Considering retirement & selling your business? HB515 may determine income tax treatment

On June 24, 2022, Governor DeWine signed 2022 House Bill 515 (“HB 515”), which codifies two distinct situations in which the sale of an equity or ownership interest in a business will be considered business income.

Traditionally, Ohio law has treated business and nonbusiness income differently. For business owners residing in Ohio, nonbusiness income is taxed at a graduated rate, which can be as high as 3.99% if over $110,650. Meanwhile, business income is taxed at a flat rate of 3%. Conversely, for business owners residing in states outside of Ohio, nonbusiness income is usually not taxed in Ohio. However, under a special statute, Section 5747.212 of the Ohio Revised Code, they may be subject to the 3% tax on business income if they sell any closely-held, pass-through businesses that they are actively involved in and operate on a day-to-day basis. These types of businesses are LLCs, S corporations, or partnerships with five or fewer persons owning all of the equity interests (with one person owning at least 50% of the equity interests themselves). Under Section 5747.212, any gains from the sale of such business is considered business income, and the amount of that gain subject to Ohio’s 3% tax on business income will hinge on the percentage of the entity’s business performed in Ohio for the preceding three years.

As this treatment makes a difference for nonresident business owners, HB 515 clarifies precisely when a nonresident business owner would be subject to Section 5747.212. Now, the definition of “business income” under Ohio’s tax code includes “the sale of an equity or ownership interest in a business”, which means sales to which either or both of the following apply:

1. The sale is treated for federal income tax purposes as the sale of assets
2. The seller materially participated in the activities of the business during the year of the sale or during any of the five preceding tax years

In either of these two situations, gains from the sale would generally be considered business income. While this may be a disappointment to nonresidents operating businesses in Ohio, as it could subject them to the 3% business income tax on the sale of their business in certain situations, this treatment also makes the gains eligible for the Ohio Business Income Deduction (Ohio BID). The Ohio BID permits taxpayers to exclude the first $125,000 of business income—or the first $250,000 of business income if filing jointly—from the 3% business income tax, with any amount over that threshold being subject to the 3% business income rate.

Although HB 515 did not become effective until September 21, 2022, HB 515 was meant to clarify the existing law, which means it likely retroactively applies to sales that have already occurred. This may enable those who did not qualify for the Ohio BID over the past few years to file a refund claim with the State of Ohio. Additionally, however, although HB 515 is favorable for Ohio business owners, there is still some uncertainty for certain types of transactions involving out-of-state business owners that sell their business equity. If you are considering selling your business in the future, you may want to consult your tax professional to determine if you are eligible for the Ohio BID due to HB 515, or have any ability to establish eligibility before the sale occurs.