Title: Agley v. Tracy

State: ohio

Issuer: Ohio Supreme Court

Document:

WebCite No. 1999-Ohio-61 
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), 87 Ohio St.3d 265.] 
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. 
 
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. 
 
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 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. 
 
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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. 
 
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. 
 
These causes are now before this court upon appeals of right. 
__________________ 
 
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. 
__________________ 
 
LUNDBERG STRATTON, J.  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. 
 
Appellants argue that nonresident shareholders of an S corporation that 
conducts business activities in Ohio should not be subject to income tax on 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, 
 
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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. 
 
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.) 
 
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 to the appellants as personal income.  Thus, the appellants, through their S 
corporations, have also availed themselves of Ohio’s benefits, protections, and 
 
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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. 
 
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. 
 
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-of-
state 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-
2458, 120 L.Ed.2d 174, 186-191.  The court in Wrigley held that the phrase 
 
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“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. 
 
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. 
 
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. 
 
The appellants argue that the distributive share of an S corporation’s income 
constitutes “nonbusiness” income to the shareholder pursuant to R.C. 5747.01(C).  
 
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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). 
 
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. 
 
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. 
 
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 
 
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gross income.  Id. at  311.  The Legislative Service Commission stated that the Act 
(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. 
 
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. 
 
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. 
 
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. 
 
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MOYER, C.J., DOUGLAS, RESNICK, F.E. SWEENEY, PFEIFER and COOK, JJ., 
concur.