The Ohio Supreme Court ruled today that the Ohio tax commissioner abused his discretion when he refused to refund a penalty to a U.S. congressman and his wife who delayed paying income tax earned by a trust because they relied on a legal interpretation that imposed the tax on the trust.

The Supreme Court directed the tax commissioner to refund a $359,822 penalty plus post-assessment interest to James B. and Tina D. Renacci of Wadsworth. The Renaccis paid the penalty in 2008 along with $1.4 million in Ohio income tax in 2007 that was owed for tax year 2000. In a majority opinion authored by Justice Paul E. Pfeifer, the Court stated the tax commissioner has broad discretion to impose and refund penalties, but in this case he abused his discretion because the Renaccis had “reasonable cause” to believe they did not owe income tax on the profits going into the trust.

Renaccis Establish Electing Small Business Trust
Justice Pfeifer explained the income at issue is derived from income from shares of Subchapter S corporation stocks held by an electing small business trust (ESBT) set up by the Renaccis. The Internal Revenue Service permits Subchapter S corporations, known as “S corporations” to be taxed differently than traditional corporations with the profits generated through an S corporation being taxed as personal income as if the corporation were an individual.

Justice Pfeifer said the delay in payment resulted from a legal dispute concerning the taxability of S corporation profits as income in Ohio. The Renaccis, along with numerous other taxpayers, and their advisors, interpreted federal law to require that income derived from S corporation shares owned by an ESBT would be paid by the trust and not the individual shareholders of the stock. The Ohio Department of Taxation took a contrary position, Justice Pfeifer wrote, and the tax department’s decision was ultimately affirmed by the Ohio Supreme Court in three decisions starting with Knust v. Wilkins in 2006, followed by Lovell v. Levin in 2007 and Brown v. Levin in 2008.

Tax Rules Unclear When Trust in Force
The Renaccis interpreted a 1996 federal law as saying any portion of an ESBT consisting of stock from S corporations should be treated as a separate trust and the portion with the stock would be subjected to special taxation rules. The tax commissioner read the IRS rules to indicate that if an ESBT is established by a “grantor trust,” then the law applying to a grantor trust takes precedent over the special rules for an ESBT. The Renaccis’ ESBT was a grantor trust, and Justice Pfeifer noted that the tax commissioner found the grantor trust rule meant income to the trust from the shares were to be treated as income to the grantor. The tax commissioner advanced the view in two information releases, one in 2000 and the other in 2002.

In 2002, the U.S. Treasury Department issued a rule that supported the Ohio tax commissioner’s position, but the rule said it generally applied to trusts established on or after May 2002, with certain portions applying to ESBTs that ended on or after Dec. 29, 2000. The Renaccis presented evidence that their ESBT ended before the 2000 date and the new federal rule did not control their situation.

The Renaccis filed their Ohio joint tax return for 2000 without reporting or paying Ohio individual income taxes on the amounts earned by their ESBT trust. The trust owned shares of three S corporations, and the combined earnings from the companies for 2000 was $14 million. The Renaccis filed a disclosure form that indicated the shares were owned by their trust.

In 2003, the tax commissioner audited the Renaccis and determined that they earned about $13.7 million in Ohio taxable income from the S corporation shares in the trust. The Renaccis filed a petition for reassessment, which was denied by the Ohio Board of Tax Appeals (BTA) in 2007.

Renaccis Pay and Seek Penalty Refund
The Renaccis ceased contesting they owed the tax in 2007 based on the Knust and Lovell decisions and sought a settlement with the tax commissioner. When they could not reach an agreement, the Renaccis decided to pay the full amount owed but pursued a refund of the penalty amount. The Renaccis paid the $1.4 million in taxes owed in three installments in 2007 and the $359,822 penalty in 2008, then filed for a refund.

Justice Pfeifer stated the tax commissioner denied the refund on the sole ground that the couple “willfully filed their return contrary to a clear Department position.” The Renaccis appealed to the BTA, and the tax commissioner and the income-tax counsel in office in 2000 testified at a hearing. The former income-tax counsel confirmed the tax department prior to the 2000 information release was not taxing S corporation income tax on grantor trusts that elected to use the ESBT. The former tax commissioner testified that he once believed the ESBT was a possible tax strategy for S corporation shareholders to minimize Ohio individual income tax, but when he took office in 1999 he determined that going forward, grantor trusts using the ESBT were to be taxed as grantor trusts.

The BTA ruled the commissioner reasonably found the Renaccis failed to follow the commissioner’s instructions and affirmed the denial of the penalty refund. The Renaccis appealed the decision to the Supreme Court, and because the BTA is an administrative agency, the Court was bound to hear the case.

Former Law Allows Right to Seek Refund
Justice Pfeifer noted the state law, R.C. 5747.11(A), at the time the Renaccis sought a refund allowed the commissioner to refund taxes on an “illegal, erroneous, or excessive assessment.” The law was revised in 2013 to only allow a refund of “any overpayment of such tax.” Justice Pfeifer stated the tax commissioner had a strong argument that the current law did not authorize him to pay back a penalty, but the former version of the law allows for repayment of an “excessive assessment,” which could include a penalty.

R.C. 5747.15(C) authorizes the tax commissioner to refund a penalty if the failure to comply with the law “is due to reasonable cause and not willful neglect,” Justice Pfeifer explained. He noted the discretionary nature of the law means the BTA and the Court must determine that the tax commissioner abused his discretion by denying the refund, and not whether they would reach a different conclusion.

The BTA indicated it upheld the tax commissioner’s position because the Renaccis’ challenge relied only on the absence of an IRS regulation stating they had to pay, and the dissenting opinion in Knust.

“That is a gross misstatement,” Justice Pfeifer wrote. “The Renaccis have consistently stated throughout these proceedings that they were relying on the interpretation of the federal statute that the tax commissioner had abandoned, i.e., the interpretation that the trust rather than the grantor was to report and pay tax on the distributive-share income. That the tax commissioner changed his view of the federal statute does not make the earlier reading unreasonable.”

The BTA acted unreasonably and unlawfully when it failed to acknowledge that federal law was part of the Renaccis’ reasonable cause argument and that it was an arbitrary decision by the BTA to contend the Renaccis acted with willful neglect because they did not abide by the tax department’s information release, Justice Pfeifer concluded.

“The tax commissioner’s insistence that any departure from his published instructions negates the taxpayer’s good faith is arbitrary,” he wrote. “Neither the commissioner nor the BTA even considered whether the statute could fairly be read in favor of the Renaccis’ position.”

Justice Pfeifer noted that an information release does not create a legal obligation, and the Court has repeatedly held when the tax commissioner seeks to exercise administrative authority in a systematic way over a broad range of taxpayer claims, the commissioner must adopt an administrative rule. No rule was adopted.

The tax commissioner also argued while it might have been reasonable for the Renaccis to resist payment when first assessed, the reasonableness evaporated with the Knust decision. Justice Pfeifer observed the Knust ruling considered a claim related to the federal treasury regulation that the Renaccis had indicated did not apply to their case. It was the Lovell decision that addressed a situation similar to theirs.

“Because Lovell was not decided until November 2007, when the Renaccis were already in the process of paying their assessment, we hold that their claim of reasonable cause extended into the time frame in which they were making payment,” he wrote.

The Court reversed the BTA decision and remanded the cause to the tax commissioner with instructions to refund the penalty with interest.

Justices Terrence O’Donnell, Judith Ann Lanzinger, Sharon L. Kennedy, Judith L. French, and William M. O’Neill joined Justice Pfeifer’s opinion.

Chief Justice Maureen O’Connor concurred in judgment only.

2014-1893. Renacci v. Testa, Slip Opinion No. 2016-Ohio-3394.

View oral argument video of this case.

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