Opinion
No. 87-1710
Submitted September 27, 1988 —
Decided December 14, 1988.
Taxation — Franchise tax — Net income calculation — Compensation paid to shareholders as employees not includable in net income, when.
APPEAL from the Board of Tax Appeals, No. 85-F-1049.
Appellant, Cohen Company, challenges the assessment by appellee, Tax Commissioner, of its 1980 and 1981 franchise tax returns. For both years, appellant, a Subchapter S corporation, filed federal 1120S forms with the Internal Revenue Service listing taxable income of $134,968 for return year 1978 and $174,329 for 1979. On its Ohio franchise tax returns for 1980 and 1981, respectively, appellant reported this federal taxable income as Ohio net income and claimed a deduction on line 3(c) of Schedule B for what appellant described as "Subchapter S distributions in lieu of compensation included in amount on line 1, but treated as a corporate expense for Ohio franchise tax purposes." For 1980, this deduction was $134,868; for 1981, it was $174,212. Appellant reported $100 as Ohio taxable income in 1980 and $117 in 1981. Since appellant reported negative net worth for both franchise tax years and since neither the net income nor net worth method produced a franchise tax in excess of $50, it paid the $50 minimum tax for each year.
Appellant's federal tax years 1978 and 1979 correspond to its Ohio franchise tax years 1980 and 1981.
The commissioner audited these returns, disallowed the deductions, and recomputed the tax. Including penalty and interest, the assessments were $13,356.50 for 1980 and $16,988.66 for 1981. On review, the commissioner abated the penalties in full but affirmed the basic assessments and interest. Appellant's final liability was $10,932.14 for 1980 and $13,764.58 for 1981. Appellant appealed to the Board of Tax Appeals ("BTA").
Appellant filed "Proposed Amended Return[s]" with the Internal Revenue Service for the relevant federal tax years and entered them into evidence at the BTA hearing. In these amended federal returns, appellant added to line 26 ("Other deductions") the amounts it had deducted from the Ohio franchise reports, thus reducing federal taxable income. It labeled them "distributions to shareholders in lieu of compensation." Appellant added the following statement to each schedule:
"This return is being amended to reflect a reclassification of distributions to shareholders from profit to expense. This is being done for the purpose of correcting the distortive effect prior treatment had on State of Ohio Tax Returns. THIS AMENDMENT WILL REQUIRE NO CHANGE IN THE TAX LIABILITY OF ANY OF THE SHAREHOLDERS." (Capitalization sic.)
Appellant had not claimed any compensation paid to any of its shareholders on its Schedule K-1s in its original federal returns, although a space was provided for this information.
According to the testimony before the BTA, compensation was paid in the following way. If a shareholder needed money, and if the funds were available, the shareholder was permitted to withdraw the desired amount from the firm's account. A compensation distribution was calculated by applying a formula that had a base allocation for each shareholder, a second allocation based on a predetermined formula, and a third allocation based on the shareholder's annual performance. Assigned compensation was then reconciled with actual withdrawals. Appellant did not perform these calculations for the BTA, nor did it present any evidence concerning the actual calculations or amounts distributed to each shareholder.
The BTA affirmed the commissioner's assessment.
The cause is now before this court upon an appeal as of right.
Kadish Bender, J. Timothy Bender and Steven L. Kadish, for appellant.
Anthony J. Celebrezze, Jr., attorney general, and Floyd J. Miller, Jr., for appellee.
R.C. 5733.01 imposes a tax on corporations for the privilege of exercising their franchise in Ohio. This tax is computed on the value of the taxpayer's issued and outstanding shares of stock, calculated on either the net worth or net income basis, whichever produces the greater tax. R.C. 5733.06. At issue here is the tax calculated on the net income basis.
Under R.C. 5733.05(B), the starting point for this calculation is determining the corporation's net income. R.C. 5733.04(I) defines "net income" as:
"* * * [T]he taxpayer's taxable income before operating loss deduction and special deductions, as required to be reported for the taxpayer's taxable year under the Internal Revenue Code [subject to several non-pertinent adjustments] * * *." (Emphasis added.)
Furthermore, R.C. 5733.01(C), during the audit period, stated:
"The tax charged by and all provisions contained in this chapter are applicable to a taxpayer that makes an election under subchapter S of chapter one of the `Internal Revenue Code of 1954,' as now or hereafter amended or reenacted, in the same manner as if such election had not been made."
Thus, the taxable income that is required to be reported for federal purposes is also the net income for the Ohio franchise tax. If the item is not required to be reported for federal purposes as taxable income it is not includable in net income for purposes of the Ohio franchise tax.
During the questioned years, Section 63(a), Title 26, U.S. Code defined "taxable income" as:
"For the purpose of this subtitle, in the case of a corporation, the term `taxable income' means gross income minus the deductions allowed by this chapter."
"Gross income" is defined in Section 61(a), Title 26, U.S. Code:
"* * * Except as otherwise provided in this subtitle, gross income means all income from whatever source derived * * *."
Section 162(a)(1), Title 26, U.S. Code provides a deduction for salaries and compensation:
"* * * There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including —
"(1) a reasonable allowance for salaries or other compensation for personal services actually rendered * * *."
Appellant argues that it may deduct the disputed amounts as compensation for Ohio franchise tax purposes even though it did not claim them for federal income tax purposes. The commissioner responds that this deduction is unauthorized.
Dividends paid by a corporation are not deductible from its gross income for purposes of federal income tax. Sections 1.162-7 and 1.162-8, Title 26, C.F.R. Thus, dividends paid to a corporation's shareholders are required to be reported as federal taxable income and, consequently, as Ohio net income for computation of the franchise tax, but reasonable compensation paid to the shareholders as employees is not. If the amount appellant distributed to its shareholders is compensation, it is not includable in federal taxable income or in Ohio net income. If it is a dividend, then it is includable in both.
In the instant case, appellant neither labeled these amounts as compensation nor claimed any amount as compensation on its initial federal returns. Appellant, therefore, cannot succeed with its argument that these distributions were compensation. Since appellant first reported these amounts as taxable income for the federal income tax, it was required to declare them as net income for the Ohio franchise tax.
In answer to appellant's proposition that the commissioner must now accept the amended federal returns as correct and deduct these disputed amounts as compensation, R.C. 5733.031(C) controls. Under this section, if the federal tax authorities confirm that appellant's federal taxable income is altered by the amended returns, and if these alterations affect its Ohio tax liability, appellant must notify the commissioner and file an amended return. The record does not disclose that this was the situation herein.
Moreover, in the tax years under review, R.C. 5747.01(S)(5) allowed an individual to deduct, from his Ohio taxable income, distributions from a Subchapter S corporation that were included in his adjusted gross income. 138 Ohio Laws, Part II, 3180. The interaction of R.C. 5733.01(C), which requires taxation of a Subchapter S corporation "* * * in the same manner as if such corporation were subject to the federal income tax," and R.C. 5747.01(S)(5), which deducted Subchapter S corporation distributions from a shareholder's income, resulted in the distribution amount being taxed to the Subchapter S corporation. In the instant case, appellant's shareholder-employees did not claim this deduction initially, but several have since applied for and received Ohio personal income tax refunds for this deduction. Thus, appellant's shareholders have attempted to avoid the tax consequences to the corporation which these distributions entail, while reaoing the tax benefits thereof.
Accordingly, since the decision of the BTA is neither unreasonable nor unlawful, it is hereby affirmed.
Decision affirmed.
MOYER, C.J., SWEENEY, LOCHER, HOLMES, DOUGLAS, WRIGHT and H. BROWN, JJ., concur.