[This opinion has been published in Ohio Official Reports at
87 Ohio St.3d 265.]
AGLEY, APPELLANT, v. TRACY, TAX COMMISSIONER, APPELLEE.
AGLEY ET AL., APPELLANTS, v. TRACY, TAX COMMISSIONER, APPELLEE.
TIMMIS ET AL., APPELLANTS, v. TRACY, TAX COMMISSIONER, APPELLEE.
[Cite as Agley v. Tracy, 1999-Ohio-61.]
Taxation—Income tax—Nonresident shareholders of a Subchapter S corporation
that conducts business activities in Ohio are subject to income tax on their
distributive share of the S corporation’s income.
(Nos. 98-1879, 98-1880 and 98-1881–Submitted September 21, 1999–Decided
December 8, 1999.)
APPEALS from the Board of Tax Appeals, Nos. 96-R-302, 96-R-301 and
96-R-303.
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{¶ 1} This matter involves three cases consolidated for review: James R.
Agley v. Tracy, No. 98-1879; Randolph J. and Judith A. Agley v. Tracy, No. 98-
1880; and Michael T. and Nancy E. Timmis v. Tracy, No. 98-1881. All appellants
seek refunds on taxes paid on their respective distributive share income generated
by Subchapter S corporations. Appellant James Agley seeks a refund for taxes he
paid in the tax years of 1989, 1990, 1991, and 1992. Appellants Randolph and
Judith Agley and appellants Michael and Nancy Timmis seek a refund for taxes
paid in the tax years of 1988, 1989, 1990, 1991, and 1992.
{¶ 2} During these tax years, all the appellants were shareholders in the
following corporations: F & M Distributors, Inc., Venture Packaging, Inc., and
Diamond Automations, Inc. James Agley was also a shareholder in Middletown
Aerospace. Appellants elected these corporations to be Subchapter S corporations
for federal income tax purposes, pursuant to Subchapter S, Chapter 1, of Subtitle A
of the Internal Revenue Code of 1986. These corporations were organized and
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existed in Michigan and conducted business in Ohio. Appellants were not residents
of, or domiciled within, Ohio during the disputed tax years. Appellants did not
personally conduct any business within Ohio during the disputed tax years.
{¶ 3} For the disputed tax years, appellants included their pro-rata share of
S corporation income or loss generated by the S corporations in their federal
adjusted gross income. Appellants paid individual income tax to Ohio on their
distributive share income generated by the S corporations.
{¶ 4} Appellants applied to appellee, Tax Commissioner, for personal
income tax refunds for the disputed tax years. James Agley sought $9,942 in
refunds, Randolph and Judith Agley sought $42,043 in refunds, and Michael and
Nancy Timmis sought $41,003 in refunds. The Tax Commissioner denied the
applications. The appellants appealed to the Board of Tax Appeals, which in each
case affirmed the commissioner’s order denying a refund.
{¶ 5} These causes are now before this court upon appeals of right.
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Timmis & Inman L.L.P., George M. Malis and Erich J. D’Andrea, pro hac
vice, for appellants.
Betty D. Montgomery, Attorney General, and Robert C. Maier, Assistant
Attorney General, for appellee.
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LUNDBERG STRATTON, J.
{¶ 6} The appellants assert five propositions of law in support of their
contention that an out-of-state shareholder should not be taxed in Ohio on the
distributive share of income he or she receives from his or her S corporation that is
doing business in Ohio. For the following reasons, we disagree. Thus, we affirm
the Board of Tax Appeals in each case.
{¶ 7} Appellants argue that nonresident shareholders of an S corporation
that conducts business activities in Ohio should not be subject to income tax on
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their distributive share of the S corporation’s income under R.C. 5747.02 because
it is the S corporation that earns the income, not the shareholder. We recently
rejected this argument in Dupee v. Tracy (1999), 85 Ohio St.3d 350, 351,
708
N.E.2d 698, 700, because this position ignores the “flow through” nature of an S
corporation, whereby business income generated by the S corporation flows
directly through to the shareholder for taxation purposes. Applying Dupee, we find
appellants’ first proposition meritless.
{¶ 8} Appellants also argue that taxation of nonresident shareholders of an
S corporation violates their due process rights because they do not have a
“substantial nexus” with Ohio. Initially, we note that appellants misstate the test
for determining whether due process has been violated. Substantial nexus is the
test used to determine whether a tax violates the Commerce Clause. See Quill
Corp. v. North Dakota (1992), 504 U.S. 298, 313,
112 S.Ct. 1904, 1913-1914,
119
L.Ed.2d 91, 107. The Due Process Clause “requires some definite link, some
minimum connection, between a state and the person, property or transaction it
seeks to tax.” Miller Bros. Co. v. Maryland (1954),
347 U.S. 340, 344-345,
74
S.Ct. 535, 539,
98 L.Ed. 744, 748. In other words, a state must have minimum
contacts with the entity in order to tax it. In assessing whether taxation comports
with due process, this court, in Couchot v. State Lottery Comm. (1996),
74 Ohio
St.3d 417, 422,
659 N.E.2d 1225, 1228, stated:
“The determination of state taxing power generally involves the flexible
application of several factors, such as the state’s power, dominion, or control over
that which it seeks to tax; the benefits, protections, and opportunities afforded by
the state; and the social and governmental costs incurred by the state.” (Emphasis
added.)
{¶ 9} Appellants have admitted that their S corporations conducted business
in Ohio. Thus, it is evident that the S corporations have utilized the protections and
benefits of Ohio by carrying on business here. This income was then passed through
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to the appellants as personal income. Thus, the appellants, through their S
corporations, have also availed themselves of Ohio’s benefits, protections, and
opportunities by earning income in Ohio through their respective S corporations.
We find that this provides Ohio the “minimum contacts” with the appellants to
justify taxing appellants on their distributive share of income. Therefore, we find
that appellants’ second proposition is not well taken.
{¶ 10} Appellants argue that taxation of the distributive share of their
income violates Section 381, Title 15, U.S.Code. Specifically, appellants claim
that they did not personally conduct any business activity in Ohio that rose to the
level of solicitation of orders as set out in Section 381, Title 15.
{¶ 11} The impetus for the promulgation of Section 381, Title 15, was the
United States Supreme Court’s decision in Northwestern States Portland Cement
Co. v. Minnesota (1959), 358 U.S. 450,
79 S.Ct. 357,
3 L.Ed.2d 421. Heublein,
Inc. v. South Carolina Tax Comm. (1972),
409 U.S. 275, 281,
93 S.Ct. 483, 487-
488,
34 L.Ed.2d 472, 478. In Northwestern States, the United States Supreme Court
rejected Due Process and Commerce Clause challenges to Minnesota’s imposition
of an apportioned tax on the net income of an Iowa corporation’s profits whose
only activity in Minnesota consisted of solicitation of orders for the sale of its
products. Northwestern States at 461-465,
79 S.Ct. at 364-366,
3 L.Ed.2d at 429-
431. Concerned that Northwestern States could be read to allow a state to tax an
out-of-state company for sales where the sole activity of the out-of-state company
in the taxing state was solicitation of orders, Congress enacted Section 381, Title
15. Heublein,
409 U.S. at 280,
93 S.Ct. at 487,
34 L.Ed.2d at 477. The Supreme
Court interpreted Section 381, Title 15, to preclude a state from taxing an out-ofstate company’s profits where the out-of-state company’s only contact with the
taxing state was the “solicitation of orders,” or the out-of-state company’s activity
(in addition to solicitation of orders) in the taxing state was de minimis. Wisconsin
Dept. of Revenue v. Wrigley (1992),
505 U.S. 214, 223-232,
112 S.Ct. 2447, 2453-
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January Term, 1999
2458, 120 L.Ed.2d 174, 186-191. The court in Wrigley held that the phrase
“solicitation of orders” as used in Section 381, Title 15, “embraces request-related
activity that is not even, strictly speaking, essential, or else it would not cover
salesmen’s driving on the State’s roads, spending the night in the State’s hotels, or
displaying within the State samples of their product.”
Id. at 226, 112 S.Ct. at 2455,
120 L.Ed.2d at 187. The court in Wrigley also stated, “whether in-state activity
other than ‘solicitation of orders’ is sufficiently de minimis to avoid loss of tax
immunity conferred by § 381 depends upon whether that activity establishes a
nontrivial additional connection with the taxing State.” Id. at 232, 112 S.Ct. at
2458,
120 L.Ed.2d at 191.
{¶ 12} In this case, appellants claim that they did not personally participate
in any business activities in Ohio. S corporations are pass-through entities for
purpose of taxation but are still corporations from a legal perspective. A
corporation is an entity separate and apart from the individuals who compose it; it
is a legal fiction for the purpose of doing business. Ohio Bur. of Workers’ Comp.
v. Widenmeyer Elec. Co. (1991), 72 Ohio App.3d 100, 105,
593 N.E.2d 468, 471.
Thus, it is S corporations’ business activity in Ohio that is dispositive as to whether
Section 381, Title 15, precludes taxation of the S corporations, not the appellants’
personal activity.
{¶ 13} The only evidence relating to the S corporations’ business activities
in Ohio is found in stipulations of fact, which indicate that S corporations
“conducted business activity in Ohio that was not limited to … solicitation of
orders within Ohio ….” (Emphasis added.) In other words, the S corporations
conducted business activities beyond mere solicitation so as to remove them from
any immunity from taxation by Ohio pursuant to Section 381, Title 15. Thus,
Section 381, Title 15, is not a bar to taxation of appellants in this case.
{¶ 14} The appellants argue that the distributive share of an S corporation’s
income constitutes “nonbusiness” income to the shareholder pursuant to R.C.
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5747.01(C). As to nonbusiness income, appellants claim that this income should
not be apportioned to Ohio, since appellants are not domiciled in Ohio pursuant to
R.C. 5747.20(B)(6).
{¶ 15} Appellants’ argument is flawed because it assumes that distributive
income from an S corporation is nonbusiness income. This characterization ignores
the true nature of the income that appellants receive from their S corporations.
Section 1366(b), Title 26, U.S.Code indicates that the character of the item
distributed to a shareholder is to be determined as if the item were realized from
the source from which the corporation realized the item. Thus, business income
generated by an S corporation retains its status as business income as it passes
through to the shareholders. As business income, it is apportioned under R.C.
5747.21 for taxation in Ohio. Thus, we reject appellants’ fourth proposition of law.
{¶ 16} Finally, appellants argue that because R.C. 5747.22 did not refer to
S corporations as being pass-through entities until after the disputed tax years, the
Tax Commissioner had no authority to tax appellants’ distributive income from the
S corporations.
{¶ 17} Appellants’ argument ignores the fact that a taxpayer’s income tax
liability is measured on the basis of the taxpayer’s adjusted gross income. Dery v.
Lindley (1979), 57 Ohio St.2d 5, 6,
11 O.O.3d 70, 71,
385 N.E.2d 291, 292. R.C.
5747.01(A) defines “adjusted gross income.” Former R.C. 5747.01(A) originally
contained language that excluded S corporation income from adjusted gross
income. 134 Ohio Laws, Part II, 1581, 1582. S corporation income was taxed
through an excise tax pursuant to former R.C. 5733.01(B). 134 Ohio Laws, Part II,
1550. However, in 1985, prior to the disputed tax years, the General Assembly
amended R.C. 5733.01 to remove the excise tax from S corporation income. 141
Ohio Laws, Part I, 310, 311. In the same Act, the General Assembly also deleted
the language from R.C. 5747.01 that excluded S corporation income from adjusted
gross income. Id. at 311. The Legislative Service Commission stated that the Act
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January Term, 1999
(Am.Sub.S.B. No. 121) “exempts S corporations from the franchise tax and
requires shareholders to include S corporation income … in their Ohio AGI.”
Ohio Legislative Service Commission Summary of Enactments (Jan.-July 1985)
146. In other words, Ohio recognized that a Subchapter S corporation election
causes the S corporation’s income to pass through to the shareholders. Thus,
subsequent to 1985, which is prior to the disputed tax years, the commissioner had
authority to tax appellants on their distributive income that was generated by their
S corporations.
{¶ 18} We acknowledge that during the disputed tax years, R.C. 5747.22
named only partnerships as having income passed through to partners for tax
purposes. We further acknowledge that it was not until 1997 that R.C. 5747.22 was
amended to include the phrase “pass-through entity.” However, contrary to
appellants’ assertion, we find that R.C. 5747.22 does not define how S corporation
income should be taxed.
{¶ 19} Unlike R.C. 5747.01, which defines a basis for taxation, including
the ability to elect S corporation status, R.C. 5747.22 defines how income and
deductions are apportioned. Thus, the General Assembly’s 1997 amendment of
R.C. 5747.22 in Am.Sub.H.B. No. 215 to add the phrase “pass-through entity” was
merely a codification of existing law as to how an S corporation’s income should
be allocated and apportioned. See, e.g., NLO, Inc. v. Limbach (1993), 66 Ohio
St.3d 389, 393-394,
613 N.E.2d 193, 197. Therefore, we find that appellants’ fifth
proposition of law is meritless.
{¶ 20} For all the aforementioned reasons, we find that the decisions of the
BTA are neither unlawful nor unreasonable. Accordingly, we affirm the decisions
of the BTA.
Decisions affirmed.
MOYER, C.J., DOUGLAS, RESNICK, F.E. SWEENEY, PFEIFER and COOK, JJ.,
concur.
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