• Monte Silver, Tax lawyer

The U.S. constitutional limits of state taxation

We all know that the U.S. and each state (like any other country) may tax income arising from/or connected to it. But are there limits beyond which the link is insufficient, making it unconstitutional for a state to tax? This article discusses the May 2016 decision of Corrigan vs. Ohio which ruled on these limits.

The abbreviated facts:

Mansfield Plumbing LLC was established and headquartered in Ohio. It had facilities in Texas and California and conducted plumbing business in all the 50 states. In 2000, Corrigan, a Connecticut resident, bought the business. On rare occasion Corrigan visited the company HQ in Ohio, “for board meetings and management presentations regarding operations, labor, finance, strategic positioning and other important matters." In 2004, Corrigan sold Mansfield Plumbing LLC to a third party for a capital gain of $27,563,977. In his 2004 Ohio tax return, Corrigan excluded all the capital gain, claiming that he was a non-Ohio resident. In 2009, Ohio challenged this and claimed he owed $847,085.19.

In the case it was undisputed that because Mansfield Plumbing was a pass-through entity, Ohio could tax Corrigan’s share of the entity’s operating income, based on the percentage of the LLCs business in Ohio. The issue before the court was whether Ohio may also tax Corrigan’s capital gain as if it were income from the business itself.

The law in question:

Ohio law imposed tax on a capital gain realized by an out-of-state investor in a pass-through entity if the investor held a 20 percent or greater interest in the entity during a three-year period including the taxable year. The law did not seek to tax all capital gains (in this case all the$27,563,977) but rather only a percentage of the gain equal to the part of the entity’s Ohio business during a three-year period.

The decision: In a detailed decision analyzing U.S. Supreme Court decisions, the Ohio Supreme court ruled that the above law violated the Fourteenth Amendment of U.S. constitution. "Due process requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax," stated the court. The connection can be based on (1) residency of the person or (2) income-producing activities conducted within the state.

Here, Corrigan was not an Ohio resident, but he did conduct Ohio business through an LLC. While his share of business profits was subject to tax in Ohio, no share of the capital gains could be taxed. The court ruled that the selling of intangible shares in the LLC by a non-resident had insufficient connection to Ohio to justify its imposing tax on the gain. In so ruling, the court acknowledged the fact that had the sale of Mansfield Plumbing been an asset sale as opposed to the sale of the LLC itself, Corrigan may well have been subject to Ohio capital gains tax arising from the sale on certain Ohio-connected assets.

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