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Gain From Sale of Stock Owned by ‘Small Business Trust’ Subject to State Income Tax
2005-2084. Knust v. Wilkins, 2006-Ohio-5791.
Board of Tax Appeals, No. 2004-M-533. Decision affirmed.
Moyer, C.J., Resnick, Pfeifer, Lundberg Stratton, O'Connor and Lanzinger, JJ., concur.
O'Donnell, J., dissents.
Opinion: http://www.supremecourtofohio.gov/rod/newpdf/0/2006/2006-Ohio-5791.pdf
(Nov. 22, 2006) The Supreme Court of Ohio has ruled that, under state and federal tax laws, when stock in a Subchapter S corporation owned by two Electing Small Business Trusts (ESBTs) was sold by the trusts for a profit, the proceeds of the sale were taxable as personal income to the individuals who established and maintained control of the trusts.
The 6-1 decision authored by Justice Maureen O'Connor affirms rulings by the Ohio Tax Commissioner and the Ohio Board of Tax Appeals, which found that taxpayers David Knust and Susan Purkrabek were not entitled to a refund of more than $2 million for taxes paid on proceeds from the sale of their business in 2000. They had argued that they were not liable for the personal income tax because the income was received not by them but by the ESBTs they had established.
“The only question … is whether the trusts' status as ESBTs changed the taxability of the income that those grantor trusts earned,” Justice O'Connor wrote. “We conclude – like the Tax Commissioner and the BTA – that it did not. The income that the trusts earned when they sold the shares of the packaging company in 2000 is properly treated as part of David and Susan's own adjusted gross income for that year.”
Knust and Purkrabek are a husband and wife who purchased the assets of a business called Precision Packaging and Services in 1983 for approximately $450,000 and built it into a company that employed approximately 300 people and had gross sales of $39 million in 1999. Between them, Knust and Purkrabek owned 100 percent of the company's stock. In 1995 they reorganized the company as a Subchapter S corporation under federal tax laws.
In 1998, Knust and Purkabek transferred ownership of all their respective shares in Precision Packaging into two separate grantor trusts, and elected to have those trusts treated as “Electing Small Business Trusts” (ESBTs) for federal income tax purposes. In February 2000, the trusts sold all of the stock of Precision Packaging to a third-party buyer, Outsourcing Services Group. The sale proceeds of approximately $33 million were deposited into bank accounts owned by the trusts, and the trusts reported the proceeds of the sale as trust income in their federal fiduciary tax returns for 2000. Knust and Purkrabek did not include the sale proceeds in their calculation of personal federal adjusted gross income (FAGI) for the 2000 tax year.
Pursuant to an advisory issued by the state tax commissioner in November 2000, Knust and Purkrabek reported the gain from the sale of the company as personal income in their joint state tax return for 2000, and paid state income tax on the proceeds. They subsequently filed a petition with the tax commissioner seeking a refund of the personal income tax they paid on the proceeds of the sale, asserting that under state law, income not reportable as part of a taxpayer's personal FAGI was not subject to state income tax. The commissioner rejected the refund petition, and the State Board of Tax Appeals (BTA) affirmed the commissioner's ruling. Knust and Purkrabek have exercised their right to appeal the BTA's holding to the Supreme Court.
In affirming the Board of Tax Appeals ruling, Justice O'Connor wrote: “Nothing in the statutory provision cited by David and Susan – Section 641(c), Title 26, U.S. Code – suggests that that principle changes when the grantor trust is designated as an ESBT. That statute simply says that when an income tax is imposed on a trust, that tax is to be calculated in a specified way if the trust is an ESBT. Where, as in this case, no income tax is imposed on the trust, however, the statute does not come into play. In other words, a grantor trust can elect ESBT status, but that status does not change the ordinary requirement that the grantor trust's income is taxed to the grantor and not to the trust itself. Grantor trusts pay no tax on the income they earn, and therefore the provisions of Section 641(c) concerning the calculation of taxes on an electing-small-business trust do not apply if the ESBT is a grantor trust.”
Justice O'Connor's opinion was joined by Chief Justice Thomas J. Moyer and Justices Alice Robie Resnick, Paul E. Pfeifer, Evelyn Lundberg Stratton and Judith Ann Lanzinger.
Justice Terrence O'Donnell wrote a dissent in which he did not disagree with the majority's reasoning but argued that the regulation they point to as governing the taxability of ESBT income did not go into effect until after the date of the sale of Precision Packaging & Services.
“The trusts in question terminated on February 26, 2000, and, therefore, their taxable year ended on that date,” O'Donnell wrote. “Treasury Regulation 1.641(c)-1(k), upon which the majority relies, is ‘applicable for taxable years of ESBTs that end on and after December 29, 2000.' (Emphasis added.) … Because the ESBTs had terminated prior to December 29, 2000, the Treasury Regulation does not apply to them. The majority attempts to circumvent this regulation and the plain language of Section 443(a) by stating that David and Susan ‘offered no separate tax returns suggesting that they treated the taxable year for the ESBTs as having ended on any date earlier than December 31, 2000.' In my view, this point is not persuasive, because Section 443(a) provides that a ‘short period' tax return ‘shall be made' when a taxpayer ceases to exist during a tax year. The tax year in question, therefore, terminated when the taxpayer ceased to exist regardless of the date indicated on the tax return.”
Contacts
Stephen M. Nechemias, 513.381.2838, for
David Knust and Susan Purkrabek.
Barton Hubbard, 614.466.5967, for the State Tax Commissioner.
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