Tax Analysts Blog

A Due Process Win for Taxpayers

Posted on May 18, 2016

You don't see many due process clause cases arising from state taxation. Nor do you see many victories for taxpayers in those cases. A taxpayer won recently in the Ohio Supreme Court. The case, which was correctly decided, hinges on facts that should be important to anyone doing interstate work.

Remember that the due process clause is all about fairness: Is it fair to subject a person to a state's taxing jurisdiction given the person's relationship to the state? It's clear from more than 100 years of Supreme Court precedent that a state cannot tax income earned outside its borders. That would simply be unfair. Remember also that due process usually involves two questions: (1) Is there a link between the person and the state (did the person avail himself of the benefits of the market)?; and (2) Is there a link between the activity generating the income and the state?

In Corrigan v. Testa, the taxpayer, who was not an Ohio resident, owned 80 percent of a limited liability company in Ohio. The state had jurisdiction to tax the income from the LLC. The owner sold the company, and the question was whether Ohio could tax him on the capital gains from the sale. The taxpayer argued that the state was trying to tax a nonresident on income earned out of state. The court said that apportioning some of the nonresident's income on the sale would violate due process.

The taxpayer clearly availed himself of the benefits of the markets in Ohio by owning a company there, but did the transaction, i.e., the sale of the company, have a connection to Ohio? The court said no -- and that has to be the answer. Note that the court determined that the sale of the company constituted nonbusiness income. The state tried to make the case that ownership of the company made all income (including from the sale) business income, but think about it. If you own an investment (say, stock) and sell it, who taxes it? Most people would say your home state has jurisdiction to tax the gains. It would be a nightmare if the states where the investments were located could subject you to tax.

Although the state could subject the owner to tax on the business income of the company, it did not have the power to tax the sale of an intangible investment. The case hinged on the determination that the proceeds from the sale did not constitute business income. Indeed, the court refused to declare the statute under which Ohio was proceeding unconstitutional.

This case is an illustration of state aggressiveness. We've seen a lot of that lately, but Ohio was not making a crazy argument if it could show unitary income. More importantly, the case illustrates the need to pay attention to how interstate deals are structured.

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