Residency and the Sale of a Flow-Through Entity

Editor’s note: this is the second of two articles exploring the potential tax implications relating to residency Read the first one here.

For owners of flow-through entities looking to sell their business, selling their ownership interest versus assets of the business is a significant decision with potential tax implications related to residency.

While buyers usually prefer to buy assets, selling an ownership interest instead can be done in certain circumstances. In these instances, the owner is selling an intangible asset, and many states view this as being taxable only in the owner’s state of residency.

 

But not all states share this view, meaning that sales of flow-through entity ownership interests can create taxable income outside the state of residency, depending on where the entity does business. It’s important to note that both Ohio and Michigan are looking not at owner residency, but at the operations of the business to determine taxability. This means, for example, that the strategy of a pre-sale move to Florida, where the state tax rate is zero, may not work to minimize tax on sale.

Let’s take a closer look at how exactly Ohio and Michigan are handling this and what it would mean for owners of flow-through entities looking to sell their business.

  • Ohio – This state has long had in place statutory law requiring sales of certain ownership interests in qualified flow-through entities to be taxable in Ohio regardless of residency of the owners. The amount taxable in Ohio is determined by applying an average of the entity’s apportionment percentage from the year of sale and two prior years to the gain on the sale.

    This provision applies if the entity is owned by five or fewer individuals, estates, or trusts, with at least 50 percent of the ownership being held by one of those owners. If the entity qualifies under that definition, then each owner owning 20 percent or more of the entity at any time during the year of the sale or the two prior years must apply the special rule of sourcing the gain on sale based on the operations of the business in Ohio.

    There were two challenges to this law in 2016, with the Ohio Supreme Court ruling in one instance that the law was unconstitutional as applied to the taxpayer, and in the other instance that the law was valid. The different opinions hinged somewhat on different taxpayer facts, but some of the justices felt the first ruling of unconstitutionality should be overturned. In sum, there is not a clear path forward for an owner selling their Ohio business to be able to avoid Ohio tax by establishing residency elsewhere, but it appears there is at least a crack that might be able to be slipped through if the fact pattern is right.

 

  • Michigan – Compared to Ohio, Michigan’s statutory law on taxation of pass-through entities and their owners is very sparse. There is nothing in the law directly addressing the issue of gains on sales of ownership interests, which apparently has led taxpayers to take whichever position benefits them. For Michigan residents, this would be to say that the sale of an ownership interest should be apportioned based on business activity; for non-residents (particularly those in low- or no-tax states) this would be to say the sale is of an intangible asset that should be taxed based on residency.

The Michigan Department of Treasury wants to push taxpayers in one direction to avoid this issue, so they are about to issue a Revenue Administrative Bulletin (RAB) saying that gain on the sale of an ownership interest in a flow-through entity is apportioned based on business operations, not simply taxable based on the residency of the owner. Treasury is basing its position on a Michigan Court of Appeals case from 2014, Aikens v. Department of Treasury. In this case, the Michigan resident taxpayers sold their interest in a limited partnership that owned a shopping mall in Florida. The Court sided with the taxpayer in saying this was business income not subject to Michigan tax, because the business operations were outside of Michigan.

However, it should be known that neither that case nor an RAB create binding law to which taxpayers must adhere. The upcoming RAB simply states the Treasury’s position on the issue. This means that non-resident taxpayers could still take a position that their sale of an ownership interest in a Michigan business is the sale of an intangible, taxable only in their state of residency. There is no requirement to disclose taking a position contrary to an RAB, but if the return were to be examined, the Treasury would obviously take the contrary position and the matter would have to go to the courts.

Residency planning for state income tax purposes still makes a lot of sense and will likely never go away. But in these two areas, taxpayers need to realize that residency may not matter as much. Rehmann’s state and local tax advisers are available to navigate clients through the nuances to save tax where possible and avoid risk where necessary.

Published in Tax

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