May 25, 2017
Income of a business owned by a pass-thru entity (PTE) is generally subject to Ohio income tax in the hands of the owner. PTEs include partnerships, “S” corporations and limited liability companies.
Starting in 2013, the definition of “adjusted gross income” found in ORC section 5747.01(A) was amended to permit each small business owner to take a “small business” income tax deduction (SBD) against his or her Ohio income tax liability. In 2016 and thereafter, the SBD for taxpayers filing a single or married filing jointly return is equal to 100% of the first $250,000 of business income the owner receives or is allocated from a PTE. For married filing separate taxpayers, the SBD limit in 2016 and thereafter is $125,000. Any remaining business income above such threshold amounts is taxed at a flat 3% rate.
ORC section 5733.40(A)(7) provides that guaranteed payments or compensation paid by a PTE to an individual who owns 20% or more interest in capital or profits of the PTE shall be considered a distributive share of income from the PTE for purposes of calculating the SBD. So in most cases, the SBD of a PTE owner who owns 20% interest or greater is the sum of: (1) the amount of income allocated to such owner as shown on his or her Schedule K-1; plus (2) the amount of wages paid to such owner as shown on his or her Form W-2.
But, SURPRISE! The Ohio Department of Taxation (ODT) says this is NOT the case if the PTE has engaged a professional employment organization (PEO) to handle employment, payroll, benefits and reporting matters for the PTE. The ODT has taken the position that a 20% or more owner of a PTE that uses a PEO to handle the payment and reporting of wages for the PTE’s employees (including the owner) may not include the owner’s wages in the calculation of SBD.
When a PTE engages a PEO to handle its employment matters, the employees of the PTE are treated as co-employed both by the PEO and the PTE for federal and state purposes. The PEO handles payroll and benefits, does employee payroll reporting and prepares tax returns including Form W-2 showing the worker as an employee of the PEO. The paycheck that the owner receives has the PEO name on it, and the Form W-2 is issued by the PEO, but PEO has no authority to control the actions of the owner (or other employees of the PTE), and the PTE pays the PEO the amount of wages and taxes that are then paid by the PEO to the PTE owner.
Most taxpayers and tax practitioners have taken the position that wages paid by a PEO on behalf of a PTE are still wages paid by the PTE for purposes of the SBD calculation. But ODT has interpreted the language in ORC section 5733.40(A)(7) which says “compensation paid by the qualifying entity . . . shall be considered a distributive share of income of the qualifying entity” to mean the compensation in question has to be paid by a check written by the PTE and show up on a Form W-2 issued by the PTE.
Nothing in ORC section 5733.40(A)(7) or anywhere else in the Ohio Revised Code expressly requires this interpretation or specifically excludes or prohibits wages paid on behalf of a PTE thru an intermediary such as a PEO from being treated as a distributive share of income of the PTE.
ODT has espoused no specific rationale for treating PTEs that engage a PEO differently from those that do not, other than their strict literal reading of the statute and their form over substance interpretation of the language in the statute. Perhaps most importantly, this position seems clearly contrary to the intent of the Ohio legislature to use the SBD as an incentive for small businesses to locate and remain in Ohio.
There was no expressed intent by the Ohio legislature to deny 20% owners of a PTE that engages a PEO the benefit of including the owners wages in the calculation of the SBD. In fact, ORC section 4125.042 seems to make it clear that the intent was just the opposite. ORC section 4125.042 says “for purposes of determining tax credits and other economic incentives that are provided by this state or any political subdivision and based on employment, shared employees under a professional employer organization agreement shall be considered employees solely of the client employer.” This seems to say rather clearly that an employee (including a 20% owner of a PTE) working under a PEO agreement is considered an employee of the PTE (not the PEO).
But ODT doesn’t get it. Yet. The National Association of Professional Employer Organizations has been contacting state legislators and ODT commissioner Joe Testa. Some taxpayers and their tax advisors have been writing letters to both Governor Kasich and Joe Testa. Hopefully the louder the message, the clearer they hear it.
If you are a 20% PTE owner and are using a PEO for employment matters, your SBD probably is based in part on the wages you were paid by the PEO on behalf of your PTE. If so, your SBD is at risk. Please call or email me at 937-223-1130 or Jsenney@pselaw.com if you would like to discuss this further or need assistance with any federal or state tax issues.