Is DISC dividend paid to pass-thru entity considered business income for purposes of the Ohio small business deduction?

IC-DISC:  Taxpayers who own a business (“Business”) that exports products or services outside the U.S. can reduce their federal income tax liability by setting up an IC-DISC.  The Business pays a royalty to the IC-DISC equal to the greater of 4% of export revenue or 50% of export income.  The Business gets a federal income tax deduction for the amount of the royalty paid to the IC-DISC.  The IC-DISC is a tax-exempt entity under federal law and does not pay income tax on the royalty payment received.  The amount of royalty paid by the Business to the IC-DISC is not taxed until it is distributed as a dividend to the IC-DISC shareholders.  The amount of the dividend received by the IC-DISC shareholders from the IC-DISC is subject to federal income tax at the 20% qualified dividend rate, not the ordinary income tax rate of up to 39.6%.   This is a huge tax savings.   But this is old news.  Most Businesses know they can save federal income tax by setting up an IC-DISC.

Ohio Small Business Deduction:  Taxpayers who own a pass-through entity(“PTE”)  can reduce their Ohio income tax liability by taking a deduction equal to the lesser of: (1) a specified threshold amount ($250,000 for a joint return filer); or (2) the amount of their Ohio taxable business income.  If the taxpayer’s share of business income is less than the threshold amount, the taxpayer pays no Ohio income tax.   Any excess over the threshold amount is subject to Ohio income tax at a flat 3% rate.  But this is also old news.  Most Ohio small business owners know that if they own an interest in a PTE that generates Ohio business income, then they should be claiming the Ohio small business income deduction.

But What if Both Apply?   What if a Taxpayer owns an export Business and has set up an IC-DISC that is owned by a PTE which he or she owns?  In such a situation, the Business would pay a royalty to the IC-DISC, the IC-DISC would pay a dividend to the PTE, and the PTE would allocate the dividend for federal (and state) income tax purposes to the Taxpayer.  In this case, would the Taxpayer be able to claim the dividend income allocated to him by the PTE as part of his share of business income for purposes of calculating the Ohio small business income deduction?  I think the answer is YES.

“Business Income” Includes Dividends Received in Ordinary Course of Business:  O.R.C 5747.01(B) defines “Business Income” as income including gain/loss:

(1)       Arising from transactions, activities, & sources in the regular course of a trade or  business operation (“Transactional Test”);

(2)       From real, tangible, 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 (“Functional Test”); and/or

(3)       From a partial or complete liquidation of a business, including gain or loss from the sale or other disposition of goodwill.

As described in Q&A 2 of the Business Income FAQ available on the Ohio Department of Taxation website, “Business Income” includes:

(a)       Distributive or proportionate shares of income from a pass-through entity (including a  partnership, S Corporation, or LLC)

(b)       Income from a sole proprietorship

(c)       Income from farming

(d)       Compensation or guaranteed payments made by a pass-through entity to a 20% investor  under O.R.C. 5733.40(A)(7)

As further described in Q&A 2, “Business Income” could also include the following if received in the ordinary course of a trade or business operation:

(i)        Royalties from real or tangible property

(ii)       Rents from real or tangible property

(iii)      Capital gains

(iv)      Interest

(v)       Dividends and distributions

(vi)      Patent, copyright royalties

Therefore, dividends received by a PTE in its ordinary business operation (i.e., created solely for investment purposes) would be Business Income when passed out to the ultimate Taxpayer.

In the situation above, the Taxpayer owns an export Business, has set-up an IC-DISC which is owned by a PTE that is owned by Taxpayer.  The Business pays a royalty to the IC-DISC.   The IC-DISC pays a dividend to the PTE.  The PTE allocates the amount of the dividend income to the Taxpayer.  The PTE is set up for the primary purpose of owning the IC-DISC and receiving the dividend payment from the IC-DISC.  The PTE could also own other investment assets.  In the ordinary course of its investment trade or business, the PTE receives the dividend from the IC-DISC.  Dividend received by the PTE from the IC-DISC seems to fall squarely within the definition of “Business Income” prescribed by the Ohio Department of taxation in the FAQ.

Bottom Line:  If you have an export Business and have set-up an IC-DISC, you should seriously consider setting up a PTE and having the IC-DISC owned by the PTE so that your share of the dividend paid to the PTE is treated as Business Income and eligible for the Ohio small business income deduction.  By so doing you can deduct up to $250,000 (for a joint return filer) and pay Ohio income tax at a flat 3% rate on the excess.  For more information about IC-DISCs or the Ohio small business income deduction or how to maximize the benefit of both contact Jeff Senney at 937-223-1130 or Jsenney@pselaw.com

AUTHOR: Jeff Senney
jsenney@pselaw.com