Posted by Matt Tomko and Hannah Prengler
On June 14, 2022, Ohio Governor Mike DeWine signed Senate Bill 246 (S.B. 246) into law, giving businesses in the state potential relief from the federal tax burden created by the Tax Cuts and Jobs Act’s (TCJA) $10,000 cap on state and local tax deductions.
Under this new legislation:
- Ohio pass-through entities may elect to be taxed at the entity-level, thereby allowing a deduction from federal income of the tax paid.
- Owners of electing pass-through entities will receive a refundable credit on their personal Ohio tax return in proportion to the tax paid.
Ohio’s new pass-through entities tax is effective for tax years beginning in 2022 and forward.
Ohio Pass-Through Entity Tax Election
Why should Pass-Through Entities Consider This Election?
A targeted response to the $10,000 itemized deduction cap for state and local taxes, the signing of SB 246 means Ohio joins 28 other states allowing pass-through entities the ability to pay tax at the entity-level and owners to receive a corresponding deduction from federal income.
Two key items to note:
- The workaround allows owners to deduct more than the annual $10,000 itemized deduction state tax cap.
- Ohio requires an addback of Ohio pass-through entity taxes deducted from federal income when calculating the Ohio pass-through entity tax.
Those that stand to benefit the most from this new election include:
- Individual owners of closely held entities primarily operating in Ohio,
- Pass-through entities with significant Ohio sourced income, and
- Pass-through entities with individual owners residing in states with no income tax.
Who is an Eligible Ohio Pass-Through Entity and Owner?
Pass-through entities are not ordinarily taxed at the entity level, meaning taxable income they generate is passed through to the owners, taxing their proportionate share of income at the owner’s level. Under SB 246, eligible pass-through entities include S corporations, partnerships or limited liability companies not taxed as a corporation. Disregarded entities are not permitted to make the pass-through entity election at their level, but a qualifying parent entity may elect.
Eligible owners include any person that is a partner, member, shareholder or investor in an electing pass-through entity.
What is the Ohio Pass-Through Entity Tax Rate?
Qualifying entities making this election are subject to income tax at the entity-level on income apportioned to Ohio. The Ohio pass-through entity income tax rate for tax years beginning in 2022 is 5%. Beginning in 2023 the tax rate will match the Ohio business income rate, currently 3%.
Additionally, electing pass-through entities are required to make quarterly estimated tax payments due on the 15th day of the fourth, sixth, ninth and 13th month. It also appears that Ohio will allow pass-through entities that made composite or withholding estimates to move those funds to/from their pass-through entity account.
How Does an Eligible Pass-Through Entity Make the Ohio Election?
Entities will make an annual irrevocable election with the filing of their entity return, which is anticipated to be due on April 15 each year. We are awaiting further guidance from Ohio regarding whether the election will be a check box on Ohio’s withholding return, or if a new 2022 Ohio pass-through entity return will be created.
Other Considerations for Electing Pass-Through Entities
Owners of electing entities must continue to evaluate how the refundable pass-through entity credit will impact their personal tax liability and refund opportunity. Owners during 2022 must evaluate the impact of the Ohio business income deduction and lower 3% rate when filing personally and the offset of the owner’s pass-through entity tax credit. Many nonresident owners realizing Ohio sourced income less than $250,000 ($125,000, married filing separate) may qualify to request a refund if the pass-through entity credit exceeds their Ohio personal tax liability.
Business Income Deduction on Equity Sales
On June 1, 2022, Ohio legislators also passed H.B. 515, an important bill Governor DeWine signed into law on June 24, 2022.
Many pass-through entity owners have realized significant tax savings when selling a business thanks to Ohio’s business income deduction. However, after the 2016 Corrigan decision the Ohio Tax Department began taxing gains on the sale of businesses differently. Owners that realized a gain from the sale of business assets were able to apply the $250,000 business income deduction and 3% tax rate on income greater than the $250,000 ($125,000 deduction when married filing separate). However, gains by owners that sold their equity in a pass-through entity were classified as non-business income and subject to the standard personal income tax rates nearing 5% in past years (recently decreased to a top rate of 3.99% effective in 2021).
Ohio has aggressively audited Ohio residents who sold their LLC interests and applied the business income deduction and the reduced business income deduction tax rate when originally filing their Ohio personal income tax returns for tax year 2018 and forward. Further, Ohio also pursued owners that sold their business through a 338(h)10 or similar transactions, whereby their sale of equity is treated as the sale of assets for federal income tax purposes, although Ohio had conformed to this federal treatment as an asset sale in years prior to the Corrigan decision. Ohio instead took a position that these equity sales were subject to the higher non-business income tax rates, and disallowed the $250,000 business income deduction on the gain.
With the clarifying legislation signed into law on June 24, 2022, Ohio will treat the sale of ownership interests in the below circumstances as business income:
- If the seller “materially participates” in the activities of the business within five taxable years preceding the interest being sold; or
- When the sale is treated as a sale of assets for federal income tax purposes.
This is great news for eligible Ohio owners selling their equity in the future, and certainly for those currently under audit for a prior period equity sale. This legislation is meant to clarify the existing law and, as such, may be applied retroactively by qualifying owners currently under audit or appealing a prior Ohio assessment on their equity sale.
While this is welcomed news for Ohio resident pass-through entity owners, the legislation will likely create Ohio tax concerns for nonresident owners previously allocating their entire equity sale gain to their state of domicile. Ohio will likely begin pursing nonresident owners they did not purse in recent years. Nonresident owners that sold or intend to sell equity in a pass-through entity in which they materially participate, as well as 20% or greater nonresident owners considered tainted under ORC 5787.212, must revisit their past and future Ohio sourcing and business versus nonbusiness income positions.
With the passage of S.B. 246 and H.B. 515, legislators continue to make Ohio’s tax system more competitive in attracting and retaining businesses and their owners within the state. Additional states, including Michigan and Pennsylvania, have legislation pending to similarly reduce their tax rates under mounting pressure from Ohio and other Midwest states with more favorable tax policies.
Contact Matt Tomko at email@example.com, Hannah Prengler at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.