Maximizing your business income deduction is critical, especially to owners of “pass through entity” businesses such as sole proprietorships, partnerships, and S corporations. While the law governing this deduction in Ohio hasn’t changed, Ohio House Bill 515 (HB 515), which went into effect September 23, 2022, clarified some things.
Why is this important? In recent years there has been some question as to specifically what constitutes business income. As an example, consider this question, “Is the sale of S Corp stock counted as Ohio business income or not?” Before HB 515, this was sometimes a cloudy issue.
HB 515 didn’t change the law as written. It simply spelled out in greater detail how the law will be administered going forward. Specifically, it “amends sections 5747.01, 5753.01, and 5753.04 of the Revised Code to exempt from income tax certain gains from the sale of an ownership interest in a business.”
Ohio’s Business Income Deduction (form IT BUS) allows S Corp shareholders to deduct the first $250,000 of business income, with anything over that threshold at a flat 3% rate. Of course you want to take advantage of as much of that $250,000 threshold as possible.
Business income is defined in Ohio Revised Code Section 5747.01(b) as follows: “Business income” means income, including gain or loss, arising from transactions, activities, and sources in the regular course of a trade or business and includes income, gain, or loss from real property, tangible property, and intangible property if the acquisition, rental, management, and disposition of the property constitute integral parts of the regular course of a trade or business operation. “Business income” includes income, including gain or loss, from a partial or complete liquidation of a business, including, but not limited to, gain or loss from the sale or other disposition of goodwill.
As stated in HB 515: the “sale of an equity or ownership interest in a business” means sales to which either or both of the following apply:
- The sale is treated for federal income tax purposes as the sale of assets.
- The seller materially participated, as described in 26 C.F.R. 1.469-5T, in the activities of the business during the taxable year in which the sale occurs or during any of the five preceding taxable years.
Let’s take a closer look at these two scenarios.
- The sale is treated for federal income tax purposes as the sale of assets. Quite simply, this means that the tangible assets of the business are sold, as opposed to simply selling stock.
- The seller materially participated, as described in 26 C.F.R. 1.469-5T, in the activities of the business during the taxable year in which the sale occurs or during any of the five preceding taxable years. This speaks to the material participation standards a seller must meet to be considered “active” in the business. This includes being active for more than 500 hours per year and being active two out of five years. Demonstrating material participation is key to eligibility for the business income deduction.
Deductions can also be taken if the entity experiences a loss provided the individual shareholder meets the “material participation” requirements – which demonstrates they were active in the business.
So, if in prior years a stock sale of a business in which you were materially participating was incorrectly treated as non-business/personal income, don’t despair; you can go back and amend that return within four years of that filing.