Title: Tetlak v. Bratenahl

State: ohio

Issuer: Ohio Supreme Court

Document:

[Cite as Tetlak v. Bratenahl, 92 Ohio St.3d 46, 2001-Ohio-129.] 
 
 
 
TETLAK, APPELLEE, v. VILLAGE OF BRATENAHL ET AL., APPELLANTS. 
[Cite as Tetlak v. Bratenahl (2001), 92 Ohio St.3d 46.] 
Municipal corporations — Taxation — Income tax — Distributive share of the 
earnings of an S corporation does not constitute intangible income 
except when the income received by the S corporation itself is intangible 
— Income is not exempt from municipal income taxation pursuant to 
R.C. 718.01(F)(3), when. 
(No. 00-380 — Submitted January 9, 2001 — Decided June 13, 2001.) 
APPEAL from the Court of Appeals for Cuyahoga County, No. 74807. 
__________________ 
 
MOYER, C.J.  This matter concerns the taxable status of certain income 
received by appellee, Joseph Tetlak, from Willow Hill Industries, Inc. in the tax 
years 1990, 1991, and 1992.  Tetlak resides in the village of Bratenahl (“village”), 
the appellant herein, and was employed by Willow Hill, a Subchapter S 
corporation in which he owns stock, located in Willoughby, Ohio.  During those 
years, Tetlak received both a salary from Willow Hill and a share of its earnings.  
Tetlak paid municipal residence tax on his salary but not on his share of the 
earnings received from Willow Hill. 
 
In 1994, Tetlak received three “Reports of Audit Adjustments,” assessing 
$8,468 in additional residence tax relating to the share of earnings received by 
Tetlak from Willow Hill.  Tetlak filed a protest challenging the audit adjustments, 
which was denied by the Central Collection Agency (“CCA”), acting as tax 
administrator.  CCA’s letter upholding the tax assessments asserted that this 
income from a Subchapter S corporation “is not considered dividends from 
intangible property” and thus exempt from municipal tax but is instead income 
SUPREME COURT OF OHIO 
2 
from an “unincorporated business entity” and therefore taxable by municipalities.  
Upon Tetlak’s appeal to the Bratenahl Board of Review, the denial was affirmed. 
 
Tetlak then filed an administrative appeal in the common pleas court 
pursuant to R.C. 2506.01.  Following Misrach v. Montgomery (1993), 90 Ohio 
App.3d 187, 188-190, 628 N.E.2d 126, 127-128, the trial court held that the 
municipality may tax Subchapter S distributions if it determines that the 
distributions are the result of services rendered to or for the corporation.  This 
determination must be supported by “the preponderance of substantial, reliable, 
and probative evidence on the whole record.” R.C. 2506.04.  Finding that the 
CCA did not make such determination, the court reversed the decision of the 
board of review. 
 
The village appealed.  The Court of Appeals for Cuyahoga County 
affirmed the decision, holding that the correct analysis is whether the distribution 
is income arising from ownership of stocks, or income arising from services 
rendered and that the village presented no evidence to support its allegation that 
municipalities have authority to tax the nonwage income passed through to Tetlak 
from his S corporation. 
 
The cause is now before this court pursuant to the allowance of the 
discretionary appeal. 
 
The question presented is whether a municipal taxing authority may tax 
the distributive shares of an S corporation.  Our analysis of the law causes us to 
conclude that the distributive share of the earnings of an S corporation does not 
constitute intangible income except when the income received by the S 
corporation itself is intangible, and, as such, is therefore not exempt from 
municipal income taxation pursuant to R.C. 718.01(F)(3).  Accordingly, we 
reverse the judgment of the court of appeals. 
I 
January Term, 2001 
3 
 
R.C. 718.01(F)(3) provides: “No municipal corporation shall tax * * * 
[e]xcept as otherwise provided in division (G) of this section, intangible income.”  
“Intangible income” is defined as “income of any of the following types: income 
yield, interest, dividends, or other income arising from the ownership, sale, 
exchange, or other disposition of intangible property including, but not limited to, 
investments, deposits, money, or credits as those terms are defined in Chapter 
5701. of the Revised Code.”  R.C. 718.01(A)(4). 
 
Congress enacted Subchapter S legislation to eliminate tax disadvantages 
that may dissuade small businesses from adopting the corporate form and to 
reduce the tax burden on such businesses.  The statute accomplishes these goals 
by treating corporate income, losses, deductions, and credits as if incurred by 
individual shareholders in a manner akin to the tax treatment of partnerships. 
Bufferd v. Commr. of Internal Revenue (1993), 506 U.S. 523, 524-525, 113 S.Ct. 
927, 928-929, 122 L.Ed.2d 306, 311.  “The corporation’s profits pass through 
directly to its shareholders on a pro rata basis and are reported on the 
shareholders’ individual tax returns.” Gitlitz v. Commr. of Internal Revenue 
(2001), 531 U.S. 206, ___, 121 S.Ct. 701, 704, 148 L.Ed.2d 613, 619. 
 
The village argues that the conclusion reached by the court of appeals that 
“how one characterizes distributions from an S corporation is a question of fact to 
be determined on a case-by-case basis” ignores the pass-through nature of an S 
corporation.  In contrast, Tetlak argues that the treatment of an S corporation for 
federal or state tax purposes, and thus the nature of an S corporation as a flow-
through entity, is irrelevant to a determination of whether a municipality may tax 
a distributive share of an S corporation.  Tetlak also argues that there is no 
distinction between income derived from S and C corporations for tax purposes. 
 
We are not persuaded by Tetlak’s argument that the treatment of an S 
corporation is not distinct from that of a C corporation for tax purposes.  
However, we are also not persuaded by the village’s argument that a case-by-case 
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determination of whether a distributive share from an S corporation is properly 
taxable by a municipality ignores the pass-through nature of an S corporation.  As 
noted above, the court determined that the municipality could properly tax 
distributions “ ‘if the city determines that the distributions from the Subchapter S 
corporation constitute payments resulting from services rendered to or for the 
corporation,’ ” quoting Alspaugh v. Rocky River (May 28, 1997), Cuyahoga C.P. 
No. CV-320089, unreported.  The Misrach court also advocated this case-by-case 
analysis, noting that the municipality could determine in each case “whether a 
distribution of a Subchapter S corporation which is nominally classified as a 
dividend is actually wages and thus subject to taxation.”  Misrach, 90 Ohio 
App.3d at 189, 628 N.E.2d at 127.  While we agree that the court must determine 
the nature of income on a case-by-case basis, we disagree with the courts’ 
analysis. 
 
We have characterized the S corporation as a flow-through entity 
“whereby the income and losses of the business are nontaxable to the corporation, 
but instead flow through to the individual shareholders.” Dupee v. Tracy (1999), 
85 Ohio St.3d 350, 351, 708 N.E.2d 698, 700.  In Dupee, we held that distributive 
share income that nonresident shareholders of an Ohio S corporation receive and 
report as part of federal adjusted gross income is subject to Ohio personal income 
taxation.  Id. at 351, 708 N.E.2d at 699.  “ ‘[A] Subchapter S corporation differs 
significantly from a normal corporation in that the profits generated through the S 
corporation are taxed as personal income to the shareholders.  The taxable income 
of the S corporation is computed essentially as if the corporation were an 
individual.  Section 1363, Title 26, U.S.Code.’ ”  (Emphasis deleted.)  Id. at 351, 
708 N.E.2d at 700, quoting Ardire v. Tracy (1997), 77 Ohio St.3d 409, 674 
N.E.2d 1155, fn. 1. 
 
This court has held that Michigan shareholders of an Ohio S corporation 
are required to pay income tax on their distributive share of the S corporation’s 
January Term, 2001 
5 
income.  Agley v. Tracy (1999), 87 Ohio St.3d 265, 268, 719 N.E.2d 951, 954.  In 
so holding, we noted, “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.”  Id. at 268, 719 N.E.2d at 954. 
 
In the instant case, both parties agree that the distributive shares arise from 
the net profits of the S corporation.  Tetlak is the sole shareholder of Willow Hill 
Industries, Inc. and characterized the net profits as ordinary income on his federal 
Schedule K-1 after deducting an amount for his salary and other items.  However, 
Tetlak argues that this income for purposes of municipal taxation is “intangible 
income” because it is related to his stock in the S corporation and therefore fits 
the statutory definition of such income as “dividends, or other income arising 
from the ownership * * * of intangible property including * * * investments.” 
R.C. 718.01(A)(4). 
 
The village argues that because the distributive shares represent the net 
profits of the S corporation, due to the pass-through nature of an S corporation, 
these shares constitute ordinary income to Tetlak.  However, the village asserts 
that earnings that an S corporation receives from interest income, royalties, or 
dividends do constitute intangible income and would be excluded from municipal 
taxation. 
 
Agley, Ardire, and Dupee support the proposition that if the income earned 
by an S corporation is not “intangible income,” the distributive share received by 
the shareholder is not intangible income and is subject to municipal taxation.  In 
other words, since “income generated by an S corporation retains its status * * * 
as it passes through to the shareholders,” the determinative issue is whether the 
income generated by the S corporation was intangible income or ordinary income 
for the S corporation.  Agley, 87 Ohio St.3d at 268, 719 N.E.2d at 954. 
SUPREME COURT OF OHIO 
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II 
 
Having determined that the distributive share of an S corporation may not 
constitute intangible income when the income received by the S corporation is not 
intangible, we answer the question of whether the village has the authority to tax 
the distributive share.  “[A] tax enacted by municipality pursuant to its taxing 
power is valid in the absence of an express statutory prohibition of the exercise of 
such power by the General Assembly.”  Cincinnati Bell Tel. Co. v. Cincinnati 
(1998), 81 Ohio St.3d 599, 601, 693 N.E.2d 212, 214.  The General Assembly has 
declared that a municipality may tax income not defined as intangible income.  
Specifically, R.C. 718.01(D)(1) provides: “[N]o municipal corporation shall 
exempt from a tax on income, compensation for personal services of individuals 
over eighteen years of age or the net profit from a business or profession.”  R.C. 
718.01(F)(3) prohibits municipal corporations from taxing intangible income, thus 
placing a clear limitation on the municipalities’ right to tax such income. 
 
Bratenahl Codified Ordinance 171.0318 defines “taxable income” as 
“wages, salaries and other compensation paid by an employer or employers before 
any deduction and/or the net profits from the operation of a business, profession 
or other enterprise or activity adjusted in accordance with the provisions of this 
chapter.”  Bratenahl Codified Ordinance 171.0501(d)(2) imposes a residence tax 
“[o]n the portion of the distributive share of the net profits earned on or after 
January 1, 1981, of a resident partner or owner of a nonresident unincorporated 
business entity not attributable to the village and not levied against such 
unincorporated business entity.” 
 
Bratenahl Codified Ordinance 171.2303 grants the Tax Administrator the 
power, “subject to the approval of the Board of Review, to adopt and promulgate 
and to enforce rules and regulations” related to the collection of taxes.  Pursuant 
to this authority, the village has adopted rules and regulations that give the Tax 
Administrator “the authority to correct or adjust any return submitted, when a 
January Term, 2001 
7 
correction or adjustment is necessary to accomplish the intent of the ordinance.” 
Central Collection Agency Administrator’s Rules and Regulations, Article 
23:03(A). 
 
Bratenahl Codified Ordinance 171.0501(d)(2) was enacted in 1980, well 
before the Subchapter S Revision Act of 1982, which transformed S corporations 
into pass-through entities.  In 1980, an unincorporated entity included 
partnerships and sole proprietorships, the only pass-through entities then existing.  
Glenn E. Coven, Subchapter S Distributions and Pseudo Distributions:  Proposals 
for Reusing the Detective Blend of Entity and Conduit Concepts (1987), 42 Tax 
L.Rev. 381, at 381.  The village argues that “[b]oth the Village and Central 
Collection Agency have historically and consistently determined that an owner’s 
distributive shares of the earnings of an S corporation fall within the scope of this 
section as well, holding that ‘unincorporated business entity,’ as used in the 
ordinance, includes any entity which is not taxed as a corporation under 
Subchapter C of the Internal Revenue Code.” 
 
The village argues that this interpretation is consistent with the pass-
through nature and tax treatment of a Subchapter S corporation and appropriately 
places S corporations on a footing similar to partnerships for taxation purposes.  
Specifically, it argues that “[b]ecause an S corporation shareholder can avail 
himself, personally, of any deductions, tax credits and losses of the S corporation, 
it is only logical and reasonable that the shareholder be responsible for the 
payment of tax on income or net profits of the S corporation which are passed 
through as part of his distributive share.”  We agree with this reasoning and hold 
that an S corporation operates as an unincorporated business entity under 
Bratenahl Codified Ordinance 171.0501(d)(2). 
III 
 
The taxpayer, not the village, has the burden of proof on the nature of the 
income at issue.  It is well settled that “ ‘when an assessment is contested, the 
SUPREME COURT OF OHIO 
8 
taxpayer has the burden “ * * * to show in what manner and to what extent * * *” 
the commissioner’s investigation and audit, and the findings and assessments 
based thereon, were faulty and incorrect.’ ”  Maxxim Med., Inc. v. Tracy (1999), 
87 Ohio St.3d 337, 339, 720 N.E.2d 911, 913, quoting Federated Dept. Stores, 
Inc. v. Lindley (1983), 5 Ohio St.3d 213, 215, 5 OBR 455, 457, 450 N.E.2d 687, 
688.  Furthermore, the “Tax Commissioner’s findings are presumptively valid, 
absent a demonstration that those findings are clearly unreasonable or unlawful.” 
Id., 87 Ohio St.3d at 339-340, 720 N.E.2d at 913-914. 
 
This reasoning is applicable at the municipal level.  The village assessed 
$8,468 in additional income tax relating to the share of earnings received by 
Tetlak from Willow Hill.  Nothing in the record before us shows whether the net 
income generated by the S corporation was intangible income or ordinary income 
to the S corporation.  Accordingly, as Tetlak has not shown what portion, if any, 
of his distributive shares arising from net profits should not be subject to taxation, 
the distributive shares at issue are subject to taxation by the village. 
IV 
 
In conclusion, we hold that the village has the authority to tax the 
distributive share of an S corporation under its current ordinance except when the 
distributive share flows from intangible income received by the S corporation.  In 
the instant case, Tetlak failed to meet his burden of proof that the income arising 
from the distributive share at issue was intangible income to the S corporation.  
Therefore the income is taxable by the village. 
 
For the foregoing reasons, we reverse the judgment of the court of appeals. 
Judgment reversed. 
 
DOUGLAS, RESNICK and F.E. SWEENEY, JJ., concur. 
 
PFEIFER, COOK and LUNDBERG STRATTON, JJ., dissent. 
__________________ 
January Term, 2001 
9 
 
COOK, J., dissenting.  For the following reasons, I respectfully dissent 
from the majority’s decision reversing the judgment of the court of appeals. 
 
As the majority notes, state law prohibits municipalities from taxing 
“intangible income.”  R.C. 718.01(F)(3).1  State law defines nontaxable 
“intangible income” to include “income arising from the ownership * * * of  * * * 
investments.”  (Emphasis added.)  R.C. 718.01(A)(4).  For a definition of 
“investments,” the General Assembly explicitly refers courts to R.C. Chapter 
5701.  Id.  What today’s majority omits from its analysis is that Chapter 5701’s 
definition of  “investments” includes “[s]hares of stock in corporations.”  
(Emphasis added.)  R.C. 5701.06(A). 
 
The majority’s omission of this key statutory reference leads the majority 
astray in the remainder of its analysis.  As part of this analysis, the majority 
adopts the theory that an S corporation is somehow “an unincorporated business 
entity.”  (Emphasis added.)  As Tetlak stated in an early notice of appeal, 
however, such a theory—in addition to being counterintuitive—conflicts with the 
legal reality that “a subchapter S corporation is just that, a corporation.”2 
 
A straightforward application of the plain language of all of the relevant 
provisions of the Revised Code—without resort to unnecessary statutory 
interpretation—would avoid such analytical conflicts and result in the following 
inescapable conclusions:  (1) state law prohibits Bratenahl from taxing “intangible 
income”; (2) state law defines “intangible income” to include income arising from 
the ownership of “investments”; and (3) state law defines “investments” to 
include shares of stock “in corporations,” without regard to those entities’ status 
                                                          
 
1. 
The general prohibition on municipal taxation of intangible income contained in R.C. 
718.01(F)(3) is subject to an exception in division (G) not applicable here.  Id. 
2. 
In an admirable yet ultimately unsuccessful effort to emphasize this point at the 
administrative level, Tetlak went so far as to attach the Ohio Secretary of State’s certificate of 
good standing to his notice of appeal before the Board of Review of the Village of Bratenahl.  
That certificate, signed by then-Secretary of State Taft, plainly states that Willow Hill Industries, 
Inc. is “an Ohio Corporation.”  (Emphasis added.) 
SUPREME COURT OF OHIO 
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for purposes of federal or state taxation.  Simply put, state law prohibits Bratenahl 
from taxing the income that Tetlak received arising from his ownership of stock 
“in corporations.”  Indeed, this court has already recognized that the General 
Assembly has placed “income from such sources as stocks” within a “fortress of 
protection from municipal taxation.”  Fisher v. Neusser (1996), 74 Ohio St.3d 
506, 512, 660 N.E.2d 435, 440. 
 
As Tetlak has argued at every stage of these proceedings, Bratenahl 
violated the foregoing provisions of state law by assessing additional residence 
taxes based on the income arising from his ownership of Willow Hill corporate 
stock.  Notably, though Tetlak raised these provisions of state law below, neither 
the Administrator nor the Board of Review of the Village of Bratenahl even 
mentioned them in their decisions affirming the assessments. 
 
For the foregoing reasons, like the court of appeals, I would affirm the 
trial court’s order cancelling the assessments.  Tetlak satisfied his burden at the 
administrative level “to show in what manner and to what extent” the assessments 
were faulty and incorrect.  Maxxim Med., Inc. v. Tracy (1999), 87 Ohio St.3d 337, 
339, 720 N.E.2d 911, 913, quoting Federated Dept. Stores, Inc. v. Lindley (1983), 
5 Ohio St.3d 213, 215, 5 OBR 455, 457, 450 N.E.2d 687, 688. 
 
PFEIFER and LUNDBERG STRATTON, JJ., concur in the foregoing dissenting 
opinion. 
__________________ 
 
Baker & Hostetler, L.L.P., Christopher J. Swift and Michael K. Farrell, 
for appellee. 
 
Stephen M. O’Bryan; Taft, Stettinius & Hollister, L.L.P., and Elizabeth A. 
Popovich, for appellants. 
 
Cornell P. Carter, Kim D. Amponsah and William E. Gareau, Jr., urging 
reversal for amicus curiae city of Cleveland, Central Collection Agency. 
January Term, 2001 
11 
 
John E. Gotherman, Barry M. Byron and Stephen L. Byron, urging 
reversal for amicus curiae Ohio Municipal League. 
__________________