effectively denying Ohio any tax revenue from the sale.  By the time 2009 rolled around, Ohio assessed Mr. Corrigan with an unpaid tax liability of approximately $850 thousand on the gain and litigation between the parties quickly followed.  Ohio’s taxing authority relied on O.R.C. §5747.212 to specifically tax the gain on the sale of a business interest in which the taxpayer held an interest of 20% or greater for the prior three years, including the transaction’s taxable year.  Ohio argued that the text of statute did not specifically exempt taxpayers domiciled outside of Ohio, so they were therefore subject to its rule.  Corrigan’s counterargument claimed that the entirety of the statute was unconstitutional because it exceeded constitutional limitations on the state’s taxing authority.

The Supreme Court of Ohio recognized that Corrigan’s controversy is governed by both the Commerce Clause and the Due Process Clause of the Constitution.  Though these Clauses are distinct, they often overlap.  The Due Process Clause requires a link – some minimum connection – between the state and the property it seeks to tax.  Additionally, when tax is levied on an activity, the tax must be connected to the activity itself.  A nonresident conducting business within a state is clearly subject to business-related taxation because they have availed themselves to the benefits of operating within the state borders.  However, the Supreme Court of Ohio viewed the sale of Corrigan’s interest not as business activity, but rather as a transfer of an intangible property by a nonresident.  The Court found this to constitute nothing more than an indirect correlation to Ohio under the circumstances present and it was not considered enough of a connection to bring the business sale under Ohio’s taxing authority.

Because the taxpayer won on his merits under the Due Process Clause, the Court did not spend time navigating through a formal Commerce Clause analysis.  Thus, the full effect of the Commerce Clause on a statute like O.R.C. §5747.212 remains open.  Also of importance, the Court did not facially invalidate the entirety of §5747.212.  Rather, the Court’s opinion is strictly limited to Mr. Corrigan, and in theory, others that are similarly situated as nonresidents domiciled outside of Ohio that may be fighting the taxation of certain capital gains resulting from the sale of business interests.

In response to the Supreme Court decision, the State of Ohio’s Department of Taxation published guidance catalogued as IT 2016-01 – Guidance Relating to an Equity Investor’s Apportionment of a Gain from the Sale of a Closely-Held Business.  Among other things, the publication recognizes that the Court followed the general rule of law stating that a capital gain derived from the sale of an intangible asset is allocable to the taxpayer’s state of domicile as nonbusiness income.  But, the guidance also underscores that the holding of the Supreme Court of Ohio was explicitly restricted to Mr. Corrigan.  Despite the noted restriction on the holding, the published guidance still provides certain considerations for taxpayers that have already filed returns containing transactions subjected to O.R.C. §5747.212.  As such, there may be opportunities to amend and/or file for refunds, depending on the specific facts and circumstances of each taxpayer.

If you have recently disposed on an interest in an Ohio pass-through entity (such as a partnership, S-corporation, or an LLC) and question the tax treatment of the transaction, please contact our office.  We are happy to review the facts and circumstances surrounding your transaction and provide guidance on achieving a proper resolution.

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