Ohio Income Tax: Dividends from accumulated C corporation earnings retain their character and are non-taxable to nonresident shareholders.

The Ohio Supreme Court encountered a relatively unique situation in Giddens v. Testa, 2016-Ohio-8412. The two shareholders of Redneck, Inc., who resided in Missouri, received large dividends in 2008, at which time Redneck was taxed as an S corporation. However, the taxpayers showed the dividends were Redneck’s earnings and profits from when the corporation was a C corporation – Redneck’s S corporation election was effective September 1, 2004. Yet, the Ohio Tax Commissioner contended the dividends were taxable as business income earned by Redneck because it was an S corporation at the time the dividends were distributed and, thus, apportioned to Ohio based upon Redneck’s apportionment ratio.

The Supreme Court recognized that the taxability of the income is determined based upon the event that triggers the tax liability. Here, “it was not Redneck’s business activity that made the dividend appear as a taxable item… It was the declaration of the dividend that did so.” Giddens, at ¶32. Accordingly, the dividend from accumulated earnings when Redneck was a C corporation was treated as nonbusiness income, and allocated to the taxpayers’ domicile of Missouri under R.C. 5747.20(B)(6).

The character of income from a pass-through entity is determined as if the income was received from the source from which the corporation received the income. R.C. 5747.231. Agley v. Tracy, 87 Ohio St.3d 265 (1999). However, this treatment of S corporation income only applies to the shareholder’s distributive share of the corporation’s income, not to earnings accumulated prior to the corporation’s S corporation election. “[T]he tax commissioner’s argument evaporates, because the income at issue in this case is not the [taxpayers’] distributive share of Redneck’s current income. Instead, the income subject to taxation here is a dividend paid out of earnings that accrued to the corporation during earlier years.” Giddens, at ¶28.