Don’t get caught in a state tax trap: What Ohio’s Corrigan case means for nonresident investors

If you own an interest in a pass-through entity (partnership or S corporation) and plan to sell your interest in the near future, you’re probably interested in learning how you’ll be taxed on any resulting gain, as well as what states have the right to tax that gain.

While most states don’t tax nonresidents on gain from the sale of partnership interests, a growing number of states do tax them under an approach called “look-through” sourcing that generally imposes tax where the partnership operated. 

Even though these look-through sourcing regimes can be complex, you can put yourself on solid footing by understanding the key pieces of the Ohio Supreme Court’s 2016 opinion in Corrigan v. Testa (149 Ohio St.3d 18).

Corrigan v. Testa

Ohio R.C. 5747.212 governs how a nonresident investor must source the gain on a sale of a “closely held” investment in cases when the investor directly or indirectly owned at least 20% of the entity’s equity voting rights at any time during the three-year period ending on the last day of the taxpayer’s taxable year.

Even though pass-throughs are always considered closely held investments, other entities (such as C corporations) can also be closely held if either five or fewer persons own all of the entity’s equity interests with voting rights, or one person directly or indirectly owns at least 50% of the entity’s equity interests with voting rights. For details, see Ohio Tax Ruling IT 2016-01 (October 7, 2016).

Under R.C. 5747.212, rather than simply allocating the gain to the out-of-state investor’s domicile, the gain must be apportioned to Ohio based on the percentage of the entity’s business conducted in Ohio during the three-year period including the taxable year of the sale. In the Corrigan case, the taxpayer, a nonresident of Ohio, contested the imposition of personal income tax on his gain from the sale of his ownership interest in Mansfield Plumbing, LLC (an entity federally taxed as a partnership).

In May 2016, the Supreme Court of Ohio decided in favor of Mr. Corrigan, holding that R.C. 5747.212 was unconstitutional, but only as applied to him. This means that, under the right facts, Ohio’s law and its look-through sourcing method could be constitutionally applied to an Ohio nonresident investor/seller.

Even though the Corrigan case created a somewhat murky state of affairs for nonresidents who are looking for certainty, it emphasized the need for nonresident sellers to closely scrutinize their level of involvement with any pass-through entity they are thinking of selling, and to consider whether they might be considered “unitary” with that entity.

How Wipfli can help

As explained in our previous article, a growing number of states are taking look-through sourcing positions similar to that in the Ohio Corrigan case. As a result, we recommend seeking guidance from a Wipfli advisor before you sell your pass-through entity interest. Contact one of our dedicated tax professionals today to get started.