Insurance: What is it? How does it work?

Assume that Acme Co[i] is paying premiums for commercial insurance[ii] coverage to protect itself from economic losses that may arise out of various events. These premiums are deductible in determining Acme’s taxable income; they represent an ordinary and necessary expense of conducting Acme’s business.[iii] As in the case of most insurance, the premiums are “lost” as the policy period expires – they are not recovered notwithstanding that the insured has not suffered a loss.

Businesses will sometimes “self-insure” with respect to a particular loss[iv] by setting aside funds to cover their exposure to such loss. Thus, Acme may decide to establish a segregated account to which it will periodically make cash contributions – basically, a reserve – and from which it may withdraw funds to cover the loss, as needed. The amount set aside as part of a self-insurance program, however, is not deductible for purposes of determining the taxable income of the business;[v] what’s more, these funds remain subject to the claims of Acme’s creditors.

The Code, on the other hand, affords businesses the opportunity to establish their own insurance company. Indeed, it encourages businesses to do so by providing certain incentives; specifically, in the case of an electing[vi] “small captive,” (i) the insured business is permitted to deduct the premiums paid to its captive insurance company, provided the premiums are reasonable for the coverage being purchased, and (ii) the captive may receive up to $2.2 million[vii] of annual premium payments free of income tax, provided the premium is reasonable for the loss being insured by the captive. In order to qualify for these benefits, however, the captive has to satisfy certain requirements.[viii]

One common business purpose for which an electing captive may be organized is to provide coverage for a particular risk exposure for which conventional commercial coverage is either not available or very expensive; another is to cover a gap in coverage in an existing conventional policy (for example, an exclusion from such a policy); there are others.

A business which identifies a bona fide, insurable risk, may incorporate a captive under the laws of a jurisdiction[ix] that has captive insurance laws; the captive will be regulated by, and will have to report to, the insurance authorities of such jurisdiction.[x] This corporation would be treated as a C corporation for tax purposes. Like other insurance companies, it will underwrite policies, set aside appropriate reserves to cover claims made against those policies, and invest the balance of the premiums received. As an electing small captive, it will be taxable only on the net investment income and gains it recognizes, provided its premium income does not exceed the above-described premium cap.

Captive as True Insurance Company

The foregoing is all well and good, but in order to enjoy these tax benefits, it is imperative that the captive actually operate as a bona fide insurance company. It must insure a bona fide risk, not one that is certain of occurring; in other words, there must be an element of “fortuity,” as the courts say, in order for the risk to be insurable.

In addition, in order to be respected as insurance, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk being insured from the business to the captive insurer. Risk distribution is the exposure of the captive to third-party risk, and vice versa, as in the case of conventional insurance; in the case of the latter, generally speaking, the actuarially determined premiums collected from many insureds provide the pool of liquidity from which the loss suffered by one insured may be covered. The IRS has issued several rulings over the years that explore these concepts in the case of a captive insurance company.

In most cases, however, it will be difficult for a captive founded by a single business to satisfy the “risk-shifting” and, especially, “risk distribution” requirements. To achieve the status of real insurance, therefore, the captive will often pool its premiums with other captives (not necessarily from the same type of business).[xi] These pools are managed by an experienced (and hopefully reputable) management company for a fee. The management company will conduct annual actuarial reviews to set the premiums, manage any claims, take care of regulatory compliance, pay on claims from the pool as they arise, etc.

Proceed With Caution – or Not

However, it seems that taxpayers are often enticed by sponsors of the above-described pools into forming captives other than solely for genuine business reasons. Indeed, many promoters tout the captive arrangement as a vehicle for retirement, compensation or estate planning device. That’s why the IRS has included captives on its list of “dirty dozen” tax scams. Among the abusive tax structures highlighted by the IRS is a variation on the so-called small captive insurance company discussed herein. The IRS has characterized the scam version as an arrangement with “poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums.’ ”[xii]

A recent decision[xiii] by the U.S. Tax Court considered whether the large premiums paid by Taxpayer to their captive constituted actual premiums, and whether the transaction in which the two engaged was actually insurance. Spoiler alert: it didn’t go well for Taxpayer.

Taxpayer was a commercial construction company with expertise as a general building contractor. As its business grew, Taxpayer and its shareholders established many subsidiaries and affiliates (the “Entities”), which the Court observed what “not at all unusual for an industry where leveraged financing is common and every project carries some risk.”

Notwithstanding the presence of many separate business entities, it was clear, according to the Court, that most of their collective business was run through Taxpayer, and the “fortunes of all these . . . entities were closely tied to the fortune of” Taxpayer.[xiv] In one year, for example, one Entity had $1.4 million in gross receipts, of which $1.2 million was “consulting fees” received from Taxpayer. This Entity then turned around and paid “consulting fees” to several of the other Entities, which “fees” turned out to be a significant part of the Entities’ revenues.

Taxpayer’s Captive

For many years, Taxpayer purchased conventional third-party commercial property, casualty, and liability insurance through its longtime insurance broker. These policies were the broadest policies available in the commercial-insurance marketplace for the risks covered.[xv] In addition, they not only insured Taxpayer, but also the other related entities, as well as the family of the principal shareholder (“Shareholder”).

However, this traditional insurance did not cover every loss that Taxpayer and its related entities faced over the years. In fact, there was a gap in coverage such that Taxpayer incurred losses of approximately $50,000 per year.

At some point, Shareholder was introduced to the concept of captive insurance. He concluded that captive insurance, “if done correctly, had potential.” Without much in the way of due diligence, Shareholder incorporated a foreign captive insurance company (“Captive”) in December of Year One, acquired all of its stock, and contracted with a company (“Manager”) to manage the captive. To ensure adequate risk distribution (see above), Manager “required” the captives it managed to participate in a risk pool. Captive never participated in this pool.

On the day after its incorporation, Captive elected[xvi] to be taxed solely on its investment income – as a small insurance company – so long as its annual premiums did not exceed the annual premium cap[xvii] set under the Code.

That same day, Taxpayer paid Captive a “premium” in the amount of $1.2 million, which it deducted as an insurance expense on its tax return for Year One.

The Court observed that this premium payment “was at least a bit odd,” because Taxpayer had not yet completed any underwriting questionnaires, and “perhaps even odder” because Captive had not yet underwritten or issued any policies to any of the Entities.[xviii]

“But what really made this first year remarkable,” the Court explained, was that the Year One policies that Captive finally got around to issuing in Year Two were “claims-made” policies, “which means that any claim had to be reported during the applicable policy period.” In other words, when Taxpayer paid the $1.2 million “premium” to Captive at the end of Year One – the same amount it would be paying annually during each of the subsequent years at issue in exchange for a full year’s worth of coverage – in reality Taxpayer was receiving at most 10 days of coverage (i.e., for the rest of December) and possibly none at all.

As in the case of Year One, the underwriting process for Year Two did not begin until after the Year Two coverage period had already closed.

During the years at issue, Taxpayer and the Entities also carried traditional commercial insurance. They supplemented this coverage with their insurance through Captive, for which they paid $1.2 million per year. As in the earlier years described above, Captive delivered these claims-made policies well after the policy periods. Thus, the Entities paid these premiums without knowing what policies they were paying for.

Fees to Premiums to Policies

The Court described the means by which money found its way from Taxpayer to Captive as “noteworthy.” The payment of Captive’s premiums during the earlier years began when Taxpayer paid just over $1.2 million to an Entity for “consulting” services. The payee Entity’s only workers at the time were two minor children related to Shareholder. The consulting payments were made without any contract between the two corporations, and indeed without any records that described when the consultation took place, what advice was received, or even what subjects were discussed.

The above payee Entity then paid another $1.1 million for “professional-consulting fees” to still other Entities that were covered under Captive’s insurance program. As these entities received this “consulting” revenue, they applied it toward the payment of premiums for on insurance from Captive.

“It is not by chance,” the Court stated, “that the consulting payments match the premiums so closely.”[xix] This pattern was repeated every year.

All these premiums, for all these years, from all of the related entities began piling up. During the periods being reviewed, Captive collected $4.8 million. During all that time, however, Captive paid only four claims aggregating only $43,000.

“And, inasmuch as these claims were made on claims-made policies that [Captive] didn’t issue until after the policy years had closed,” the Court continued, “one might expect there to be something odd about them. One would be right.” For example, as to two of the claims, the Manager requested additional support for the claims, but none was ever submitted. Instead, Shareholder (as Captive’s owner) overruled the Manager and ordered that the claims be paid. And both these claims were filed before Captive issued the policies under which they were made; indeed, before the policies were even underwritten.

In calculating its taxable income, Taxpayer deducted the payments that it made to the Entity as consulting expenses. All the other Entities reported their payments to Captive as a combination of deductible insurance and other, related expenses – Captive reported these as premiums.

Tax Returns

Captive reported itself as a small insurance company and, therefore, did not include the $1.2 million in premiums as taxable income on its tax returns.

For the years at issue, CPA prepared the tax returns for Taxpayer and almost all of the Entities. The Entities provided CPA with anything that was requested, and CPA simply reported the information that was given to him.[xx] He was unaware that many of the Entities were paying nearly 100% of their gross receipts from consulting on insurance premiums to Captive.

This activity “set off some alarms,” as the Court put it, and the IRS investigated; eventually, notices of deficiency were issued to Shareholder, Taxpayer, and many of the Entities, which then petitioned the Tax Court.

The Court’s Analysis

A taxpayer is allowed to claim a deduction for all ordinary and necessary business expenses. However, where the expenses are incurred between related parties, both the IRS and the Courts are more skeptical of their legitimacy. The reason is that “expenses” paid by one related party to another often represent disguised distributions of profits, which are not deductible. In order to allay any concerns over the true nature of the payments, the IRS and the Courts will look for corroborating evidence related to the expenses claimed.

Both consulting fees and insurance premiums are deductible by a taxpayer as ordinary and necessary expenses if paid or incurred in connection with a trade or business.[xxi] In turn, the consulting fees and premiums are included in the income of the consultant or insurance company, as the case may be.[xxii] Insurance companies are generally taxed on their income in the same manner as other corporations. According to the Court, “that’s what made the $1.2 million in consulting deductions and premiums so likely to raise the IRS’s bureaucratic eyebrows – that’s the limit on premiums that an insurer can receive without owing tax.[xxiii]

A “small insurance company,” the Court stated, with premiums that do not exceed $1.2 million for the year, can elect under the Code to be taxed only on its investment income. These rules are more complicated, the Court explained, when the insurer and the insureds are related to one another because while insurance is deductible, amounts set aside in a loss reserve, as a form of self-insurance, are not. Unfortunately, neither the Code nor the regulations actually define what is meant by “insurance.”


According to the Court, the line between nondeductible self-insurance and deductible insurance can be blurry. In order to distinguish one from the other, the Courts look to four nonexclusive criteria: “risk-shifting; risk-distribution; insurance risk; and whether an arrangement looks like commonly accepted notions of insurance.”

To determine whether Captive’s policies were insurance, the Court applied the four-part test described above.

Risk Distribution

Risk distribution is one of the common characteristics of insurance, and courts will find it when an insurer pools a large enough collection of unrelated, independent risks that occur randomly over time. “By doing so, the insurer smooths out losses to match more closely its receipt of premiums.”

In previous small captive insurance cases considered by the Court, the captive tried to show risk distribution by investing in an “insurance pool” – a way to reinsure a large number of diverse third parties. In the present case, Captive chose not to participate in such a pool.

The Court then noted that another way that small captive insurers have tried to show that they met the risk-distribution requirement was by issuing policies to their own brother and sister entities. In those cases, the Court asked: “[W]as there a large enough pool of unrelated risk?” “The question is not solely about the number of brother-sister entities insured,” the Court explained, “but the number of independent risk exposures.” In other words, was there a large enough pool of unrelated risk from the policies issued to the related entities?

In Taxpayer’s case, the IRS argued that Captive did not have enough independent risks. The risks it faced made for much too small a risk pool. Moreover, all of the risks were heavily tied to one entity – Taxpayer. The strong correlation of risk between the smaller Entities and Taxpayer prevented Captive from having adequate risk distribution.[xxiv]

In response, Taxpayer argued that Captive adequately distributed risk, relying upon the “law of large numbers”: that Captive insured a sufficient number of unrelated risks to allow the law of large numbers to predict losses. The Court rejected this argument, relying upon caselaw which, according to the Court, demonstrated that the number of independent risks that had to exist in order for risk to be sufficiently distributed to meet this element was “orders of magnitude” greater than the risks covered by Captive. What’s more, the majority of the risks Captive faced were not independent risks. The Entities were all very dependent on Taxpayer.[xxv]

Looks Like Insurance?

Finally, Captive was not operated as an insurance company. For one thing, its process of pricing policies was “very different” in that it backed into the premium amount. In addition, it didn’t issue policies until after the claims period being insured had ended.[xxvi] Its handling of claims was also abnormal; two claims were even paid on policies that had not yet been written. Finally, the Court pointed to the payment made by Taxpayer to Captive for only 10 days of coverage, which was nearly the same as later paid for a full year’s worth of coverage. “This particular fact,” the Court stated, “shows how much more likely it is that [Captive] is self-insurance, if not just a tax-avoidance scheme.”

Next, the Court found that Captive’s premiums were neither reasonable nor the result of an arm’s-length transaction. The historical loss experience of the Entities did not justify the amount paid to Captive as premiums. An unreasonably large premium, the Court noted, is likely to be for something other than “insurance” as that term is commonly understood. Finally, the Court found that the premiums weren’t actuarially determined, and their parameters and assumptions were not properly documented.

Thus, the Court concluded that the premiums paid to Captive and deducted by Taxpayer and the Entities were not paid for “insurance” for federal tax purposes.[xxvii]

A Silver Lining

The Court’s holding on the above facts was a foregone conclusion. Taxpayer had no chance of sustaining its claim that Captive was an insurance company.

That being said, the Court’s opinion highlighted the importance of treating at arm’s length with related parties, including in the context of transactions that intend to be insurance.

The Court also called attention to many practices that should be avoided by anyone who is planning to organize a small captive if they hope to attain the desired tax treatment. As that great American philosopher, Groucho Marx, once said, “Learn from the mistakes of others. You can never live long enough to make them all yourself.”


[i] Yep, I’m channeling Wiley Coyote.

[ii] Generally speaking, commercial insurance covers general liability (to cover claims against the business), workers’ compensation (to cover employees’ work-related injuries), and property insurance (to cover damage to business property).

[iii] IRC Sec. 162.

[iv] Say, for example, anything involving the Road Runner.

[v] After all, the business taxpayer that self-insures is simply moving money from their left pocket to their right pocket – or is it from right to left?

[vi] The election is irrevocable.

[vii] Adjusted for inflation. See the Protecting Americans from Tax Hikes (PATH) Act of 2015, which was enacted in 2015, as part of the Consolidated Appropriations Act (P.L. 114-113). The premium cap was set at $1.2 million for taxable years beginning before January 1, 2017.

[viii] Among other things, these include a “diversification” requirement which was added to IRC Sec. 831(b) as part of the PATH Act in an effort to prevent the use of captives for other than insurance planning purposes; specifically, for estate planning (as evidenced by the alternative test described below).

In order to satisfy the diversification test, no more than 20 percent of the written premiums of the captive company for the taxable year may be attributable to any one policyholder (a risk diversification test); “related” policyholders are treated as one policyholder for this purpose.

In the event that the foregoing test is not satisfied – a likely outcome considering we are taking about a captive insurance company, which was probably organized by a single business – the Code provides an alternative test which may be satisfied if no person who holds (directly or indirectly) an interest in such captive insurance company is a “specified holder” who holds (directly or indirectly) aggregate interests in such company which constitute a percentage of the entire interests in such insurance company which is more than a de minimis percentage higher than the percentage of interests in the relevant “specified assets” with respect to such insurance company held (directly or indirectly) by such specified holder. .

[ix] Vermont or Delaware seem to be popular choices.

[x] Among other things, these State insurance regulators seek to ensure that a captive formed in their jurisdiction maintains adequate liquid reserves. They also regulate investments by a captive in order to reduce the risk of investment loss that may impair the captive’s ability to satisfy its obligations.

[xi] Much the same way that many insureds pay premiums to a single insurance company.

[xii] According to the IRS, promoters in such scams received large fees for managing the captive insurance company while assisting unsophisticated taxpayers “to continue the charade.”

[xiii] Caylor Land & Development, Inc. v. Comm’r, T.C. Memo. 2021-30.

[xiv] The Court described the relationship among these entities as follows: “[Taxpayer] was the driver of the success or failure of all the other . . . entities – in a room full of mice, it was the 800-pound gorilla.”

[xv] Commercial property, general liability, umbrella/excess liability, electronic data processing, contractors equipment, installation floater, commercial auto, and terrorism.

[xvi] Under IRC Sec. 831(b).

[xvii] $1.2 million for the taxable years at issue.

[xviii] Taxpayer eventually filled out an underwriting questionnaire for the year at issue and it did eventually acquire policies that covered itself and several other related entities.

[xix] In fact, Shareholder testified that when he began making these payments in 2008, he made sure the consulting payments were slightly more than the premium payments so, as he put it in an email, “the pay-ins do not match the payouts exactly.”

[xx] The Court found that CPA was unable to advise the entities about whether Consolidated was properly operated as an insurance company. He never provided a tax opinion or memorandum regarding the requirements for a small captive insurance company under the Code.

[xxi] IRC Sec. 162; Reg. Sec. 1.162-1.

[xxii] IRC Sec. 61.

[xxiii] IRC Sec. 831(b).

[xxiv] The Court rejected Taxpayer’s arguments to the contrary: insuring a number of unrelated risks sufficient to allow the law of large numbers to predict expected losses; having risks of at least 12 affiliated companies, none of which has liability coverage of less than 5% nor more than 15% of the total risk insured by the insurance; or arranging for at least 30% of the risks assumed by the insurance company to be those of unrelated parties.

[xxv] Many of the Entities received all or most of their revenue from Taxpayer. Many had no clients other than Taxpayer. If something were to happen to Taxpayer, it would have a severe effect on all of the other Entities.

Taxpayer, in turn, was concentrated in the real estate market of a single geographic region. This lack of diversity supported the Court’s finding that the risks insured by Captive were not sufficiently distributed; absent sufficient risk distribution, what Captive provided was not insurance.

[xxvi] A policy written after the claims period is being written after there is no longer a risk of loss, which defeats the whole purpose of insurance.

[xxvii] Because Captive failed to distribute risk and was not selling insurance in the commonly accepted sense, the Court did not decide whether Captive’s transactions involved insurance risk or risk shifting.

Corporate Rate Increase? 

We begin this week with the Senate having passed the President’s $1.9 trillion coronavirus relief and economic stimulus plan (the “American Rescue Plan”[i]) following a marathon session during which Senate Democrats tried to address the concerns of centrists within their own party,[ii] but without alienating more progressive members of the party in both the Senate and the House. Now the revised bill heads back to the House, before being sent to the White House for Mr. Biden’s signature.[iii]

Following this legislative victory, the Democrat-controlled Congress is expected to turn its attention to the President’s multi-trillion[iv] dollar infrastructure (“Build Back Better”) plan, the details of which have not yet been released,[v] but which are expected to include certain tax increases, including corporate tax hikes.[vi]

Speaking of which, a corporation’s taxable income is currently subject to Federal income tax at a flat rate of 21 percent.[vii] During the Presidential race, Mr. Biden proposed increasing that rate to 28 percent – the midway point between today’s tax rate and the top graduated rate of 35 percent[viii] that was in effect before 2018.[ix]

The business profits of a C corporation, or of any other corporation that may be subject to a corporate-level income tax,[x] are subject to income tax twice: once to the corporation, and again upon the distribution by the corporation of its after-tax profits to its shareholders in the form of a dividend.[xi] Under current law, with a 23.8 percent[xii] tax rate for qualified dividends paid by a C corporation to an individual shareholder, the combined effective rate to the corporation and shareholder is 39.8 percent. If the corporate rate were increased to 28 percent, and the dividend rate remained unchanged, the combined effective rate would be 45.14 percent.

Corporate Response?

Other things being equal, an increase in a business’s tax liabilities will cause a reduction in the return on its capital; stated differently, the corporation’s shareholders will enjoy a lower return on their investment in the business.

How, then, does a C corporation respond to increased taxes?[xiii] If it does nothing at all, then its shareholders will bear the brunt of the tax liability – that’s not option that any shareholder would accept, let alone voluntarily select; the corporation may try to pass the increased cost to its customers[xiv]; it may try to cut costs – after all, taxes are another cost of doing business[xv]; the corporation may try to reduce its taxable income.

One means by which corporations have historically tried to reduce taxable income, and also avoid the double taxation of corporate profits, is by foregoing the distribution of non-deductible, after-tax dividends and, instead, transferring such profits to its individual shareholders by means of deductible payments, such as rent for the use of property owned by a shareholder, or as compensation for services rendered by the shareholder.[xvi]

Provided these transactions represent bona fide business arrangements, the corporation will be permitted to deduct the amounts paid to the shareholder,[xvii] acting (for example) as landlord or as service provider, in determining its taxable income, and it will thereby succeed in avoiding corporate-level tax with respect to the amount paid.

Of course, the amount thus paid by the corporation to the individual shareholder will be taxable to the shareholder as ordinary income.[xviii]

Taxpayer’s Payments for “Services”

A recent decision by the U.S. Tax Court explored the factors that a corporation will have to consider if it hopes to support its tax treatment of a payment to an individual shareholder as something other than a non-deductible dividend.[xix]

Taxpayer was a subchapter C corporation for Federal income tax purposes. Most of its revenue came from contracts with government entities for which it had to submit bids.

Taxpayer had three shareholders: Corp (owning 40% of the issued and outstanding shares of Taxpayer’s stock), Ltd (also 40%), and Individual (owning 20%).

Taxpayer did not declare or distribute any dividends to any of its shareholders during the years in issue or in any prior years.


Individual served as Taxpayer’s president and was responsible for its day-to-day management. His responsibilities included project oversight, identifying and bidding on projects, equipment decisions, and personnel matters. Individual also served on Taxpayer’s board of directors. He had decades of experience working for Taxpayer. Individual did not receive written performance reviews from the board of directors. He did not keep records of hours worked.

Individual’s compensation for a year consisted of a base salary, plus a bonus which was paid out of a bonus pool that was based on Taxpayer’s profitability for such year. Individual also received “management fees,” which were set annually by Taxpayer’s board of directors. Additionally, he received director’s fees for his service on the board.

Corp and Ltd

Corp was a holding corporation with no operations or employees. Corp’s president spent five to ten hours helping Taxpayer with a single bid project each year.

Ltd was a C corporation for Federal tax purposes. Its president was not an officer or employee of Taxpayer, though he made himself available to Individual for advice on Taxpayer’s business matters. He also monitored and managed Taxpayer’s investment account; he took a buy-and-hold approach to investing in mutual funds, and did not actively trade funds. He did not track his time spent on Taxpayer-related matters.

Setting the Compensation

Taxpayer did not enter into any written management or consulting services agreements with any of its three shareholders. No management fee rate or billing structure was negotiated or agreed to between the shareholders and Taxpayer for any of the years in issue. None of the shareholders billed or invoiced Taxpayer for any services provided.

Rather, Taxpayer’s board of directors would approve the management fees to be paid to the shareholders at a board meeting held later in the tax year, when the board had a better idea of how Taxpayer was going to perform that year and of how much earnings Taxpayer should retain.

The board did not attempt to value or quantify any of the services performed by Corp or Ltd but, instead, approved a lump-sum management fee for each shareholder for each year. The management fees paid to each entity were always equal each year, even though the services provided by either entity might vary from year to year.[xx]

Moreover, the fees paid to Individual did not represent payment for any particular service provided; rather, the board approved Individual’s management fees as an additional reward beyond what he received through the bonus pool.

Ordinary, Necessary, Reasonable

Taxpayer filed IRS Form 1120, U.S. Corporation Income Tax Return, for each of the tax years in issue, on which it claimed deductions for the above-described payments to its shareholders.

The IRS disallowed these deductions (thereby increasing Taxpayer’s taxable income), and issued a notice of deficiency, which Taxpayer protested by filing a petition with the Tax Court.[xxi]

The Court explained that a C corporation is subject to Federal income tax on its taxable income, which is determined by deducting all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on its business, including a reasonable allowance for compensation for personal services actually rendered.[xxii]

An expense is “ordinary,” the Court continued, if it is customary or usual within a particular type of business or industry, or if it relates to a transaction “of common or frequent occurrence in the type of business involved.” An expense is “necessary” if it is appropriate and helpful for the development of the business. Whether an expense is ordinary and necessary is generally a question of fact.

In determining whether compensation is deductible, the Court next considered whether Taxpayer’s payments were “in fact payments purely for services.” This was also a question of fact to be determined from all the facts and circumstances. The Court explained that distributions to shareholders disguised as compensation were not deductible; stated differently, any amount paid in the form of compensation, but not in fact as consideration for services, was not deductible. In determining whether the compensation paid to a corporation’s shareholders is, instead, a distribution of profit, all the facts and circumstances have to be considered.

Thus, an ostensible salary paid by a corporation may actually be a distribution of a dividend on the corporation’s stock. This is most likely to occur, the Court stated, in the case of a corporation having few shareholders, practically all of whom draw salaries. If, in such a case, the salaries are in excess of those ordinarily paid for similar services, and the excessive payments correspond to, or bear a close relationship to, the stockholdings of the shareholder-employees, it would seem likely that the salaries were not paid wholly for services rendered; rather, the excessive portion of each payment constituted a distribution of earnings upon the stock.

The Court explained that compensation paid by a corporation (especially one that was closely held) to its shareholders would be closely scrutinized to ensure the payments were not disguised distributions. Moreover, where the corporation was controlled by the very employees to whom the compensation was paid, the Court continued, special scrutiny would be given to such compensation in the absence of arm’s-length bargaining.

In order to be deductible, the amount allowed as compensation for services may not exceed what is reasonable under all the circumstances.[xxiii] Generally speaking, “reasonable compensation” is only such an amount as would ordinarily be paid for like services by like enterprises under like circumstances. The reasonableness of the amount paid is a question of fact to be determined from the record in each case. Finally, the test of reasonableness is not applied to the shareholders as a group, but rather to each shareholder’s compensation in light of the individual services performed.

Taxpayer’s Situation

The Court observed that most of the evidence indicated that Taxpayer paid the management fees to its three shareholders as disguised distributions.

Taxpayer made no distributions to its three shareholders but paid management fees each year. According to the Court, this indicated a lack of compensatory purpose.[xxiv] Although the management fees were not exactly pro rata among the three shareholders, Corp and Ltd always received equal amounts despite the different and varying services they provided to Taxpayer each year. This indicated that the management fees were determined on the basis of Corp’s and Ltd’s equal ownership interests, and not on a good faith valuation of the services they provided. In addition, the percentages of management fees that all three shareholders received roughly corresponded to their respective ownership interests in Taxpayer. This finding further supported an inference that Taxpayer paid management fees to Individual, Corp and Ltd as distributions of profits.[xxv]

Also, Taxpayer paid management fees as lump sums at the end of the tax year, rather than throughout the year as the services were performed, even though many services were performed throughout, or early in, the tax year. This practice indicated a lack of compensatory purpose. Another indication that the management fees were disguised distributions of nondeductible profits to the shareholders was the fact that Taxpayer had relatively little taxable income after deducting the management fees.[xxvi] It was not a stretch, the Court stated, to infer that Taxpayer was using management fee payments to lower its taxable income while getting cash to its three shareholders.

Lastly, Taxpayer’s process of setting management fees was unstructured and had little, if any, relation to the services performed. The fees for services were not set in advance of the services’ being provided. Taxpayer did not attempt to value the individual services attributable to the management fees paid to Corp and Ltd, and Individual conceded that his management fees were not paid for any specific services he performed beyond his duties as Taxpayer’s president. This unstructured process for setting management fees indicated that Taxpayer paid management fees as a way to distribute earnings to its shareholders, and not to compensate them for services rendered.

The numerous indicia of disguised distributions, described above, showed that the management fees paid to the three shareholders were not “in fact payments purely for services.”

Reasonable Compensation

At this point, the Court sought to determine whether any portion of the payments made to the shareholders was ordinary, necessary, and reasonable compensation for services. The Court observed that: the parties did nothing to document a service relationship between Taxpayer and either Corp or Ltd; there were no written management services agreements outlining what services were to be performed; no evidence – documentary or otherwise – outlined the cost or value of any particular service; neither corporate shareholder sent invoices for services rendered.[xxvii]

Additionally, Taxpayer presented no evidence showing how management fee amounts were determined, how much any particular service cost, or what portion of each management fee paid to either Corp or Ltd was attributable to any given service.

Reasonable compensation, the Court stated, was only the amount that would ordinarily be paid for like services by like enterprises under like circumstances.[xxviii] Taxpayer presented no evidence concerning what like enterprises would pay for like services. Taxpayer and its shareholders made no attempt to attach dollar values to the individual services provided, let alone demonstrate that like enterprises would pay that amount for such services. Taxpayer failed to introduce any expert testimony to aid in assessing the reasonableness of the amounts paid for the various services. And Taxpayer failed to establish the nature, occurrence, and frequency of most of the services that it argued justified the management fees paid. Neither Corp nor Ltd actually performed any of the “personal services” that Taxpayer argued justified payment of management fees.[xxix] In fact, neither corporate shareholder was in the business of providing management services, or even in a business related to that of Taxpayer’s.[xxx]

Multi-Factor Approach

The Court then turned to whether the management fees paid to Individual reasonable. The Court explained that, in the case of shareholder-employee compensation, the courts have considered the following factors:

  • the employee’s qualification;
  • the nature, extent, and scope of the employee’s work;
  • the size and complexities of the business;
  • a comparison of salaries paid with the gross income and the net income;
  • the prevailing general economic conditions; a comparison of salaries with distributions to stockholders;
  • the prevailing rates of compensation for comparable positions in comparable concerns;
  • the taxpayer’s salary policy for all employees; and
  • in the case of small corporations, with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

No single factor is dispositive of the issue; instead, the Court explained, its decision must be based on a careful consideration of the applicable factors in the light of the relevant facts.

Independent Investor

In addition to the above multifactor approach for analyzing shareholder-employee compensation, the Court considered the “independent investor” test, which asks whether an inactive, independent investor would have been willing to pay the amount of disputed shareholder-employee compensation, considering the particular facts of the case.

Court’s Analysis

The Court first applied the multi-factor test. In assessing whether Individual’s management fees were reasonable in amount, the Court indicated that an employee’s superior qualifications may justify higher compensation for his services, as may the employee’s duties performed, hours worked, general importance to the success of the company, and the company’s performance in the context of prevailing general economic conditions.[xxxi]

Perhaps the most significant factor, the Court stated, was a comparison of the Individual’s compensation with prevailing rates of compensation paid to others in similar positions in comparable companies within the same industry. For each taxable year in issue, Individual received a salary, a bonus from an employee bonus pool, and management fees. The Court determined that the management fees Taxpayer paid to Individual were not meant to compensate him for any unique services outside the scope of his responsibilities as president, but instead served essentially as additional bonus compensation.

Without taking into account the management fees, it appeared that Individual was already highly compensated relative to presidents at Taxpayer’s industry peers. Indeed, his average annual salary and bonus exceeded the industry average and median by a substantial margin. Considering only Individual’s salary and bonus, the Court found that Individual was overcompensated during the taxable years at issue. Because the management fees paid to Individual were ostensibly additional compensation for services that he performed as Taxpayer’s president – services for which he was already highly compensated in comparison to peer companies – the entire amount of the management fees paid to Individual appeared unreasonable.

Next, the Court applied the independent investor test. The failure to pay more than a minimal amount of dividends, it observed, may suggest that some of the amount paid as shareholder-employee compensation was a dividend. Of course, a corporation is not required to pay dividends – shareholders may be equally content with the appreciation of their stock. The independent investor test, the Court noted, may be used to assess whether the amount of shareholder compensation was reasonable in the light of the return on equity the corporation’s shareholders received during the same timeframe.

The Court reiterated that Taxpayer never paid dividends. And while Taxpayer argued correctly that it was not required to pay dividends, it did not show that the shareholders received a fair return on account of their shares. Taxpayer did not present evidence or expert testimony regarding what return on equity an independent investor might find reasonable. The IRS, however, provided data and analysis which indicated that Taxpayer’s shareholder compensation scheme did not allow for adequate shareholder returns. The report concluded that Taxpayer’s operating income margins were significantly below those of its industry peers. By paying such high shareholder compensation, Taxpayer was less profitable. Low profitability led to relatively lower retained earnings and, consequently, low returns for the hypothetical independent investor.

In the end, Taxpayer failed to show that a hypothetical independent investor in its stock would have found its investment returns reasonable with the shareholder compensation.

Court’s Conclusion

In sum, Taxpayer failed to carry its burden of proving that the management fees paid to Individual were reasonable. They were not for any services beyond his responsibilities as president, and the IRS provided persuasive evidence that Individual was already overcompensated by his salary and bonus alone.

As indicated above, there were numerous indicia that the management fees paid to Individual were simply disguised distributions; and much of the evidence supported the conclusion that the management fees paid to him were not reasonable.[xxxii]

Finally, Taxpayer never paid dividends to its shareholders and presented no evidence showing that an independent investor would have been satisfied with investment returns after shareholder compensation.

Thus, the Court sustained the IRS’s disallowance of Taxpayer’s claimed deductions for management fees paid to its three shareholders.

What’s Next?

It is likely that the Federal corporate income tax rate will be increased in the not-too-distant future. It is equally likely that closely held C corporations and their shareholders will seek ways to withdraw value or profits from the corporation while mitigating the tax and economic impact of the tax increase.

As discussed above, the payment of reasonable compensation to a shareholder-employee is a viable option, provided it is determined and paid in accordance with the factors indicated. The establishment of a qualified retirement plan is another way to reduce a corporate employer’s tax liability while setting funds aside for the benefit of shareholder-employees and other employees.

If the shareholders own real property out of which the corporation operates, they should enter an arm’s-length lease (if they don’t have one already). The rental payments would be deductible by the corporation; at the same time, the real estate may be generating depreciation deductions that would reduce the shareholder-landlords’ income tax liability attributable to the rental payment.[xxxiii]

Another way for shareholders to access corporate funds is by borrowing from their corporation, especially in a low-interest rate environment. Although the loans made are not deductible by the corporate-lender, neither are they taxed as income to the shareholder-borrower, provided the loans are structured and treated as bona fide loans.[xxxiv]

Most importantly, the corporation and its shareholders should consult their tax advisers on a regular basis to stay on top of tax legislation, including the effective date of any changes, and to ensure they are taking advantage of every income deferral opportunity, every deduction and every credit available.


[i] H.R. 1319.

[ii] Remember, the Democrats couldn’t afford to lose any members in the evenly-divided Senate if they hoped to give Vice President Harris the tie-breaking vote.

[iii] It is expected to pass this week; probably today or tomorrow. The President will be signing the bill no later than this weekend.

[iv] “Trillion” – that’s a “1” with twelve (12) zeroes after it.

So, where does that take us? $2.30 trillion in the March 2020 CARES Act, $0.90 trillion (“billion” is so passé) in the December 2020 Consolidated Appropriations Act, $1.90 trillion in the March 2021 American Rescue Plan; a total of $5.0 trillion within a 12-month period.

[v] You may recall that, in early February, the Associated Press wrote that Mr. Biden was tentatively scheduled to appear before Congress on February 23, 2021 to give an “unofficial” State of the Union address, by which time, it was hoped, the American Rescue Plan would have been well on its way to enactment. Various other publications indicated that the President intended to use the occasion to unveil a large infrastructure package, including tax increases. Then, one week before the joint session, AXIOS reported that the White House press secretary had informed reporters that no such address was scheduled. Go figure.

[vi] Late last month, Treasury Secretary Yellen stated that the Administration was considering increased corporate taxes to help fund its infrastructure plan, which would be set in motion later this year – probably before the summer recess.

[vii] IRC Sec. 11, as amended by the Tax Cuts and Jobs Act of 2017. P.L. 115-97.

[viii] Which was among the highest in the world.

[ix] Query, given where interest rates are today, whether deficit spending is preferable? Or is it just a means of deferring more difficult decisions; basically, taking the easy way out so as to avoid offending, or incurring the wrath of, any constituents? If government were a business, the latter approach would eventually end in its dissolution.

[x] For example, an S corporation that is subject to the built-in gains tax under IRC Sec. 1374.

[xi] The so-called “double taxation” to which the profits of a C corporation are subject.

C corporations may try to delay or avoid making a dividend distribution so as to defer or avoid the shareholder-level tax. However, see the accumulated earnings tax at IRC Sec. 531 to 537.

[xii] The 20 percent income tax under IRC Sec. 1(h), and the 3.8% surtax on net investment income under IRC Sec. 1411.

It should be noted that, during the campaign, Mr. Biden also proposed to increase the income tax rate on dividends paid to certain high-income taxpayers from 20 percent to the rate applicable to ordinary income (which is currently 37 percent, but which Mr. Biden would increase to 39.6 percent). .

Ms. Yellen has indicated that increased rates for capital gains are on the table. At the same time, she has stated that tax increases may not be appropriate during a recession. Thus, as the economy improves, the likelihood of such a rate hike increases.

[xiii] There are twice as many studies out there as there are answers to this question: one study that supports a particular answer, and another that refutes it.

[xiv] There are practical limits to this approach, like driving customers away, to less expensive competitors.

[xv] That’s why (before the enactment of the GILTI rules in 2017) U.S. corporations sought to defer U.S. tax by keeping the profits earned by foreign subsidiaries overseas. That’s why businesses leave New York and California for jurisdictions with lower taxes and lower labor costs.

[xvi] Similar efforts are often made upon the sale of a C corporation’s assets. The shareholders will seek a way to by-pass the corporation and direct consideration to the shareholders themselves; for example, through the sale of personal goodwill, or through the leasing of personally-owned property. The IRS is well attuned to identifying such gambits.

[xvii] IRC Sec. 162.

[xviii] Currently set at a Federal rate of 37 percent; Mr. Biden has proposed an increase to 39.6 percent.

[xix] ASPRO, Inc. v. Comm’r, T.C. Memo. 2021-8.

[xx] According to the Court, nothing in the record explained the fluctuation in management fees paid to each entity.

[xxi] The taxpayer generally bears the burden of proving that the IRS’s determinations in a notice of deficiency are erroneous. Tax Court Rule 142(a). The Code requires the taxpayer to maintain records sufficient to establish the amount of any deduction claimed. IRC Sec. 6001.

[xxii] IRC Sec. 162(a)(1); Reg. Sec. 1.162-7(a).

[xxiii] Reg. Sec. 1.162-7(b)(3).

[xxiv] “[T]he absence of dividends to stockholders out of available profits justifies an inference that some of the purported compensation really represented a distribution of profits as dividends.”

[xxv] Reg. Sec. 1.162-7(b)(1).

[xxvi] Without deducting the management fees Taxpayer would have had taxable income; the fees eliminated 89%, 86%, and 77% of what would have been Taxpayer’s taxable income for the taxable years at issue.

[xxvii] Unlike the two corporate shareholders, Individual was an employee of Taxpayer, providing personal services on an ongoing basis. Thus, there was no reason to question whether it was ordinary or necessary for Taxpayer to compensate Individual. But the total compensation still had to be reasonable.

[xxviii] Reg. Sec. 1.162-7(b)(3).

[xxix] The Court could not identify any “personal services” performed by Ltd or Corp, and Taxpayer did not establish what amounts of the management fees paid to each shareholder were to compensate for these “services” and whether such amounts would have been paid by like enterprises under like circumstances.

[xxx] Taxpayer did not establish that it was customary or usual for a business like Taxpayer’s to pay for advice. Taxpayer did not establish what amount this service should cost or that like enterprises would pay an amount for advice like this.

[xxxi] This “factor helps to determine whether the success of a business is attributable to general economic conditions, as opposed to the efforts and business acumen of the employee.”

[xxxii] The same conclusion applied equally to the management fees paid to the two corporate shareholders, not just Individual.

[xxxiii] Don’t forget to consider the effect of IRC Sec. 267(a)(2): .

[xxxiv] For example, they should bear interest at a rate that is at least equal to the applicable federal rate; preferably, the interest should be payable currently. The loan should be documented accordingly, with board minutes authorizing the loan and a promissory note issued by the shareholder.

And don’t overlook the opportunity to use corporate loans creatively; for example, to acquire life insurance as part of a split-dollar arrangement. Reg. Sec. 1.7872-15.

Into the Fire

Let’s play a game of “Guess Who?”[i]

Here are the clues:

  • the legislature has called for an investigation into his mishandling of the crisis brought on by the pandemic,[ii]
  • he has stated that he doesn’t trust the advice of health experts,[iii]
  • members of the opposition party, as well as his own, are calling for his impeachment,[iv]
  • members of his own party are moving to strip him of certain powers,[v]
  • women are accusing him of improper advances,[vi]
  • he is described as having made a threatening phone call to an elected official of his own party during which he insisted that the official “issue a new statement clarifying his remarks,” which were critical of him;[vii]
  • he is from Queens, New York; and
  • he attended Fordham University as an undergraduate.

Did you say former President Trump? Nope. Try again. Give up? Please see the answer at endnote “viii.”[viii]

But “why should we care about the answer?” you ask.

Taxes: Cuomo vs the Legislature

It’s ironic, but if you’re the owner of a closely held New York business, the personality described above may be the last line of defense against a legislature that is eager to raise existing taxes and to enact new taxes.

Governor Cuomo has consistently argued that the State cannot tax its way out of the current fiscal crisis, though his proposed budget – in an attempt to assuage Albany’s more vocal advocates for tax increases – does provide for increased income tax rates (in the form of “temporary surcharges”) for certain high-income taxpayers.[ix]

In addition, Mr. Cuomo has long been concerned about driving wealthy New Yorkers and their businesses out of the State by increasing their tax burden.[x] Until this year, his ability to veto tax legislation without being overridden by his own political party – the Democrats controlled the State Senate but did not have a supermajority in that chamber – has acted as a check on tax increases. That changed last November; beginning with 2021, the Democrats now have supermajorities in both chambers.

Even before Mr. Cuomo’s recent troubles, however, the New York Senate and Assembly have seen the introduction of many revenue-raising proposals, including the following:

  • stock transfer tax[xi]
  • pied-a-terre tax[xii]
  • inheritance income tax[xiii]
  • mark-to-market tax on capital assets[xiv]

At the same time, the future of New York’s “convenience of the employer” rule[xv] may be in doubt, thanks to a challenge filed with the U.S. Supreme Court by New Hampshire against the Massachusetts version of the rule.[xvi] Under this rule, New York sources a nonresident employee’s wages to New York, and taxes them accordingly, if the employee’s office or primary work location is in New York, notwithstanding that the employee may perform most of their work outside the State.

Under the foregoing circumstances, the Governor’s ability to negotiate with the legislature in the hope of tempering the harshness or reach of any tax proposals may be compromised.

For some business owners, and their key employees, who may have been counting on Mr. Cuomo’s powers of persuasion to keep Albany’s tax hounds at bay, a withdrawal from New York may suddenly seem inevitable.

Deferred Compensation

Although there are many issues that these individuals will have to consider in planning their move, a relatively recent advisory opinion[xvii] published by the Department of Taxation (the “Dept.”) offers some welcome guidance to both employers and employees regarding the taxation of deferred compensation that is payable to a nonresident.

The taxpayer to which the opinion was issued (“Taxpayer”) asked whether payments from its nonqualified deferred compensation plans to individuals who, at the time of payment, were nonresidents of New York were New York source income for personal income tax purposes and subject to income tax reporting and withholding.

Taxpayer maintained offices and transacted business in various states, including New York. Taxpayer maintained a 401(k) Plan and a Pension Plan, both of which qualified for favorable tax treatment under the Code.[xviii] Because of their tax-favored status, the Code limits the contributions and benefits that participants can receive under such plans.[xix]

Taxpayer also maintained two unfunded plans that were nonqualified deferred compensation plans.[xx] The sole purpose of the nonqualified plans was to supplement participants’ qualified plan benefits by providing benefits in excess of the statutory limits that apply to the qualified plans.[xxi] The first nonqualified plan provided for elective deferrals, company matching contributions, and several types of non-elective company contributions.

This plan generally provided for payment following a participant’s termination of employment. Payments may be made in the form of a single lump sum or between two and ten annual installments. If a participant died before benefits have been paid in full, the remainder of the participant’s benefit is paid to one or more designated beneficiaries in a single lump sum payment.

Under the second nonqualified plan, a participant’s plan benefit equaled the benefit the participant would have accrued under the Pension Plan without regard to the above-referenced limitations under the Code, minus the Pension Plan benefit the participant actually accrued under the Pension Plan.

Plan generally provides for payment following a participant’s termination of employment. Payments may be made in the form of a single lump sum, a single-life annuity, or a joint and survivor annuity. Different portions of a participant’s Plan benefit may be paid in different forms.

The nonqualified plans were subject to the requirements of Sec. 409A of the Code. In order to comply with Sec. 409A, any deferred compensation must be paid upon a participant’s “separation from service,” as that term is defined for purposes of Sec. 409A. In limited circumstances, a participant’s “separation from service” is not the same as the date the participant terminates employment with Taxpayer for other purposes.[xxii]

In accordance with terms of the nonqualified plans, all amounts payable under such plans constituted general unsecured obligations of Taxpayer and were payable out of Taxpayer’s general assets. The sole purpose of the nonqualified plans was to allow participants to make elective deferrals and/or receive company-provided benefits that they were unable to make or receive under the qualified plans because of the limitations imposed under the Code.

Taxpayer stated that when distributions are made from the plan they are reported on Form W-2, Box 1, are subject to federal income tax withholding and are considered supplemental wages for federal income tax withholding purposes.[xxiii]

The Dept.’s Analysis

The Tax Law provides that the New York source income of a nonresident individual shall be the sum of the net amount of items of income, gain, loss and deduction entering into the nonresident’s federal adjusted gross income derived from or connected with New York sources, including those items attributable to a business, trade, profession or occupation carried on in the State.[xxiv]

The Tax Law also requires that every employer maintaining an office or transacting business within New York, and making payment of any wages taxable under the State’s personal income tax, must deduct and withhold from the employee’s wages an amount of tax substantially equivalent to the New York State personal income tax reasonably estimated to be due resulting from the inclusion in the employee’s New York adjusted gross income or New York source income of their wages received during the calendar year.[xxv]

Payments that are considered wages for Federal income tax withholding purposes also are considered wages for payments of withholding for New York State personal income tax.[xxvi] Every employer required to deduct and withhold taxes from wages under the personal income tax must file a New York State withholding tax return and pay over the taxes required to be deducted and withheld.[xxvii]

Federal Law

Under Federal law (the “Pension Source Law”),[xxviii] no state may impose an income tax on any retirement income of an individual who is not a resident or domiciliary of such state. This legislation was enacted in 1996 in response to the attempt by many states (including New York) to tax the retirement income of former residents.

According to the accompanying committee report,[xxix] the states have typically followed the Federal practice of deferring income taxes on pension contributions and related investment earnings until they are distributed to the taxpayer after their retirement.

Objections arose, however, when at that point the retired taxpayer had relocated to another state; after all, wasn’t the deferred income earned while the individual was a resident of the state, and wasn’t the deferral of recognition a matter of legislative grace?

Congress rejected these positions, citing what it described as the “unreasonable” burden that source taxation of retirement income imposed upon the retired former resident.

For purposes of the Pension Source Law, the term “retirement income” means any income from qualified plans.[xxx] However, it also includes income from any nonqualified plan[xxxi] if such income (i) is part of a series of substantially equal periodic payments,[xxxii] not less frequently than annually, made for the life or life expectancy of the recipient, or the joint lives or joint life expectancies of the recipient and the designated beneficiary of the recipient, or a period of not less than 10 years, or (ii) is a payment received after termination of employment and under a plan, program, or arrangement (to which such employment relates) maintained solely for the purpose of providing retirement benefits for employees in excess of the limitations on contributions or benefits imposed by the Code with respect to qualified plans.[xxxiii]

Dept.’s Conclusion

The Dept. observed that, in earlier opinions, it had determined that, under the Pension Source Law, lump sum payments to nonresident employees from a nonqualified deferred compensation plan maintained by their employer were not New York source income for New York State personal income tax purposes.[xxxiv] Like Taxpayer’s nonqualified plans, the nonqualified plan referenced in those opinions provided a benefit in excess of the benefit the employee was entitled to receive from a tax-qualified profit-sharing plan, due to the application of various limits under the Code, and provided for payment following the employee’s termination of employment.

The Dept. indicated that although the facts in the present matter were, in some respects, substantially similar to the facts set forth in its earlier advisory opinions, in that the purpose of the nonqualified plans in both cases was to allow participants to make elective deferrals and/or receive company-provided benefits that they were unable to make or receive under the employer’s qualified plans because of the limitations imposed under the Code.

However, the plans in the present matter differed from the plans considered in those earlier opinions because, in order to comply with Sec. 409A of the Code, the plan benefits in this matter may in certain situations be received by participants prior to termination of their employment.

The Dept. concluded that the payments made by Taxpayer to nonresident former employees after termination of employment from Taxpayer’s plans that are maintained for the sole purpose of providing employees benefits in excess of the compensation limitations for qualified plans under the Code conformed to the definition of “retirement income” under the Pension Source Law.[xxxv] Therefore, those payments will not be subject to New York State income tax, income tax withholding or reporting.

However, payments made by Taxpayer to nonresident employees prior to termination of employment do not come within the definition of “retirement income” and are not protected by the Pension Source Law. Therefore, any income, gain, loss or deduction derived from New York sources with respect to the distributions to the nonresident individuals from these plans will be subject to New York personal income tax.

Moreover, since the payments received by the nonresident from the nonqualified deferred compensation plans are considered wages for Federal income tax withholding purposes, the payments also will be considered wages for New York State withholding tax purposes and Taxpayer must deduct and withhold from these payments an amount of tax substantially equivalent to the New York State personal income tax reasonably estimated to be due and file a New York State withholding tax return and pay over the taxes required to be deducted and withheld.


As indicated above, the Dept. concluded that the payments made to nonresidents after termination of employment conformed to the definition of “retirement income,” and were not subject to New York State income tax withholding and reporting. However, payments made to nonresidents prior to termination of employment did not conform to the definition of “retirement income” and were subject to personal income tax reporting and withholding.

Based on the foregoing, a highly paid employee (including certain owner-employees of a New York corporation) who may be considering a move away from New York and toward a warmer, and tax-friendlier, climate, may want to review their deferred compensation arrangements right away. If these arrangements do not qualify for the “retirement income” exclusion from New York income, described above, it may still be possible to redress any shortcomings.

[i] Published by Milton Bradley.

[ii] .

[iii] .

[iv] .

[v] .

[vi] .

[vii] .

[viii] New York’s Governor Cuomo.

I confess, I had high hopes.

In Plato’s Republic (VI, 491-d, 491-e and 492-a), Socrates warns us of the very talented:

“We know it to be universally true of every seed and growth, whether vegetable or animal, that the more vigorous it is the more it falls short of its proper perfection when deprived of the food, the season, the place that suits it. . . .

“So it is, I take it, natural that the best nature should fare worse than the inferior under conditions of nurture unsuited to it. . . .

“[S]hall we not similarly affirm that the best endowed souls become worse than the others under a bad education? Or do you suppose that great crimes and unmixed wickedness spring from a slight nature and not from a vigorous one corrupted by its nurture, while a weak nature will never be the cause of anything great, either for good or evil?” . . . .

“Then the nature which we assumed in the philosopher, if it receives the proper teaching, must needs grow and attain to consummate excellence, but, if it be sown and planted and grown in the wrong environment, the outcome will be quite the contrary unless some god comes to the rescue.”

Whatever the source of Mr. Trump’s appeal, Plato would never have applied the foregoing to him.

[ix] . Also included in the budget is the legalization and taxation of cannabis and gaming.

[x] .

[xi] A.7791 and S.6203. These have prompted threats to leave New York from members of the State’s financial services industry. Financial activities account for almost 30% of the state gross product. .

[xii] S.44/A.4540. This bill would authorize the City to impose a tax on expensive second residences located in the City.

[xiii] S.3462. . The bill also calls for a new gift tax.

[xiv] .

[xv] 20 NYCRR 132.18.

[xvi] .

New Jersey and Connecticut have filed amicus briefs in support if New Hampshire. .

[xvii] N.Y. Dep’t of Tax’n & Fin., TSB-A-20(8)I, 10/06/20. An Advisory Opinion is issued at the request of a taxpayer. It is limited to the facts set forth in the opinion and is binding on the Department of Taxation only with respect to the taxpayer to whom it is issued, and only if the taxpayer fully and accurately described all relevant facts to the Dept.

[xviii] IRC Sec. 401(a).

[xix] IRC Sections 401(a)(17), 401(k), 401(m), 402(g) and 415.

[xx] As defined in IRC Sec. 3121(v)(2)(C). .

[xxi] An “excess benefit” plan.

[xxii] These rules were designed in accordance with IRS rules to prevent abusive arrangements in which participants could avoid “terminating” by working very few hours or taking an extended leave, thereby delaying their payments. Any attempt by Taxpayer or the participant to postpone such payments until the participant terminates employment would trigger substantial tax penalties under IRC Sec. 409A.

[xxiii] Treas. Reg. Sec. 31.3402(g)-1(a)(1)(i).

[xxiv] Tax Law Sec. 631(a).

[xxv] Tax Law Sec. 671(a) and 20 NYCRR 171.1.

[xxvi] 20 NYCRR 171.3(a).

[xxvii] Tax Law Sec. 674(a) and 20 NYCRR 174.1

[xxviii] 4 USC Sec. 114. .

[xxix] H. Rept. 104-389.

[xxx] Including IRC Sec. 401(a) and 401(k) plans. See 4 USC Sec. 114(b)(1)(A)-(H).

[xxxi] The term “nonqualified deferred compensation plan” means any plan or other arrangement for deferral of compensation other than a qualified plan. IRC Sec. 3121(v)(2)(C).

[xxxii] The fact that payments may be adjusted from time to time pursuant to such plan, program, or arrangement to limit total disbursements under a predetermined formula, or to provide cost of living or similar adjustments, will not cause the periodic payments provided under such plan, program, or arrangement to fail the “substantially equal periodic payments” test.

[xxxiii] See 4 USC Sec. 114(b)(I).

By contrast, items of nonretirement income derived from New York sources include those attributable to income received by a nonresident related to a business, trade, profession or occupation previously carried on in this state, whether or not as an employee, including but not limited to, covenants not to compete and termination agreements. Tax Law Sec. 631(b)(1)(F).

[xxxiv] TSB-A-00(6)I and TSB-A-01(2)I.

Also, in TSB-A-16(1)I, the Dept. determined that, under the Pension Source Law, a lump sum payment to a nonresident employee after termination of employment from a nonqualified deferred compensation plan maintained by the retiree’s former employer was not New York source income for New York State personal income tax purposes. The nonqualified plan referenced in that opinion provided a benefit in excess of the benefit the employee was entitled to receive from a tax-qualified plan due to the application of the Code limits referenced above.

[xxxv] 4 USC Sec. 114(b)(1)(I)(ii).

Wither the Weed?

It has been one month since Mr. Biden’s inauguration as President of the United States. Among the many questions being asked of President Biden is whether he will seek the decriminalization[i] of cannabis. During the campaign, the Democratic Party’s official position (part of the party’s platform) regarding cannabis was as follows:[ii]

Democrats believe no one should be in prison solely because they use drugs. Democrats will decriminalize marijuana use and reschedule it through executive action on the federal level. We will support legalization of medical marijuana, and believe states should be able to make their own decisions about recreational use. The Justice Department should not launch federal prosecutions of conduct that is legal at the state level. All past criminal convictions for cannabis use should be automatically expunged.

The Democratic Party’s interest in decriminalizing and rescheduling cannabis ostensibly stems from a stated desire to redress the “legacy of racial and ethnic injustices, compounded by the disproportionate collateral consequences of 80 years of cannabis prohibition enforcement,” yet it concludes by calling for “proactive steps to mitigate inequalities in the legal cannabis marketplace and ensure equal participation in the industry.”[iii]

Of course, those businesses that already operate in the “legal cannabis marketplace,”[iv] and many others who would like to enter the industry, have long waited for Federal legislation to clear their path toward a “normal” commercial existence.[v]

Fast forward.

“Mass Pardon?”

Of the approximately fifty-six Executive Orders, Directives and Memoranda (“executive actions” within the meaning of the platform, quoted above) issued by the President since January 20, 2021, none address the issue of cannabis.[vi]

Last week, on February 18, 2021, thirty-seven Members of Congress sent a letter[vii] to President Biden in which they reminded him that, during his campaign for the White House, he committed to expunging all past marijuana convictions for use and possession.

The letter indicated that 36 states have legalized medicinal cannabis, and fifteen states have enacted adult use policies. “Following the lead of voters,” the letter explained, the House passed the Marijuana Opportunity, Reinvestment and Expungement (“MORE”) Act[viii] “to ensure that these programs work as intended.” The MORE Act would also decriminalize cannabis under Federal law.

The letter concluded by urging the President to exercise his power to “to grant executive clemency for all non-violent cannabis offenders.”

Opposition to Writ

One week earlier, on February 12, 2021, the U.S. Department of Justice[ix] filed a brief with the U.S. Supreme Court in opposition to a taxpayer’s petition for a writ of certiorari[x] to the Federal Court of Appeals for the Tenth Circuit.[xi]

The taxpayer is a medical marijuana dispensary that was operated in accordance with Colorado law. The IRS investigated the taxpayer’s returns and, when the taxpayer was not forthcoming with information, the IRS issued a third-party summons to the Marijuana Enforcement Division of the Colorado Department of Revenue. The taxpayer sought to quash the summons, claiming that it lacked a legitimate purpose. The lower courts disagreed with the taxpayer.

In the process, the taxpayer questioned the IRS’s application of the preemption doctrine, pointing out that local criminal activity has “traditionally been the responsibility of the States.” Citing the principles of Federalism and the Tenth Amendment, the taxpayer argued that a Federal criminal statute cannot prohibit an expressly state-legal act unless “explicitly” directed by Congress. The taxpayer also challenged the constitutionality[xii] of Section 280E of the Code – which disallows deductions for expenses paid or incurred in carrying on a trade or business that consists of trafficking in controlled substances – claiming that it results in the taxation of something other than “net income.”

The Justice Department’s brief rejected the taxpayer’s arguments. “The IRS,” it stated, “seeks to obtain information about [the taxpayer’s] marijuana dispensary as part of an investigation into the accuracy of [the taxpayer’s] federal income tax returns, including whether [the taxpayer] claimed any business expense deductions disallowed by” Section 280E of the Code.[xiii] It also rejected the taxpayer’s other assertions.

Another One Bites the Dust

No sooner had the Justice Department responded to the taxpayer in the Standing Akimbo matter, than the U.S. Tax Court issued yet another adverse opinion to yet another medical cannabis dispensary (“Taxpayer”), this time in California.[xiv]

Taxpayer was licensed to sell cannabis to individuals who held a valid doctor’s recommendation to use cannabis. Taxpayer also sold non-cannabis items, including T-shirts, pipes, and batteries. In addition, Taxpayer offered acupuncture and chiropractic services, as well as other “holistic” services.[xv] It did not charge a separate fee for membership, acupuncture, chiropractic services, or any other services.

Taxpayer incurred certain expenses in connection with its operations, which it reported on its Form 1120, U.S. Corporation Income Tax Returns for the years at issue. Among the expenses reported, Taxpayer claimed deductions for depreciation and for charitable contributions.

The IRS disallowed all of Taxpayer’s deductions pursuant to Section 280E of the Code. Taxpayer maintained that Section 280E did not foreclose its deductions for depreciation and charitable contributions because (1) depreciation is not “paid or incurred during the taxable year” and (2) its charitable contributions were not made “in carrying on” a trade or business. Taxpayer also argued that none of its expenses should be disallowed by Section 280E because its business did not “consist of” trafficking in controlled substances.[xvi]

The IRS disputed Taxpayer’s contentions, and issued notices of deficiency that disallowed the deductions claimed. Taxpayer timely filed petitions with the Tax Court seeking redetermination of the income tax deficiencies set forth in the IRS’s notices.

The Court’s Opinion

The question before the Court was whether the deductions for depreciation and for charitable contributions[xvii] fell within the broad prohibition of Section 280E of the Code.

The Court explained that the Code imposes a tax “on the taxable income of every corporation” for each taxable year.[xviii] “Taxable income,” it continued, “is defined as ‘gross income minus the deductions allowed by this chapter.’ ”[xix] The Code further provides that, “[i]n computing taxable income * * *, there shall be allowed as deductions the items specified in this part.”[xx] According to the Court, the referenced “part” includes the deductions for depreciation and for charitable contributions. The “deductions specified in Part VI of Subchapter B of the Income Tax Subtitle of the Code [which includes the deductions for depreciation and for charitable contributions] are ‘subject to the exceptions provided in part IX.’” One of these exceptions is Section 280E.

Section 280E provides: No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

In other words, a deduction will be disallowed if each of the following conditions is satisfied: (1) the deduction is for an amount paid or incurred during the taxable year; (2) that amount was paid or incurred in carrying on any trade or business; and (3) that trade or business (or the activities that comprise the trade or business) consisted of trafficking in certain defined controlled substances.

In deciding whether the depreciation and charitable contribution deductions claimed by Taxpayer met each of the statutory conditions summarized above – and are therefore disallowed under Section 280E – the Court first addressed Taxpayer’s argument that, because its trade or business included more than the sale of cannabis items, that trade or business did not “consist of” (that is, does not comprise exclusively) trafficking in controlled substances. The Court rejected Taxpayer’s position, stating that it reads “Section 280E to deny business-expense deductions to any trade or business that involves trafficking in controlled substances, even if that trade or business also engages in other activities.”


The Court turned next to Taxpayer’s argument that the depreciation deduction falls outside the scope of Section 280E because depreciation is not “paid or incurred during the taxable year.”[xxi] Taxpayer argued that the meaning of Section 280E is “unambiguous” and that its reach is limited to “deductions and credits for business expenditures.” In Taxpayer’s view, the business expenditures covered by Section 280E included (but were not limited to) the ordinary and necessary business expenses described in Section 162 of the Code.[xxii] But they do not include depreciation because depreciation is not described in Section 162 and is not an amount “paid or incurred during the taxable year.” The Court disagreed with Taxpayer’s contention that depreciation was not “paid or incurred during the taxable year.”[xxiii] When the asset is used to further the taxpayer’s day-to-day business operations, the periods of benefit usually correlate with the production of income, the Court stated. Thus, to the extent that equipment is used in such operations, a current depreciation deduction is an appropriate offset to gross income currently produced. The Court noted, however, that when the consumption of the asset takes place in the construction of other assets that, in the future, will produce income themselves, the cost represented by depreciation does not correlate with production of current income; rather, the cost, although presently incurred, is related to the future and is appropriately allocated as part of the cost of acquiring an income-producing capital asset. In light of the foregoing, the Court concluded that Section 280E applied by its terms to Taxpayer’s circumstances.

Charitable Contribution

Taxpayer next argued that its charitable contributions should be deductible because they were not paid “in carrying on” a trade or business as required by section 280E.

The Court disagreed. Section 280E, it explained, applies to disallow a deduction for “any amount paid or incurred * * * in carrying on any trade or business.” Taxpayer was a corporation that was engaged in a trade or business when it made the relevant charitable contributions. California State law, the Court explained, specifically authorizes a corporation to make charitable contributions, and courts have long permitted corporations to decide whether a charitable gift is consistent with their financial and operational goals. Taxpayer chose to contribute the amounts at issue, and the Court saw no reason to conclude that this action was somehow separate from, or outside the scope of, Taxpayer’s business activities. The Court observed that many other courts have acknowledged the potential benefits to a corporation of making a charitable gift where the so-called gift tends reasonably to promote the goodwill of the business of the contributing corporation. In the view of the Court, Taxpayer contributed the amounts at issue “in carrying on” its trade or business.

Finally, Taxpayer argued that Section 280E should not apply to charitable contributions as a matter of policy, because to decide otherwise could produce unfavorable outcomes for taxpayers who contribute capital property or inventory to charities. These arguments, the Court stated, were beside the point.

Based on the foregoing, the Court concluded that Section 280E applied to Taxpayer’s charitable contributions for the years at issue, and thus that the corresponding deductions were disallowed.

What’s Next?

It appears, notwithstanding the House’s passage of the MORE Act in 2020, that there is no sense of urgency in the Senate to act on that bill.

Moreover, it appears that Mr. Biden is in no hurry to decriminalize cannabis by executive order, let alone push for its legalization.[xxiv] Query whether he even has an appetite for granting a mass pardon of convictions for past marijuana possession and use?

Without any movement by Congress or the President, the Courts – including the Tax Court – have no choice but to continue applying the existing Federal laws under which cannabis is treated as a controlled substance. This means that a cannabis business, operated in a State in which such operation is legal, will be denied a deduction, for purposes of determining its Federal income tax liability, for any expenses paid or incurred in carrying out its business.[xxv]

In the meantime, States like New York – which is hoping to legalize cannabis this year – view the cannabis business as a significant source of future tax revenues. Indeed, if cannabis legislation were passed as proposed by Governor Cuomo, New York’s effective tax rate on cannabis (including its sales tax) would be 20 percent.[xxvi] That’s pretty high, but it’s also on par with other States in which cannabis is legal.[xxvii] It is also another reason why the inability to deduct the expenses paid or incurred by such a business (for income tax purposes) may give pause to anyone who may be considering entering in the industry – just think of the effective Federal income tax rate in the absence of such deductions.[xxviii]

Stay tuned.

[i] Not the same as legalization. If cannabis is decriminalized, an individual would not be prosecuted for possession of up to a specific amount. Legalization, however, would remove all legal prohibitions, as a result of which cannabis would be available for purchase and use by all adults.

[ii] .

[iii] See Section 2 of H. Rept. 116-604, which accompanied the MORE Act (see below). .

Confused? Me too.

[iv] Legal under the law of the particular State.

[v] Because of its status as a controlled substance, banks are unwilling to make loans to cannabis businesses. For the same reason, these businesses are denied bankruptcy protection. They do not qualify for PPP loans. Although not identified as a “sin business” under the Qualified Opportunity Zone rules, the fact remains that “trafficking in” cannabis is illegal under federal law; thus, it is doubtful that such a business would qualify as a qualified opportunity zone business. Until recently, attorneys were concerned about advising cannabis businesses, lest they are found to be in violation of Federal criminal law and State ethics rules. Many States have addressed this last issue; for example, last year the California Bar Association issued an advisory opinion which stated that attorneys may advise clients on compliance with the State’s cannabis laws. .

[vi] .

You may recall that then-candidate Bernie Sanders promised to legalize cannabis in the first hundred days of his administration with “executive action.” Could the President Legalize Marijuana Through Executive Action? – Marijuana Law, Policy, and Authority (

[vii] .

[viii] H.R. 3848 was passed by the House on December 4, 2020, and was received in the Senate on December 7, 2020, following which it was referred to the Committee on Finance,, which is where it remains.

[ix] Now controlled by the Biden Administration.

Interestingly, and in contrast, the Justice Department, on February 10, 2021, withdrew the Federal government’s (i.e., the Trump Administration’s) support in favor of striking down the Affordable Care Act. California v. Texas. Query why its position toward cannabis cases has not changed? I guess the Administration is waiting for Congress to send it a bill.

[x] Basically, an order to the lower court to send up its record of the case to the Supreme Court for its review. Traditionally, four of the nine Justices must vote to accept a case. (Presumably to prevent a majority from dictating which cases the Court will entertain. Good luck finding that in the Supreme Court’s Rules.)

[xi] Standing Akimbo, LLC v. United States, Docket No. 20-645. . The case was docketed on November 12, 2020. The Government’s response was originally due December 14, 2020.

We discussed the taxpayer’s petition here: .

[xii] Under the Sixteenth Amendment to the Constitution.

[xiii] .

[xiv] San Jose Wellness v. Comm’r., 156 T.C. No. 4 (Feb. 2021).

[xv] My firm regularly provides such services to stressed-out attorneys – NOT. J

[xvi] Taxpayer must have been under the influence when preparing its arguments.

[xvii] Allowed by Section 167 and Section 170 of the Code, respectively.

[xviii] Section 11(a).

[xix] Section 63(a).

[xx] Section 161.

[xxi] Taxpayer conceded that the depreciation was incurred “in carrying on” a trade or business.

[xxii] Section 162 of the Code allows as a deduction all the ordinary and necessary expenses paid or incurred by a taxpayer during the taxable year in carrying on any trade or business.

[xxiii] According to the Court, Taxpayer’s contention is foreclosed by the Code and Supreme Court precedent. Section 7701(a)(25) of the Code provides that, “[w]hen used in this title, where not otherwise distinctly expressed or manifestly incompatible with the intent thereof,” “[t]he terms ‘paid or incurred’ * * * shall be construed according to the method of accounting upon the basis of which * * * taxable income is computed under subtitle A.” Generally, “[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” Sec. 446(a).

During the taxable years at issue, Taxpayer used the accrual method of accounting, a permissible method under Section 446 of the Code. Focusing on the concept of depreciation, the Court noted that over a period of time a capital asset is consumed and, correspondingly over that period, its theoretical value and utility are thereby reduced. Depreciation is an accounting device which recognizes that the physical consumption of a capital asset is a true cost, since the asset is being depleted. As the process of consumption continues, and depreciation is claimed and allowed, the asset’s adjusted income tax basis is reduced to reflect the distribution of its cost over the accounting periods affected. The Court stated “[T]he purpose of depreciation accounting is to allocate the expense of using an asset to the various periods which are benefited by that asset.”

[xxiv] Yes, I know, it has been only one month, and folks are preoccupied with the proposed $1.9 trillion relief package. By the same token, such an environment may have been perfect for such executive action, and would have been welcomed by the Party’s more liberal wing.

[xxv] This may be of general interest: .


[xxvii] For other states’ taxes, see: .

[xxviii] The power to tax . . .

“Tax the Rich” in N.Y.

Over the last few months, we’ve considered on several occasions how Albany may respond to the fiscal crisis arising from the pandemic and the ensuing reduction in economic activity. These circumstances have placed an incredible strain upon the State’s various social safety nets,[i] as many individuals find themselves in need of government assistance in one form or another; they have also compromised New York’s ability to maintain these programs, at a time when they are needed most, by severely impairing the State’s tax revenues.[ii]

At the same time, however, many of the State’s residents seem to have not only weathered the proverbial storm, but to have emerged from it relatively unscathed – at least from an economic perspective – or, in many cases, even wealthier than before.[iii]

The juxtaposition of these two extreme outcomes has, predictably, given rise to demands that the folks in Albany impose higher taxes upon the folks on Wall Street. “Tax the rich” has become the rallying cry for those who support a wealth tax on billionaires,[iv] a more progressive income tax on high-earning taxpayers,[v] a tax on financial transactions,[vi] a tax on inherited wealth,[vii] and other wealth-redistribution measures.

In the face of what promises to turn into an even more hostile tax environment, New Yorkers ranging from the moderately well-off[viii] to the obscenely wealthy are doing what they have always done: they are threatening to leave the State. This time, however, there are three additional factors in play that were absent from earlier versions of this game of chicken:

  1. first, as a result of the pandemic experience, many of these New Yorkers – including business owners, investors, and well-paid employees – have discovered they neither have to live nor physically work in New York[ix] in order to engage in the commercial activity by which they make money – indeed, they have realized that they can even save money by losing the Manhattan co-op with the confiscatory common charges, and by giving up the outrageously priced office lease;
  2. second, other jurisdictions are no longer shy about openly soliciting and enticing New Yorkers away from the Empire State – just look at what Florida’s Governor DeSantis and Miami’s Mayor Suarez are doing to attract finance and technology companies to the Sunshine State;[x] and
  3. third, the State Legislature in Albany now has a veto-proof Democratic majority that seems committed to increasing taxes, come what may.

Although tax increases are very likely – at both the State and Federal levels – it remains to be seen how aggressive a tax posture New York will ultimately adopt toward its more economically secure residents. Query whether the State’s actions will be enough to convince many of these residents to leave New York and to take their businesses with them?

Among those residents who decide to abandon the State as their permanent home,[xi] there will be several who will nevertheless want to maintain a “second home” in New York – perhaps a pied-a-terre in the City, or a vacation property on the East End or in the Hudson Valley. However, a decision issued by New York’s Tax Appeals Tribunal late last month may cause some of these folks – especially those that plan to continue working or doing business in New York – to reconsider having any such connection to the State.[xii]

“Obus” – Round One[xiii]

Taxpayer was domiciled in New Jersey, worked primarily out of an office in New York City, and was present within New York for over 183 days during each of the years in issue.

Taxpayer owned a house in Upstate New York (the “House”), more than 200 miles from their office, which they used for vacation purposes only. During the years at issue, Taxpayer spent no more than two to three weeks at the House.

The property included an attached apartment which was rented, year-round, to an unrelated tenant pursuant to an oral lease under which the tenant paid a de minimis amount of rent, while Taxpayer paid all of the expenses associated with the property, which far exceeded the rent received.

Taxpayer filed a New York State nonresident income tax return, on Form IT-203, for each of the years at issue. The Form contains a question regarding whether the taxpayer maintained “living quarters” within the State during the taxable year for which the return is being filed. Taxpayer indicated that no living quarters were maintained within the State during the years at issue.[xiv]

After an audit conducted by the Division of Taxation (the “Division”), the Division found that Taxpayer was a statutory resident: they maintained a permanent place of abode in New York (the House), and were present within the State in excess of 183 days. A notice of deficiency was issued to Taxpayer asserting additional New York State income tax due, plus interest and penalty, for the years at issue.

Taxpayer protested the notice by filing a timely petition with the Division of Tax Appeals. After a formal hearing, the Administrative Law Judge (the “ALJ”) observed that the only issue before the Court was whether Taxpayer maintained a permanent place of abode in New York during the years at issue.

The ALJ noted that Taxpayer’s argument primarily challenged the definition of the term “permanent place of abode,” and the Division’s interpretation thereof, in light of the Court of Appeals’ holding in Matter of Gaied v. New York State Tax Appeals Trib.[xv]

Taxpayer claimed that because the property was maintained for the use of another (the tenant), the House could not be deemed Taxpayer’s own permanent place of abode.

The ALJ compared the facts of Gaied with Taxpayer’s, determined that Gaied was distinguishable, and concluded that the House was maintained by Taxpayer for their own use.[xvi]

The ALJ next rejected Taxpayer’s argument that the House was not a permanent place of abode because it was used and suitable only for vacations. According to the ALJ, Taxpayer was at no point prevented from using the property for substantially all of the year. The House, it stated, could be (and was) used year-round and, as such, was considered permanent. The fact that Taxpayer chose to use the property exclusively for vacations did not transform its characterization as a permanent place of abode.

The ALJ also found Taxpayer’s contention that, under Gaied, their subjective use of the House should be determinative of its status as a permanent place of abode, was without merit, stating that it was the physical characteristics of the House that made it suitable for year-round use.

“Obus” – Round Two

Taxpayer appealed the ALJ’s decision, sustaining the notice of deficiency, to the Tax Appeals Tribunal (“TAT”), claiming that the ALJ erred in finding that the House qualified as a permanent place of abode in light of the Court of Appeals’ holding in Gaied.[xvii]

In furtherance of this argument, Taxpayer maintained that the Division’s regulations regarding statutory residency were invalid to the extent they define “permanent place of abode” in terms of ownership and maintenance, without considering the taxpayer’s subjective use of the dwelling.

According to Taxpayer, Gaied stands for the proposition that the correct analysis for determining whether a residence is “permanent” depends on a taxpayer’s use of the dwelling, rather than the physical characteristics of the dwelling.[xviii]

The Division countered that the ALJ properly determined Taxpayer to be a statutory resident because they were present in the State for the required number of days and maintained dominion and control over the House during the tax years in question.

According to the Division, the ALJ correctly recognized the validity of the Division’s regulation regarding a permanent place of abode after Gaied, which the Division claimed did not invalidate its regulation regarding the permanency of a dwelling for purposes of determining residency.

The TAT’s Opinion

The Court explained that New York Tax Law provides two bases for state tax residency: (a) individuals “domiciled” in New York, and (b) individuals not domiciled in the State but who (i) are present therein for more than 183 days, and (ii) maintain a “permanent place of abode” in the State for “substantially all of the taxable year” (“statutory residence”).

At issue in this case, the Court continued, was Taxpayer’s status as a New York statutory resident. The Court noted there was no dispute that Taxpayer, (i) by virtue of working in New York City,[xix] was present in New York for at least 183 days in each of the years at issue, and (ii) by their continuing ownership and upkeep of the House, maintained the House for those years.

Taxpayer’s disagreement with the determination of the ALJ, the Court stated, concerned the ALJ’s finding that Taxpayer’s House was a “permanent place of abode.”

The Court began its analysis with the Division’s regulation, which provides:

“A permanent place of abode means a dwelling place of a permanent nature maintained by the taxpayer, whether or not owned by such taxpayer, and will generally include a dwelling place owned or leased by such taxpayer’s spouse. However, a mere camp or cottage, which is suitable and used only for vacations, is not a permanent place of abode. Furthermore, a barracks or any construction which does not contain facilities ordinarily found in a dwelling, such as facilities for cooking, bathing, etc., will generally not be deemed a permanent place of abode.”[xx]

The Court next turned to Taxpayer’s contention that the Division’s above regulatory interpretation of the term “permanent place of abode” was no longer valid in light of the Court of Appeals’ ruling in Gaied.

In Gaied, the taxpayer was domiciled in New Jersey and owned an apartment building in Staten Island, where he provided an apartment for his parents with whom he would occasionally stay overnight, although he kept no personal items at the apartment and only stayed overnight at his parents’ request. Due to the taxpayer’s commuting to his business on Staten Island on a daily basis, the taxpayer was also physically present in New York for more than 183 days.

The Court explained that, in accordance with prior decisions, the lower courts in Gaied determined that the taxpayer qualified as a statutory resident because, on its face, the Tax Law only required a taxpayer to maintain a dwelling in order for it to be considered a permanent place of abode.

Taxpayer’s Interest in the House

The Court of Appeals[xxi] in Gaied, however, held there was no rational basis for the above interpretation, that the mere maintenance of a dwelling was sufficient to qualify it as a permanent place of abode of a taxpayer for purposes of determining statutory residence. It concluded that:

“[t]he legislative history of the statute, to prevent tax evasion by New York residents, as well as the regulations, supports the view that in order for a taxpayer to have maintained a permanent place of abode in New York, the taxpayer must, himself, have a residential interest in the property.”

In light of Gaied, the question as to Taxpayer, according to the Court, was whether Taxpayer had a “residential interest” in the House sufficient to sustain the Division’s determination that the House was a permanent place of abode.

Taxpayer argued that their infrequent, short stays at the House for vacations, when compared to the use of their primary residence in New Jersey, were insufficient for such use to deem the House to be a permanent place of abode.

The Court properly rejected Taxpayer’s argument that the Court of Appeals’ holding in Gaied excluded use of a dwelling as a vacation home from the meaning of a “residential interest.”

The question of statutory residency, the Court stated, should turn on whether a taxpayer “maintained living arrangements for himself to reside at the dwelling.” In the present case, the Court continued, Taxpayer had the right to reside in the House, maintained living arrangements at the House, and exercised that right, albeit sparingly, during the years at issue.

The fact that Taxpayer used the House for vacation purposes, and subjectively considered it suitable only for such purposes, did not exclude the House as a permanent place of abode as to Taxpayer.[xxii]

Accordingly, the Court found that Taxpayer maintained the House as a permanent place of abode in New York, and exercised their residential interest therein by using it as a vacation home.

Residential Interest

The Court’s conclusion that Taxpayer maintained the House as a permanent place of abode was absolutely correct under current law: (i) Taxpayer was present in New York for more than 183 days during the taxable year;[xxiii] (ii) Taxpayer maintained the House for substantially all of the taxable year; and (iii) Taxpayer had a “residential interest” in the House – they had the right to reside in the House, and “maintained living arrangements” at the House – as evidenced by their use of the House as a vacation home.

The implication for individuals, like Taxpayer, is obvious: if you (i) are domiciled outside New York, (ii) work anywhere in New York, and (iii) maintain and use a vacation home anywhere in New York – without regard to the distance between your workplace and the vacation home – you will be taxed as a resident of the State.

More significant than this fairly predictable outcome, however, was the Court’s “interpretation” of the opinion rendered by the Court of Appeals in Gaied and, in particular, the question of what constitutes a “residential interest.”

The Court clearly stated clearly that, before Gaied, the Tax Law only required a taxpayer to maintain a dwelling in order for it to be considered a permanent place of abode. There was no rational basis, the Court stated, for the interpretation that the mere maintenance – generally speaking, bearing the related costs – of a dwelling was sufficient to qualify it as a permanent place of abode of a taxpayer for purposes of determining statutory residence. Something more was required.

According to the Court of Appeals, in order for a taxpayer to have maintained a permanent place of abode in New York, the taxpayer must have maintained living arrangements for themselves at the property – they must have a residential interest in the property.

The Court explained that the taxpayer’s subjective view of a property was not determinative of whether the taxpayer had a residential interest in the property and, therefore, of its status as a permanent place of abode.

It also indicated that a taxpayer’s dominion and control over a property, and the fact that they were at no point prevented from using the property, were consistent with a residential interest; for example, they do not have to ask permission to remain at the property; they do not have to wait to be invited to the property.

The short period of time that a taxpayer remains at a property, or the taxpayer’s infrequent use of the property, does not, by itself, demonstrate that the taxpayer does not have a residential interest therein, especially where the taxpayer has dominion and control over a property.

Which brings us to the question of “living arrangements.” This term is not defined in the statute, but some of the case law is helpful; for example, the Gaied court indicated that the taxpayer kept no personal items at his parents’ apartment, while in Evans[xxiv] (which found that the taxpayer maintained a permanent place of abode) the taxpayer kept personal items in the rectory, including clothes, and also furnished his room with various pieces of furniture.

Based on the foregoing, “living arrangements” may be defined as the plans someone makes, either on their own or with others, which allow them to live at a place (whether indefinitely, for a specific period of time, or whenever they wish to), and to decide how they want to live at that place (for example, by leaving their personal items at the place, or by otherwise “making it theirs”). It may be said that an individual who has such an “arrangement” with respect to a place, and who contributes toward its maintenance, has a residential interest in that place for purposes of the statutory residence test.

Hopefully, the Courts will continue to shed light upon what it means to have a residential interest in a property, as that term was used in Gaied. Until then, many questions will remain, and taxpayers domiciled outside New York will have to tread warily before retaining or acquiring a residence in the State or, having done so, how they interact with that residence.


[i] Governor Cuomo has proclaimed New York the most “progressive” State in the nation.

[ii] In particular, income taxes and sales taxes. In the case of New York City, one would add real property transfer taxes. To this list, we will eventually be adding real property taxes, as failed or failing brick and mortar retailers (and maybe their landlords) are taken off the tax rolls, and as tenants at office buildings adjust to the reality of working remotely and, consequently, have less need for office space.

[iii] When someone figures out the scientific correlation between the stock market’s performance relative to that of the economy generally, please send me an email: .

[iv] .

[v] .

[vi] Bill number S3980.

[vii] Bill number S3462.

[viii] By New York standards. Can’t stress this enough.

[ix] Of course, these folks have to be aware of New York’s “convenience of the employer rule” (for purposes of allocating income to New York), and of the dispute between New Hampshire and Massachusetts that may be heard by the U.S. Supreme Court. ; .

[x] The friendlier tax environment and warmer weather also help.

[xi] Specifically, they cease to be taxed as individuals who are domiciled in New York.

[xii] Nelson Obus and Eve Coulson, Tax Appeals Tribunal, Decision DTA No. 827736.

[xiii] We reviewed “Round One” of this contest in 2019: .

[xiv] A taxpayer who answers this question in the affirmative must complete and file Schedule B of Form IT-203-B, on which they are required to identify the property and indicate the number of days spent in New York.

This drives me nuts. I have seen returns, like Taxpayer’s, that answer this question in the negative notwithstanding the preparer’s knowledge of a New York house or apartment. I have seen returns with respect to which the preparer never asked whether the taxpayer had such a house or apartment, but answered in the negative, or simply repeated the response given on the preceding year’s return.

The burden of proof is already on the taxpayer; now the taxpayer’s representative also has to contend with a loss of credibility.

In the present case, the Court rejected Taxpayer’s request that penalties be abated based, in part, upon Taxpayer’s having reported that they did not maintain any living quarters in New York on their nonresident tax returns for the years at issue. Such a denial, the Court explained, was inconsistent with a finding of good faith, and supported the imposition of negligence penalties.

[xv] 22 NY3d 592 (2014). According to the Court of Appeals, “[t]he legislative history of the statute, to prevent tax evasion by New York residents, as well as the regulations, supports the view that in order for a taxpayer to have maintained a permanent place of abode in New York, the taxpayer must, himself, have a residential interest in the property.”

[xvi] The Tribunal rejected Taxpayer’s argument that he maintained the residence for the tenant’s use. The tenant had their own separate living quarters and, as such, their occupancy did not affect the use of the House by Taxpayer as a vacation home.

[xvii] Taxpayer also argued, unsuccessfully, that New York’s statutory residency statute is unconstitutional as applied to them in that it violates the Commerce Clause of the U.S. Constitution (Art I, Sec. 8).

[xviii] Did Taxpayer misunderstand the ALJ’s position? The latter was merely explaining that the House could be a permanent residence because it was suitable for year-round use.

Indeed, according to the Court, the threshold question, when examining whether a taxpayer maintained a permanent place of abode, is whether the dwelling exhibits the physical characteristics ordinarily found in a dwelling suitable for year-round habitation. If answered in the negative, the dwelling is not a permanent place of abode. If answered in the affirmative, the question then becomes whether the taxpayer has a legal right to occupy that dwelling as a residence. If this question is answered in the affirmative, and if the taxpayer exercised that right by enjoying their residential interest in that dwelling, it can be concluded that the taxpayer maintained a permanent place of abode.

The Court agreed with the ALJ’s conclusion that Taxpayer’s House constituted a permanent place of abode. The dwelling exhibited physical characteristics that made it suitable for year-round habitation.

[xix] There are approximately 260 weekdays in a taxable year.

[xx] 20 NYCRR 105.20[e][1].

[xxi] New York’s highest court.

[xxii] Just look at all the “city folks” who abandoned their Manhattan apartments to quarantine in their vacation homes on the East End – I daresay that most of them are still there.

[xxiii] Yes, he was over 200 miles away from the New York abode, but that’s irrelevant under the Tax Law. That’s a silly law.

[xxiv] Decision DTA No. 806515.

Procedural Mumbo Jumbo? [i]

Remember your civics class in elementary school? * * * . What’s that? Not really. * * *. Doodling, you say? * * * . The principal’s office? OK, what about high school social studies? * * * . Repressed memories? I understand – too painful to recall. Well, did you ever watch Schoolhouse Rock as a kid, the “I’m Just a Bill” episode,[ii] in particular? * * * . Of course you did, that’s great. Remember how involved the process was for a bill to make it through Congress and hopefully become a law? * * * . I’ll take that as a “yes.” Well, increase that at least one hundredfold and you’ll have some idea of what it takes for Congress to enact budget legislation. Hey, where are you going?

Generally speaking, Congress is required to adopt an annual budget resolution to establish an overall budget plan for the Federal government, and to set guidelines for action on spending and revenue, as well as for the public debt.[iii] In brief, the resolution recommends the size of the budget for a fiscal year, sets forth the budget outlay for the year among various “major functional categories,”[iv] and estimates the amount from each source of funding (taxes and borrowing).

Because the government’s fiscal year begins on October 1 of one calendar year and ends on September 30 of the next calendar year, the process for adopting a budget for a particular fiscal year, and for passing appropriations bills[v] to fund the operation of the government for that fiscal year, usually starts in February of the preceding fiscal year, and should be completed – i.e., signed into law by the President – by September 30 of such preceding fiscal year.[vi]

When the 2021 fiscal year began on October 1, 2020, the then-divided 116th Congress had not yet adopted a budget resolution for such fiscal year, let alone voted on appropriations bills. In other words, the Federal government started its 2021 fiscal year without a budget.

Congress, therefore, had to pass a “continuing resolution” to fund the government on a temporary basis, and allow it to continue operating until the regular appropriations acts were passed.[vii] Indeed, a total of five continuing resolutions[viii] were passed between the start of the 2021 fiscal year and the enactment of the Consolidated Appropriations Act on December 27, 2020.[ix] The latter included $900 billion of stimulus spending related to the pandemic.

On Friday, February 5, 2021 – a little over two weeks into Mr. Biden’s administration – the 117th Congress, controlled by the Democrats following the general election in November 2020 and the runoff Senate election in Georgia in January 2021, adopted a budget resolution for the current fiscal year, ending September 30, 2021,[x] and thus took advantage of the 116th Congress’s failure to do so. How’s that, and why?

Reconciliation Hocus Pocus?

The adoption by Congress of a budget resolution for the 2021 fiscal year is a “parliamentary” prerequisite for initiating the so-called “reconciliation” process, which allows Congress to expedite the consideration of certain legislation relating to taxes, spending, and the debt limit for the 2021 fiscal year.[xi]

Perhaps more importantly, under Senate rules, a reconciliation bill is not subject to the filibuster,[xii] which requires the vote of at least sixty Senators[xiii] to end Senate debate on a bill before bringing it to a vote.[xiv] Thus, under reconciliation, an evenly-divided Senate, such as we have now, may pass a bill by majority vote of 51 to 50, relying upon the Vice President to break what otherwise would be a tie along party lines.

The budget resolution starts the reconciliation process by instructing[xv] various committees of the House and Senate to prepare legislation on some or all of the proposals set forth in the resolution, and to report such legislation by a specified date.

With respect to the 2021 fiscal year, the recently passed budget resolution calls for the enactment into law of President Biden’s $1.9 trillion pandemic relief “American Rescue Plan.” According to the House Committee on the Budget:[xvi]

The 2021 budget resolution has a single purpose: it gives Congress the option of using a budget reconciliation measure to get crucial relief to the American people as quickly as possible. Reconciliation provides fast-track procedures that will allow the American Rescue Plan to pass with a simple majority in the Senate.

In very broad strokes, the American Rescue Plan[xvii] calls for: national vaccination, testing and tracing programs, and other measures to contain the pandemic; the reopening of schools; the delivery of economic relief to those in greatest need; and financial support for the hardest-hit small businesses. The Plan also provides some tax relief by expanding certain tax credits for individuals.

The 2021 budget resolution provides that the various Congressional committees charged with drafting the legislation to implement President Biden’s Rescue Plan must report such legislation to the House and Senate Budget Committees[xviii] by February 16 (next Tuesday). It shouldn’t take long for the full House and Senate to consider their respective bills, iron out any differences between them in conference committee, then pass an agreed-upon version before sending it to the President for his signature.

It is safe to say that the legislation will be enacted no later than mid-March, which is when many benefits under the CARES Act[xix] and the Continued Assistance Act are otherwise scheduled to expire.[xx]

Where is This Going?[xxi]

Think about it: $1.9 trillion is a lot to spend. And don’t forget that the CARES Act (passed in March 2020) came with a price tag of $2.2 trillion, while the Consolidated Appropriations Act added another $900 billion to the pandemic relief effort – a total of $5 trillion.

Compare this pandemic relief figure to the amounts spent by the Federal government during the 2018 fiscal year (over $4.1 trillion) and during the 2019 fiscal year (over $4.4 trillion).

It’s possible that all of these expenditures are necessary if we are going to bounce back from the economic dislocation brought on by the pandemic. That said, how are we going to pay for this?

You may recall that, just a few weeks ago, the then Treasury Secretary-designate, Janet Yellen, said she would work with lawmakers to fast-track[xxii] a series of tax increases on wealthy Americans.[xxiii]

The House Budget Committee echoes this approach, though in more cryptic terms:[xxiv]

Once the vital relief in the President’s plan becomes law, Congress will begin its work on a forward-looking, comprehensive budget resolution for 2022. That budget will provide urgently needed economic support and address longstanding deficits in our communities and underlying inequities in our society, which have been so starkly revealed and exacerbated by COVID-19. It will foster an inclusive recovery and make responsible investments to help us rebuild a stronger and fairer economy than what we had before.

Now, you may be wondering, two budget resolutions within the same calendar year – is that possible? Yep. Remember, the first relates to the 2021 fiscal year; the second, as indicated above, would be “a forward-looking, comprehensive budget resolution for 2022” – the fiscal year that begins on October 1, 2021.

From this, it follows that Congress can consider two reconciliation bills within the same calendar year. You may remember that the 115th Congress did just that in 2017, during Mr. Trump’s first year in office: the first was for the 2017 fiscal year, ending September 30, 2017, for which no budget resolution had been passed[xxv] – that reconciliation bill unsuccessfully sought to repeal the Affordable Care Act;[xxvi] the second was for the 2018 fiscal year beginning October 1, 2017 – it resulted in the enactment of the Tax Cuts and Jobs Act.[xxvii]

Waiting for the Other Shoe?[xxviii]

According to the Associated Press, Mr. Biden is tentatively scheduled to appear before Congress on February 23, 2021 to give an “unofficial” State of the Union address.[xxix] By then, the legislative text for the American Rescue Plan will have been delivered to the House and Senate Budget Committees, and will be well on its way to enactment.

Various publications have indicated that the President intends to use the occasion of his first address to Congress to unveil a large infrastructure package,[xxx] including tax increases.

Although Mr. Biden is certain to invite the Republican members of Congress to join him in this endeavor, he will not need their collaboration after having primed the reconciliation pump with his pandemic relief plan.[xxxi]

It will behoove us to tune into the President’s address to Congress, only two weeks from now, to see which elements of his tax plan[xxxii] are going to be added to the Code. Perhaps we’ll get lucky. It may be that he decides to defer their enactment until the 2023 fiscal year,[xxxiii] which will begin on October 1, 2022 – just one month before the all-important mid-term Congressional elections.[xxxiv]

In that case, taxpayers and their advisers will have the opportunity – a second chance, you might say – to consider and implement strategies for reducing their future Federal tax burden.

[i] Is that sufficiently “PC” for you? You have to admit, it lacks the character of the original.

Speaking of which, there are many versions for the origin of this colloquialism, ranging from Brunhilde’s ride into the funeral pyre in Wagner’s “Ring Cycle,” to Kate Smith’s rendition of “God Bless America” at Philadelphia Flyers games.

My favorite: Al Capone became much enamored of opera, studying scores, listening to records, and even hiring tutors, until he felt himself sufficiently prepared to sample the real thing. Accompanied by two bodyguards, he took his seat at the opera house. After the first aria, the guards rose to leave, whereupon Al grabbed them by their coattails. “Siddown,” he growled, “it ain’t over ‘til the fat lady sings.”


[iii] Under the Congressional Budget Act of 1974; P.L. 93-344.

[iv] Actually, the budget resolution typically provides a “fiscal blueprint” for the next ten fiscal years; each succeeding year’s resolution tweaks the estimates made in earlier resolutions.

[v] There are twelve different ordinary appropriations bills that are passed annually. Each chamber of Congress has an Appropriations committee that is, in turn, divided into twelve subcommittees, each having responsibility for one of these bills.

[vi] In brief: during the first two months of the current fiscal year, the Administration will give Congress its budget for the next fiscal year; the House and Senate will each analyze the President’s budget proposal; each Chamber will then draft a budget resolution that sets overall spending levels; if there are differences between the two resolutions, a conference committee of members from both Chambers will try to resolve them; appropriations bills are then drafted by committees of each Chamber – these bills are the vehicles by which Congress funds the Federal government; each Chamber then votes on its own appropriations bills; these bills are then sent to another conference committee that will “merge” the two versions; the House and the Senate will then vote on the same version of the bill; if passed, the bill is then sent to the President.

[vii] These resolutions represent legislation that is passed when a new fiscal year is about to begin, or has already begun, and the Congress has failed to reach agreement on the appropriations bills for the full fiscal year.

[viii] One in September 2020, and four in December.

[ix] P.L. 116-260. The legislation provides for $2.3 million in spending for the 2021 fiscal year.

[x] The vote in the House was 219 to 211, with one Democrat joining all of the Republicans to vote against the resolution. The vote in the Senate was 51 to 50, with the Vice President breaking the 50-50 tie between the two parties.

[xi] Under the Senate’s “Byrd rule,” reconciliation legislation cannot include provisions that do not affect the level of spending or revenues, or the debt limit. Thus, no “extraneous measures” (unrelated to the principal purpose of the reconciliation bill) can be attached to the bill.

[xii] The House rules do not provide for the filibuster.

[xiii] In the current, evenly-split Senate, ten Republicans would have to agree with all 50 of the Democrats (assuming the latter act in unison) in order to stop a filibuster.

[xiv] Invoking cloture.

[xv] “Reconciliation directives.”

[xvi] .

[xvii] .

[xviii] The House Committee is chaired by John Yarmuth (of Kentucky), while the Senate Committee is chaired by Bernie Sanders.

[xix] P.L. 116-136.

[xx] .

[xxi] As a Boy Scout many years ago, we performed the following skit at Alpine Scout Camp, in New Jersey: A boy and his donkey have been walking for many days. The poor donkey keeps asking for water, and the boy always responds, “Patience, Jackass, patience.” As this exchange is repeated over and over, some exasperated audience member stands up and demands to know whether the skit is going to come to some conclusion. That’s when the boy turns to the audience member and says, “Patience, Jackass, patience.” Laughter ensued. (You had to be there.)

Oh, in case you were wondering, we all had our shots before crossing the George Washington Bridge – I can still say that, right? – into the hinterlands of New Jersey.

All kidding aside, though, the battles fought in New Jersey between the British/Hessian forces and the Colonials from late 1776 into early 1777 (the “Ten Crucial Days”) demonstrated that General Washington was the right man for the job.

[xxii] Ms. Yellen was clearly referring to the reconciliation process.

[xxiii] .

[xxiv] .

[xxv] I have often referred to President Obama’s Green Book – his last – for the 2017 fiscal year as the source for much of Mr. Biden’s tax plan.

[xxvi] There were 52 Republican Senators, and 48 Democrats. You may recall Senator McCain’s bucking the Republican leadership to vote against repeal. .

[xxvii] P.L. 115-97.

[xxviii] What the hell is the origin of this idiom?

[xxix] .

[xxx] See, for example, ; .

[xxxi] I hope I used that idiom correctly.

[xxxii] ; ; .

[xxxiii] By which time, hopefully, the economy will have fully recovered.

[xxxiv] Will the Republicans reclaim the Senate?

“Find a Hobby”

Over the years, many colleagues, friends and family who have observed my work habits have suggested, with the best of intentions, that I find a “hobby,” by which they mean something other than a work-related activity (broadly defined) toward which I may redirect my attention and energy.[i] Their entreaties have taken on a more urgent tone over the last several weeks as my focus on legislative proposals and related developments in Washington and Albany (and their significance to our clients) threaten to drive me meshuga.

I have always appreciated these “interventions” – especially when they occurred over a gin martini with olives, accompanied by oysters or a crabmeat cocktail,[ii] at which point they usually turned into pseudo-symposia – but they inevitably lead me into what I hope is a humorous dissertation of how taxpayers with hobbies often get into trouble with the IRS.

A staple of this poor excuse for a monologue is a matter I had several years ago. The taxpayer, a retired professional – not a farmer by trade – owned many acres of land on the outskirts of a fairly well-to-do suburban area. Situated in one corner of the property was the owner’s house, along with a pool and tennis court. The rest of the land, however, constituting over 99 percent of the total acreage, was dedicated to various agricultural activities. There was an apple orchard, the output of which was picked, then boxed before being trucked and sold to local stores; there were chicken coops (with bird netting to protect from raptors[iii]), the eggs from which were gathered and stored in cartons which were then transported and sold to the same local establishments, including restaurants; there were heavy-coated sheep,[iv] capable of withstanding Northeastern winters,[v] that grazed over several adjoining poly-wired[vi] pastures[vii] (over which they were herded using electronically-controlled and timed gates), that were shorn prior to lambing in the spring – the raw wool was then shipped elsewhere to be processed into yarn and dyed, and then returned to be readied for sale; and there were forested areas from which dead trees were felled and, along with storm-felled trees, were cut, split and stacked before being sold to the public as firewood.[viii]

The taxpayer managed the farm and kept meticulous records; several times a day, he would get into his Jeep and crisscross the property to inspect the fences,[ix] look for newly fallen trees, check on the sheep and chickens, etc. The entire operation was run on a skeletal staff of part-time laborers overseen by a foreman, who were not infrequently paid in kind with the products of the farm.[x]

Pretty impressive operation, right? No doubt. And the taxpayer seemed very knowledgeable (at least to a lay person). But the farm never turned a profit. For every year of its operation, the taxpayer’s federal income tax return reflected a loss for the farming operation. And that single fact caught the attention of the IRS.

Why Care?

In general, taxpayers can only deduct hobby expenses – those that are ordinary and necessary for the particular activity – up to the amount of hobby income. If hobby expenses (which must be itemized) exceed hobby income, the hobby loss cannot be deducted from other, non-hobby income.

According to the IRS, a hobby is an activity in which an individual taxpayer is engaged for recreation or pleasure, notwithstanding that it may also generate some revenue. By contrast, a key feature of a business is the profit that the individual taxpayer expects to generate by engaging in the business activity. The income tax treatment of the income and expenses arising from a given activity will depend upon whether the activity is properly characterized as a business or as a hobby.

In distinguishing between a hobby or business activity, one has to take into account all of the facts and circumstances with respect to the activity. A hobby activity is an activity not engaged in for profit. According to the IRS, one must generally consider the following factors (none of which, by itself, is decisive) in determining whether an activity is a business engaged in making a profit:

  • Whether the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records.
  • Whether the taxpayer has personal motives in carrying on the activity.
  • Whether the time and effort the taxpayer puts into the activity indicate they intend to make it profitable.
  • Whether the taxpayer depends on income from the activity for their livelihood.
  • Whether the taxpayer’s losses are due to circumstances beyond their control (or are normal in the startup phase of the type of business).
  • Whether the taxpayer has the knowledge needed to carry on the activity as a successful business.
  • Whether the taxpayer was successful in making a profit in similar activities in the past.
  • Whether the activity makes a profit in some years and how much profit it makes.
  • Whether the taxpayer can expect to make a future profit from the appreciation of the assets used in the activity.[xi]

In light of the foregoing, what could be said of the taxpayer’s farming operations, as described above? The IRS asserted that they constituted a hobby, notwithstanding the business-like manner in which the farm was managed and operated. After all, the IRS reasoned, who continues to run a business that consistently runs at a loss and that requires the constant infusion of capital to cover its revenue shortfalls?

I’ll tell you who – a taxpayer whose real property taxes are determined based upon their land’s agricultural assessment rather than on its full assessment, which in this case meant land suitable for development – it was the significant savings in property tax dollars that made the farming operation “profitable.”[xii]

In the end, it turned out well for the taxpayer.[xiii] Just last week, however, I came across a decision in the case of a less fortunate taxpayer.[xiv]

What Business?

Over several years, Taxpayer carried on some form of farming activity on a large tract of land. Every year, Taxpayer reported net losses from this activity.[xv]

Initially, Taxpayer raised chickens on the property to sell for meat. That activity did not go well; indeed, Taxpayer could not recall whether they ever sold any of the chickens. After three or four years, Taxpayer switched from raising chickens for meat to raising them for egg production. Within a year, however, Taxpayer had determined that she would not make money with commercial egg production because of an upward trend in the price of chicken feed. Taxpayer switched from commercial egg production to building a flock in order again to sell chickens for meat. Taxpayer purchased approximately seventy birds. There were no sales in the first two years, but Taxpayer planned to begin sales in the third year. Unfortunately, this plan was thwarted when wild dogs destroyed most of the flock.[xvi]

During this period, Taxpayer was also growing watermelons, squash, peppers, apples, bananas, pomegranates, date palms, and asparagus on the property. Taxpayer claimed the expenses of growing those crops as farming expense deductions, but reported no revenues from sales. The lack of revenue was due to the fact that the property bordered the edge of a large evaporative salt plant, and a spill from the plant created a salt flat on a portion of the property. Moreover, evaporation from the salt plant blew across the property and poisoned the soil.[xvii] Thus, crops grown on the property were not commercially acceptable. Taxpayer planted a test crop of peppers, which was not successful because insects destroyed the crop. Taxpayer did not market produce from the property.

Taxpayer also acquired three cows and three calves. The plan was simple: “Feed the calves, make them big, sell them, impregnate the mothers * * * repeat.” That plan did not work because, as Taxpayer explained: “[I]t quickly became apparent that we weren’t going to make money on cows because when I turned them out onto the [land], they couldn’t find enough to eat. * * * We immediately got rid of the cows.”[xviii]

By this time, a reasonable person would have: (a) sold the land, (b) sought the services of a reputable shaman to remove a curse,[xix] (c) given up farming, (d) shot themselves, (e) played the stock market, or (f) taken up golf.[xx] Clearly, Taxpayer was anything but reasonable.

Taxpayer explained the impetus behind their progression from activity to activity:

“When you have something in a business that is not making money, you change it, and you figure out why it’s not making money. You evaluate to see if you could make it make money. If it doesn’t, you stop doing that – and you start doing something else. * * * [W]e have tried several things on this property; so far, nothing has worked. * * * Will something come along that will work? When the right opportunity comes, financial conditions change, market conditions change, then yes, I fully expect to be able to make a profit. At the present moment, no, * * * [we] don’t.”

For the tax years at issue, Taxpayer reported the gross income and expenses from their farming activities. The IRS disallowed Taxpayer’s deductions for the farming losses, explaining that Taxpayer did not incur those losses carrying on a trade or business.[xxi] Following the issuance of a notice of deficiency, Taxpayer petitioned the U.S. Tax Court.

The Court

The Court considered whether Taxpayer’s farming-activity rose to the level of a trade or business.

Section 162 of the Code, the Court explained, allows “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”. The IRS argued that Taxpayer could not deduct the farming activity losses under Section 162 because (a) Taxpayer lacked a profit motive, and (b) Taxpayer’s business had not even commenced during the years at issue – rather, Taxpayer’s “farm activity never moved beyond initial research and investigation into an operating business.”

The Court acknowledged that Section 183 of the Code generally disallows any deduction attributable to an activity not engaged in for profit. However, the Court also stated that Taxpayer had convinced the Court, “notwithstanding seven fallow years,”[xxii] that Taxpayer was actually seeking to earn a profit from farming.

Nevertheless, the Court agreed with the IRS that, during the years at issue, Taxpayer’s activities were for the most part preoperational and, for that reason, the losses could not be deducted.

The Court observed that, in order for expenses to be deductible under Section 162(a), the expenses must relate to a trade or business functioning when the expenses were incurred. A taxpayer has not “‘engaged in carrying on any trade or business’ within the intendment of section 162(a)”, the Court explained, “until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” “Carrying on a trade or business” the Court continued, “requires a showing of more than initial research into or investigation of business potential.”

“Until the time the business is ‘performing the activities for which it was organized,’ expenses related to that activity are not currently deductible.” They are instead classified as “startup” expenses – which include those incurred “before the day on which the active trade or business begins” – are only deductible over time once an active trade or business begins.[xxiii]

Startup Costs

Section 195(a) provides that no deduction shall be allowed for startup expenditures, which are defined to include, among other things, any amount paid in connection with creating an active trade or business, which, if paid or incurred in connection with the operation of an existing active trade or business, would be allowable as a deduction for the taxable year in which paid or incurred. Such expenditures may, at the election of the taxpayer, be treated as deferred expenses that are allowed as a deduction prorated equally over a 15-year period beginning with the month in which the active trade or business begins.

During the years at issue, Taxpayer’s farming activities never moved beyond initial experimentation and investigation into an operating business. The Court noted that there was some question of whether to treat all of Taxpayer’s farming activities as one activity or as separate activities for determining whether Taxpayer had commenced any active trade or business. In the end, the Court concluded that it may not make much difference because Taxpayer did not segregate costs by activity.

What’s the Point?

Stay away from golf? Absolutely. Avoid hobbies altogether? Of course not – just be careful of claiming deductions on your tax return in respect of a “hobby” that generates any income.

That said, it felt good to write about something tax-related other than the Democrats’ likely use of the reconciliation process to enact a number of federal tax increases,[xxiv] probably within the next couple of months, or about the pressures on Albany to tax the “rich” on their way out of New York.[xxv]

On reflection, maybe moving to a farm isn’t such a bad idea. It won’t be easy, and I’ll have a lot to learn but, to borrow from Garrison Keillor, it would be “A life in which people made do, made their own, lived off the land, lived between the ground and God.”[xxvi] That doesn’t sound so bad, does it?

[i] “Take up golf,” some have said. This is often followed by “It’s a great game.” (Some even refer to it as a sport!) My reply: “I’d rather develop a pizza allergy.” For those who know me, and of my love for pizza, that’s saying a lot.

[ii] It’ll be a long time before we can indulge in such sessions again.

[iii] Reminds you of Foghorn Leghorn and Henery Hawk? “You’re a chicken and I’m a chicken hawk. Are you comin’ quietly, or do I have to muss ya up?!”

[iv] My mom hails from a tiny village in a hollow among the mountains of northwestern Epirus. The rocky land was not arable, but it could sustain a few goats and small family gardens.

[v] The taxpayer learned the hard way that not all breeds of sheep are equal – earlier acquisition succumbed to the cold.

[vi] To keep coyotes out.

[vii] Over time, the taxpayer experimented with using different forage that has been adapted for the Northeast.

[viii] The taxpayer opened the farm to the public at designated hours on certain days of the week; he also hosted elementary school and Scout groups.

[ix] He told me how he once caught some folks trying to steal one of his sheep. They stopped their car on the road that ran along the edge of one of the pastures, got out, somehow made it over the fence, identified their victim, and were in the process of packing the poor thing into the back seat of the car when he came upon them.

[x] I visited the farm a few days before a scheduled tour by the IRS examiner. (Yes, I wore a suit and shoes, yes it was a gray day that turned into a rainy one, yes we got out of the Jeep several times, and yes, it was muddy. Happy?

Anyway, there were two or three smallish tractors parked together near one of the buildings. When I asked how they were used, the taxpayer told me they hadn’t been operated in years. I asked him not to volunteer that information.

At one point, we stopped at a barn in which, along with the tools one might expect to find in a barn, was something quite unexpected: a Jaguar – no, not the big cat, the automobile. I suggested that he remove it before the examiner’s visit. (I can tell you I held my breath on the day of the examiner’s inspection as the taxpayer opened the barn’s gate – thankfully, the car was gone.)

[xi] See Reg. Sec. 1.183-2(b).

[xii] I suggested that he consider an agricultural easement. He had other plans: he hoped to hold onto the property until his passing, in order to obtain a basis step-up. IRC Sec. 1014. In that way, his family, none of whom lived nearby, could eventually sell the property without paying income tax.

[xiii] The disallowance of certain deductions that could not be adequately substantiated. Taxpayer’s burden.

[xiv] Costello v. Commissioner, T.C. Memo 2021-9 (Jan. 25, 2021).

[xv] On Form 1040, Schedule F, Profit or Loss from Farming.

[xvi] A not-so-subtle message from above?

[xvii] Lot’s wife would have understood all too well.

[xviii] You can’t make this up.

[xix] Seriously, who would ever get into a car with this individual, let alone a plane?

[xx] Obviously, set out in order of preference.

[xxi] The IRS disallowed Taxpayer’s farm-activity losses only to the extent they exceeded her farm-activity income.

[xxii] Query whether the Court or Taxpayer was thinking of Joseph’s interpretation of Pharaoh’s dreams in Genesis 41: 1-36? Only in reverse? Seven years of great abundance, Joseph explained to Pharaoh, would be followed by seven years of great famine. It worked out pretty well for Joseph.

[xxiii] IRC Sec. 195.

[xxiv] Perhaps with retroactive effect? I doubted it until recently.

[xxv] Query whether this will include a California-like provision for like-kind exchanges in which New York real property is exchanged for non-New York real property? Under such a provision, the owner of the non-New York replacement property would have to report annually the New York-sourced gain that was deferred as a result of the like-kind exchange. When such replacement property is sold in a taxable transaction, the taxpayer will be required to inform New York of the sale, and report (and pay tax on) the lesser of the gain from the sale or the deferred New York-sourced gain from the original exchange.

[xxvi] “Hog Slaughter,” by Garrison Keillor.

Budget Time in New York

Last week, we reviewed some of the tax measures discussed by Governor Cuomo in his report on the State of the State, and how they may affect New York businesses and their owners.[i] Today, we’ll take a look at just a few of the “revenue provisions” included in Mr. Cuomo’s proposed Executive Budget for the Fiscal Year 2022, as released on January 19.

It’s important to bear in mind that the State’s fiscal year begins in just over two months, on April 1, 2021. Now that the Governor has submitted his budget to the Legislature for its approval – along with the related appropriation and revenue bills – the Senate Finance and the Assembly Ways and Means committees will analyze the Governor’s proposals and estimates. After each chamber has completed its review of the budget, a conference committee process will be used to organize the issues identified by each chamber. These will be deliberated, they may be amended and, ultimately, the Legislature will reach an agreement on the budget.

Any changes that the Legislature makes to the Governor’s proposals will be sent to him for approval. The Governor has line item veto authority to reject specific items, though his veto may be overridden by a vote of two-thirds of the members of each chamber – following the 2020 elections, the Democrats (the Governor’s own Party) have a veto-proof supermajority in each chamber.

Don’t Bother Waiting

The foregoing process takes time, but it must be completed before April 1, 2021. In the meantime, New York – like so many other States – continues to wait on the Federal government to deliver funding to help offset the revenue losses from the economic disruption caused by the coronavirus pandemic.

It seems very unlikely, however, that Congress will act quickly enough to relieve the pressure on New York’s fiscal situation. Indeed, last week a number of moderate Republican Senators indicated that it was too soon to consider President Biden’s proposed $1.9 trillion economic stimulus plan, and the financial support it promises to deliver to state and local governments. The Senators did not disagree with the proposition that more financial stimulus will be needed, but they reasoned that Congress enacted a $900 billion relief package only last month, and it should be given time to work before additional fiscal measures are taken.

I imagine that, at some not-too-distant time – perhaps in March[ii] – President Biden and the Democrats will abandon their plan for a bipartisan relief bill, and will instead use the reconciliation process to fast-track economic stimulus and tax increases through Congress.[iii] Indeed, last week, “Treasury Secretary-designate Janet Yellen said she would work with lawmakers to fast-track a series of tax increases on . . . wealthy Americans.”[iv]

The flurry of Executive Orders during Mr. Biden’s first few days in office presages this outcome.[v] The President is pushing his Party’s agenda (and those of its various constituents) on many different fronts. The use of Executive Orders allows him to unilaterally move a number of items. In the end, however, he will need Congress – the power of the purse – including the Senate, to support him. If he cannot achieve a bipartisan consensus on certain items, or if he is frustrated by the prospect of the filibuster, he will turn to the reconciliation process sooner rather than later. Congressional elections will be held in less than two years – the Democrats have some momentum now, and will have to demonstrate that they’ve made progress.

What Has New York Already Done?

Certainly, New York has not been caught off guard by the foregoing developments – the State had to be prepared to act in the event Mr. Trump were reelected, or in the event the Republicans retained control of the Senate.

In fact, like any “fiscally responsible state,”[vi] New York has taken certain measures to staunch the bleeding, if you will.

For example, New York has chosen to decouple from the more relaxed rules provided under the CARES Act[vii] for the use of NOLs with respect to certain taxable years[viii]; thus, in determining their New York income tax liability for those years, taxpayers must re-compute their Federal NOL deduction using the more restrictive rules that were in place prior to the CARES Act.[ix]

At the same time, however, New York has decided to conform to the Federal treatment of PPP loans. Specifically, if a forgiven loan is excluded from Federal adjusted gross income, it will also be excluded from New York adjusted gross income.

What’s more, New York has also chosen to follow the Federal treatment of business expenses that were paid or incurred with the proceeds from a forgiven PPP loan; if these expenses are deducted in computing Federal adjusted gross income, the same deductions will automatically be allowed in determining New York adjusted gross income.

In other words, New York has chosen to disregard certain business-friendly Federal tax changes made in response to the pandemic, by which it hopes to retain tax revenues by avoiding the payment of refunds, and it has chosen to adopt other business-friendly Federal measures,[x] by which it will lose tax revenues.

What’s In the Budget?

So where does that leave New York?

According to the State’s Budget Director, Robert Mujica, as set forth in the FY 2022 Executive Budget Briefing Book:

“The State has no choice. Unlike the Federal government we cannot print money and must balance our budget. Every spending decision is zero sum: Any area where we don’t reduce spending means deeper reductions in another. If $15 billion in Federal funding materializes, the tax increases that will make New York less competitive and the spending reductions that hurt New Yorkers go away. If they fail to act, the State’s ability to meet even the most basic funding needs will be cut for universities and affordable college programs, childcare, combatting homelessness, and much more.”

The Governor’s $193 billion[xi] budget plan for fiscal 2022 addresses, to some degree, the need for more revenues, while also acknowledging certain political realities, as described below.

Rate Hikes

For months, the Legislature, as well as many members of New York’s Congressional delegation,[xii] have been calling for a mark-to-market-based wealth tax.[xiii] The Governor has prudently chosen, instead, to offer a toned-down version of an earlier Senate bill.[xiv]

The proposed budget would impose an income tax surcharge on certain high-income individuals, and would only apply for the 2021, 2022 and 2023 taxable years. The addition of the “temporary” surcharge would effectively increase New York’s highest marginal income tax rate for individuals, which is currently set at 8.82 percent, and which applies to single individuals with taxable income in excess of just over $1 million for 2020.[xv] Specifically, the budget calls for five new rate brackets, based upon taxable income, to which varying surcharge tax rates would be applied. In the case of a taxpayer with taxable income of:

  • More than $5 million but not more than $10 million, the income tax surcharge would be 0.50%;
  • More than $10 million but not more than $25 million, the surcharge would be 1.0%;
  • More than $25 million but not more than $50 million, the surcharge would be 1.50%;
  • More than $50 million but not more than $100 million, the surcharge would be 1.75%;
  • More than $100 million, the surcharge would be 2.0%.

Yes, these brackets represent significant amounts of income. How many New Yorkers would actually be subject to this surcharge? In New York City,[xvi] over 30,000 residents reported earning $1 million or more in 2018; of these, 2,626 residents reported income of between $5 million and $10 million, and 1,786 (representing 0.05 percent of all filers) reported income in excess of $10 million.[xvii] What if we looked state-wide? New York taxpayers with taxable income of $1 million or more accounted for just 1 percent of all filers in tax year 2016, but they accounted for 37 percent of the total personal income tax liability.[xviii]

Query how many of these taxpayers attributed their multi-million dollar incomes to a one-time event, such as the sale of a business? The addition of the surcharge should certainly be considered by a target company’s owners in determining whether a prospective buyer’s offering price is sufficient; remember, New York does not tax long-term capital gain at a preferred rate relative to ordinary income.

In an interesting twist, the budget also provides that a taxpayer to whom the surcharge will apply may voluntarily prepay their tax year 2022 and tax year 2023 surcharge liability through their tax year 2021 estimated tax payments. If a taxpayer chooses this option, they will receive a “repayment” via tax deductions in tax years 2024 and 2025.

According to the Budget Briefing Book, the temporary surcharge is “an innovative way to address the State’s short-term fiscal challenges while minimizing the impact on taxpayers over the long-term and to help maintain New York’s ability to compete.”

It is worth noting, however, that the 8.82 percent tax rate was enacted in 2009 as a temporary, three-year, surcharge (i.e., an increase) in response to the fiscal crisis brought on by the Great Recession.[xix] Before then, New York’s top rate was 6.85% for individuals with taxable income in excess of $215,400. Since that time, the “temporary” tax surcharge has been extended several times; it is now scheduled to run through 2024.

Would I be surprised if the budget’s proposed “temporary” surcharge follows this pattern?[xx] Not at all – in fact, I expect the tax will be extended (and re-extended), especially if it does not have the adverse effect of prompting taxpayers to leave New York.

SALT Cap Workaround

You may recall that then-candidate Biden promised to restore the itemized deduction for (i) state and local real property taxes; (ii) state and local personal property taxes; and (iii) state and local income taxes.

Prior to the enactment of the TCJA, individual taxpayers were permitted a deduction for these taxes, whether or not incurred in a taxpayer’s trade or business or activity for the production of income.[xxi] Property taxes were allowed as a deduction in computing adjusted gross income if incurred in connection with property used in a trade or business; otherwise they were an itemized deduction. In the case of state and local income taxes, the deduction was an itemized deduction notwithstanding that the tax may be imposed on profits from a trade or business.

Under the TCJA – for taxable years beginning after December 31, 2017, and beginning before January 1, 2026[xxii] – in the case of an individual, the itemized deduction for the aggregate of (i) state and local property taxes not paid or accrued in carrying on a trade or business, or in conducting an activity for the production of income,[xxiii] and (ii) state and local income taxes (or sales taxes in lieu of income taxes) paid or accrued in the taxable year, is limited to $10,000 ($5,000 for a married taxpayer filing a separate return).[xxiv]

You may also recall that, shortly after the enactment of the SALT cap, many high-tax states sought to overturn or somehow circumvent the limitation. These early efforts were not successful but, in November of 2020, the IRS approved of an arrangement under which a state would impose a mandatory or elective entity-level income tax on partnerships and S corporations that do business in the state, or that have income derived from sources within the state. According to the IRS, this entity-level income tax would be deductible by partnerships and S corporations in computing their non-separately stated income or loss; in this way, the entity’s tax payment would be reflected in an individual partner’s or shareholder’s distributive or pro-rata share of non-separately stated income or loss reported on a Schedule K-1. This indirect owner-level tax benefit would not be taken into account, the IRS indicated, in applying the SALT deduction limitation to the individual partner or shareholder.[xxv]

Of course, this workaround is limited – it only applies to partners in a partnership and to shareholders of an S corporation. It does nothing, for example, to reduce the impact of the cap on higher-paid employees who live or work in high tax states, including New York.

Campaign promises aside, many observers believe that the elimination or increase of the SALT cap may be difficult to achieve outside the reconciliation process. Moreover, it may not be politically wise to even try to keep that promise, as demonstrated by Treasury Secretary-designate Janet Yellen last week, when she “dodged the question of whether a repeal of the cap on state and local tax deductions, as proposed by Biden, would deliver a big tax cut to wealthy Americans while doing next to nothing for those in the bottom half of income distribution.”[xxvi]

Governor Cuomo must have anticipated these risks and, so, the budget introduces an elective “pass-through entity tax” similar to the workaround approved by the IRS, described above. The tax will be available only to partnerships and S corporations, all the owners of which are individuals. The tax will be imposed at the rate of 6.85 percent[xxvii] upon the adjusted net income of an electing pass-through entity that is doing business in New York, to the extent such income is allocable to New York. The pass-through entity’s partners or shareholders will be entitled to a credit against their New York personal income tax liability based upon their profit percentage of the partnership or their pro rata share of the S corporation, and the amount of entity tax paid by the partnership or S corporation, as the case may be.[xxviii] A similar credit will be available to a resident partner or shareholder for their share of any pass-through entity tax imposed by another state upon the entity’s income derived from that state. In this way, the partners and shareholders will be permitted to indirectly deduct the SALT taxes paid by their pass-through entity.

Other Items to Note

The revenue provisions of the Governor’s budget proposal are 415 pages long. In addition to the items described above, they include a variety of tax-related changes, some of which will attract greater attention than others; for example, the legalization and taxation of adult-use cannabis.

Two of the provisions of which the owners of a closely held business should be aware are the following:

  1. the budget bill would mandate conformity to Federal S corporation status by amending the New York Tax Law to provide that all Federal S corporations will be treated as S corporations for State tax purposes – no separate New York election will be required; and
  2. the budget bill would amend the Tax Law to clarify that the grantor (seller), and only the grantor, is responsible for paying the basic real estate transfer tax, and that the grantor is not allowed to pass through the cost of the transfer tax to the grantee (buyer).

What’s Next?

Most of the tax changes in the proposed New York budget seem reasonable. Of course, there is room for disagreement, especially among the more progressive members of the Governor’s party. It remains to be seen, for example, whether they will demand permanent tax increases, or perhaps even insist upon some version of the wealth tax that received much attention last year.

Then there is the status of the Federal stimulus – when will it be forthcoming, and will New York be allocated a sufficient share of it?

Finally – and this is the key issue – in the event the State’s revenues, whether in the form of the hoped-for Federal assistance, the proposed additional taxes, and/or loan proceeds, are not enough to sustain the many programs and social safety nets that New York provides its residents, how will Albany react?

Given the veto-proof majority that the Democrats have in both chambers of the Legislature, will the State decide in favor of increasing the tax burden imposed on a greater number of its “wealthy” residents than proposed by the Governor, notwithstanding his concern over prompting these individuals and their families, along with their businesses, to leave New York? After all, there are over 500,000 millionaire households in the State.[xxix]

Stay tuned.

[i] .

[ii] Former President Trump’s impeachment trial in the Senate is scheduled to begin the week of February 8, 2021.

[iii] I don’t see bipartisanship in our immediate future. After all, we have members of Congress publicly stating that they fear for their safety when in the presence of some of their colleagues. We have other members making accusations that their colleagues informed the mob of their whereabouts prior to and during the January 6 violation of the U.S. Capitol. We have the impeachment trial of a former President whose supporters still number in the tens of millions. And Trump aside – I don’t think he is capable of persuading a rock to sit still – those same citizens, and their elected representatives, fundamentally disagree with so many of the policies articulated by those from across the aisle. Finally, let’s not forget that the Democrats lost seats in the House in 2020, and that the Parties are split 50-50 in the Senate; the 2022 elections will be here before you know it – why would the Republicans play nice?

[iv] . That doesn’t sound like bipartisanship to me.

[v] Of whom does it remind you? Query whether Mr. Biden, like his predecessor, will seek funding by “repurposing” (i.e., diverting) resources from their committed task to another.

[vi] .

[vii] You will recall this is the $2.2 trillion economic relief legislation enacted in March of 2020; the “Coronavirus Aid, Relief, and Economic Security Act,” P.L. 116-136.

[viii] For example, the CARES Act allows the taxpayer to carry back certain NOLs, which may result in the refund of taxes paid by the taxpayer in a carryback year.

[ix] These more restrictive rules were enacted by the Tax Cuts and Jobs Act (“TCJA”); P.L. 115-97. .

[x] Inconsistent? Somewhat, but New York is also fighting to keep taxpayers and their businesses in New York – it has to pick its poison.

[xi] Second only to California, among the states. California’s GDP is double New York’s (and the 5th largest in the world), while New York’s budget per capita is almost double California’s.

[xii] Especially “She Who Must Not Be Named.”

[xiii] .

[xiv] S.7378.

[xv] For married taxpayers with taxable income above $2,155,350.

[xvi] Don’t forget to add New York City’s top rate of 3.876 percent for resident individuals.

[xvii] .

[xviii] .

[xix] It was referred to as the “millionaires’ tax.”

[xx] Think of a “temporary” surcharge as a fiscal gateway drug.

[xxi] In determining an individual’s alternative minimum taxable income, no itemized deduction for property, income, or sales tax was allowed.

[xxii] Yes, this is yet another of the TCJA changes that sunsets after 2025.

[xxiii] Thus, under the provision, in the case of an individual, state and local property taxes, and state and local sales taxes, are not subject to the SALT cap limitation when paid or accrued in carrying on a trade or business, or an activity for the production of income.

[xxiv] Sec. 11042 of the TCJA and sec. 164 of the Code. The “State and Local Tax,” or SALT, Cap.

[xxv] IRS Notice 2020-75.

[xxvi] .

[xxvii] The highest New York tax rate applicable to individuals, disregarding the “temporary” surcharge taxes.

[xxviii] The electing pass-through entity will be liable for the tax in the first instance; in addition, the partners or shareholders of the pass-through entity will be jointly and severally liable for the tax.

[xxix] .

Only 347 Days to Go

What a year it has already been, and we are just beginning the third full week of 2021. The Democrats swept Georgia, thereby giving that Party a majority in the U.S. Senate and ostensible control over Congress. The U.S. began vaccinating high risk health care workers against the COVID-19 virus. The NFL playoffs began.[i] The U.S. Capitol was stormed while Congress was in session to confirm the vote of the Electoral College.[ii] National Guard units from all over the country have been deployed to D.C. to ensure that the January 20 presidential inauguration remains secure and peaceful. Mr. Trump was impeached by the House, again.

Closer to home, the New York Attorney General sued the New York City Police Department, alleging that its officers had abused protesters during last summer’s demonstrations.[iii] Query whether this is the first time a state’s Attorney General has sued the law enforcement agency of a municipality within that state?

State of the State

Governor Cuomo reported on the State of the State last week. “We now turn towards 2021 with the spirit of optimism that is grounded in experience,”[iv] he began. Optimism? Experience? I am less optimistic, in no small part because of the historical record;[v] and delivering his report in the War Room[vi] at the State Capitol does not change the historical record.

This was followed by a lot of fluff,[vii] what appeared to be a gratuitous political diatribe,[viii] and some omissions (like the fact that we started 2020 with a $6 billion budget deficit[ix]).

Finally, he moved onto the crux of his presentation. “To close our $15 billion budget gap on our own,” he said, “would require extraordinary and negative measures. Imagine this: If we raise taxes to the highest income tax rate in the nation, on all income over $1 million – billionaires, multi-millionaires, millionaires – any income over $1 million, we would only raise $1.5 billion.”[x]

It seems, then, that the Governor does not want to tax the wealthy residents of New York,[xi] the State which he proclaimed as “the progressive capital of the nation.” The State’s legislators, we know, feel very differently about taxing the wealthy; what’s more, the Governor’s own Party now has a veto-proof majority in both the New York Senate and the Assembly.

At the same time, however, he stated, “If we postponed our important tax cut for our struggling middle class, we would save $500 million.[xii] If we froze labor contracts on our hard working public employees, we would save $1 billion. If we cut education funding for our children 20 percent, we would save $5.2 billion.[xiii] Even after all of that pain, we would still need billions in cuts to healthcare in the middle of a pandemic.”

Translated: New York will not cut its costs (i.e., programs or personnel).

How, then, will the State maintain its status as the progressive capital of the nation?

The Governor tells us that “We would need to borrow billions at the cost of future generations. It would be devastating to all New Yorkers.”

OK, so the Governor will not increase taxes, will not cut costs, and will not borrow the necessary funds. What does that leave? Raise the entrance fees at State parks? Solicit contributions from the public?[xiv] No, on both counts.

Where, then, are these billions of dollars to be found?

Drugs and Gambling?

Remember this scene from “The Godfather”?

Don Corleone: [to Sollozzo] “I must say no to you, and I’ll give you my reasons. It’s true. I have a lot of friends in politics, but they wouldn’t be friendly very long if they knew my business was drugs instead of gambling, which they rule that as a – a harmless vice. But drugs is a dirty business…It makes, it doesn’t make any difference to me what a man does for a living, understand. But your business, is uh, a little dangerous.”[xv]

According to the Governor, “[a]fter 4 years of Washington’s assault on New York . . . [o]ur federal representatives must deliver fairness for New York and they must do it quickly.” Basically, a federal grant.[xvi]

To dispel that notion, however, the Governor told us that “New York will do its part,” by legalizing the recreational use of cannabis by adults. This will raise revenue, he said.

According to projections from the State, however, the tax revenue from the marijuana industry is expected to generate only around $300 million annually once the program is “stabilized.”[xvii]

Mr. Cuomo also proposed that the State allow and tax sponsored mobile sports betting in order to raise additional funding. According to the Governor’s Budget Director, the standard sports betting model would net New York approximately $50 million a year in tax revenue, whereas a single-operator monopoly may bring in as much as $500 million per year.[xviii]

By my math, the combined estimated tax revenue from marijuana and sports betting would be less than $1 billion – generated by legalizing the use of a harmful drug and by promoting gambling. I’d be less offended, I suppose, if Albany’s “reforms” were motivated by Will Rogers’s statement, “We don’t seem to be able to stop crime, so why not legalize it and put a heavy tax on it.  We have taxed other industries out of business; it might work here.” Unfortunately, I doubt many legislators in Albany are familiar with the humorist’s work.[xix]

In any case, that still leaves us about $14 billion shy. But the Governor says he won’t raise taxes, or cut spending, or borrow money. Why is each of these options presented as an all-or-nothing proposition? Why not combine elements of these? Perhaps then Mr. Cuomo can genuinely assure the federal government, as he did in his address, that “We are a fiscally responsible state; we only ask for an equitable partnership from Washington.”[xx]

The Country Owes Us (?)

An equitable partnership. According to Mr. Cuomo, “Washington raised our taxes to benefit other states and those states then appeal to our residents to relocate to their lower tax states. The infuriating irony is that New York subsidizes those state’s lower rates.”

It’s clear that New York fears the migration of residents and businesses from the State to points south. In recognition of the “out-migration” from New York to Florida that has occurred to-date, and of what is expected to be the continued flow of wealthy individuals from North to South, Goldman Sachs is said to be considering South Florida as the new home for its asset management division. Other financial services firms have already made the move, or have announced plans to move.

At least New York has company. Texas has become to California what Florida has been, and continues to be, to New York. Indeed, last week, Digital Realty Trust announced that it was moving its headquarters from the Golden State to Texas; in doing so, it joins Oracle, Hewlett Packard, Tesla and others.[xxi]

Will California make the same argument as New York? After all, it has the highest marginal tax rate for personal income in the country: in the case of a married couple filing jointly, 13.3% for taxable income in excess of $1.18 million; compare New York’s top rate of 8.82% for taxable income in excess of $2.155 million; add New York City’s 3.876% and you’re at approximately 12.7%.

Maybe not. By late November, California was projecting a surplus of $15 billion; beginning with the 2022-23 budget, it projects a deficit of more than $6 billion; “and by the 2024-25 budget, the deficit could grow to $11 billion if no adjustments to spending or revenue are made.”[xxii]

In any case, we’ll see soon enough how generous Washington will be to New York, but will that generosity be enough to spare New York from having to make some difficult decisions?

Probably not, and one has to assume that Albany has come to the same conclusion, and has prepared to act accordingly.

What if the Country Disagrees?

Under those circumstances, why wouldn’t Albany raise taxes (and cut some expenses), notwithstanding the Governor’s stated reluctance to do so? Wouldn’t it be irresponsible not to?

Among the revenue sources upon which the State will most surely rely is the collection of tax from those individuals who claim to have ended their status as New York residents.

As long as enough of these folks continue to delude themselves into believing that they “know” what it takes to successfully (1) establish Florida, or Tennessee, or whatever, as their new home, and (2) to abandon New York as their place of residence – yes, there are two elements that have to be satisfied – the State will be assured of a steady stream of funds from taxes, interest and penalties.

Truth is, there’s nothing to buying a place in Florida, filing a declaration of domicile, filing a homestead exemption, registering to vote, registering a car, getting a driver’s license, joining a place of worship, and counting days. Having checked the box on each of the foregoing “action steps,” many taxpayers believe they’re home-free (like the pun?). But it’s not nearly enough, as so many – especially those who can count – are dismayed to learn.

Then there are those hopefully (in their minds) “former” New Yorkers who sought professional advice, but who often didn’t like what they heard. The “sacrifice” required of them was too dear. They told their adviser that they planned to remain active in their New York-based business – “all I need is my tablet and I can manage operations from anywhere”[xxiii] – and they refused to give up their gorgeous New York City apartment or Westchester home. What’s more, they clearly stated their intention of spending up to one-half of the year minus one day in New York, primarily during the warmer months and holidays. “Why bother?” I ask such clients. “You’ll just have to pay me to defend you over many months. You will be anxious. You’ll get frustrated. You will ask me to stop saying, ‘I told you so.’ Then you’ll probably end up paying most of the tax, with interest.”

Finally, there are some, like the taxpayer in a recent ALJ ruling, who truly are a godsend to the State’s treasury.[xxiv]

Fool for a Client

The question before the Court was whether Taxpayer (a lawyer who represented himself) was domiciled in New York City for 2012[xxv] and, as such, was taxable as a resident of New York State and New York City.

Taxpayer owned two apartments in the same New York City building during 2012, one of which he acquired and renovated in 2011, before selling it in March 2012. The other apartment was his residence (the “NYC apartment”).

Taxpayer moved to Florida to be closer to his brother, who lived there. Taxpayer stayed with his brother through most of 2012. Taxpayer had no family in the New York City area.

Taxpayer explained that he had a nervous system condition that was aggravated by the cold. He found Florida and the warm weather easier to live in. Taxpayer also explained that he enjoyed the “American suburban chain restaurants” found in Florida (which I’m sure did wonders for his heart condition – just kidding).[xxvi]

Taxpayer spent the majority of his time in 2012 looking for apartments in Florida by searching on-line for Florida apartments, or traveling the State. He spent 177 days in New York during 2012, but also spent a number of days outside both states.

In November 2012, Taxpayer purchased a residence in Florida, which he described as being “nicer” than the residence he owned in New York City. The Florida home was more than 30 percent larger than his New York City apartment, and had a balcony overlooking a canal.

The following month, Taxpayer registered to vote in Florida, and also obtained a Florida driver’s license.

Taxpayer also purchased three investment properties in Florida. Although he originally planned to sell the New York City apartment, Taxpayer decided to keep it, and maybe rent it out for a couple of years.

Taxpayer worked as an attorney and had only one case in 2012, which was handled almost entirely from Florida. Taxpayer did not work for any employer in New York during 2012, and his only New York business activity was the sale of the apartment described above. Otherwise, all business activity was in Florida, which included searching for and making real estate investments for income.

Approximately 95 percent of Taxpayer’s near and dear items were moved to Florida in January 2013. The moving of these items – with the exception of two very important new “vintage-styled” pairs of sneakers[xxvii] –was delayed from mid-December 2012 until early January 2013 at the request of the previous owner of the Florida property.[xxviii] Taxpayer finally moved into his Florida residence on December 16, 2012. Even after doing so, he left his bed in the New York City apartment.

ALJ’s Analysis

Taxpayer’s 2011 New York State resident income tax return, form IT-201, identified the New York City apartment as his permanent home address. His 2012 New York State nonresident and part-year resident income tax return, form IT-203, identified North Miami Beach, Florida as such address.

However, Taxpayer’s 2012 New York State nonresident and part-year resident income allocation worksheet, on form IT-203-B, indicated that Taxpayer maintained living quarters at the New York City address throughout 2012; the form also indicated that Taxpayer spent 177 days of 2012 in New York State.

Then, in 2013, Taxpayer filed a resident income tax return, form IT-201, providing the New York City apartment as his permanent address.

His 2012 federal form 1040, Schedule C, profit or loss from business, identified the New York City apartment as Taxpayer’s business address.

The Law

According to the State’s Tax Law and the City’s Administrative Code,[xxix] a resident individual means an individual:

(A) who is domiciled in this city, unless (i) [h]e maintains no permanent place of abode in this city, maintains a permanent place of abode elsewhere, and spends in the aggregate not more than thirty days of the taxable year in this city, or … (B) who is not domiciled in this city but maintains a permanent place of abode in this city and spends in the aggregate more than one hundred eighty-three days of the taxable year in this city. . .”[xxx]

The classification of an individual’s status as a resident versus a nonresident is significant because nonresidents are taxed only on their New York State source income, whereas residents are taxed on their worldwide income.[xxxi]

Because Taxpayer was in New York for only 177 days during 2012, he was not a statutory resident for that year. Thus, the matter before the Court involved only Taxpayer’s domicile.

The State’s regulations define “domicile” as follows:[xxxii]

“(1) Domicile, in general, is the place which an individual intends to be such individual’s permanent home — the place to which such individual intends to return whenever such individual may be absent.

(2) A domicile once established continues until the person in question moves to a new location with the bona fide intention of making such individual’s fixed and permanent home there. No change of domicile results from a removal to a new location if the intention is to remain there only for a limited time, this rule applies even though the individual may have sold or disposed of such individual’s former home. The burden is upon any person asserting a change of domicile to show that the necessary intention existed. In determining an individual’s intention in this regard, such individual’s declarations will be given due weight, but they will not be conclusive if they are contradicted by such individual’s conduct.

* * *

(4) A person can have only one domicile. If such person has two or more homes, such person’s domicile is the one which such person regards and uses as such person’s permanent home. In determining such person’s intentions in this matter, the length of time customarily spent at each location is important but not necessarily conclusive.”

The Court explained that the party alleging the change of domicile bears the burden to prove, by clear and convincing evidence, the change in domicile. Whether there has been a change of domicile, the Court continued, is a question “of fact rather than law, and it frequently depends upon a variety of circumstances.”

The test of intent with regard to a purported new domicile is “whether the place of habitation is the permanent home of a person, with the range of sentiment, feeling and permanent association with it.” While certain declarations may evidence a change in domicile, such declarations are less persuasive than informal acts that demonstrate an individual’s “general habit of life.”

The Court then distinguished between (i) “residence,” which simply requires bodily presence as an inhabitant in a given place and (ii) “domicile,” which requires both bodily presence in that place and also an intention to make it one’s fixed and permanent home.

The Court stressed that, in order to acquire a new domicile there must be “a union of residence and intention. Residence without intention, or intention without residence, is of no avail.” And mere change of residence, although continued for a long time, does not effect a change of domicile, while a change of residence even for a short time, with the intention “in good faith” to change the domicile, has that effect.

While the standard is subjective, the Courts have consistently looked to certain objective criteria to determine whether a taxpayer’s general habits of living demonstrate a change of domicile. “The taxpayer must prove his subjective intent based upon the objective manifestation of that intent displayed through his conduct.” Among the factors that have been considered are the retention of a permanent place of abode in New York, the location of business activity, the location of family ties, the location of social and community ties, and formal declarations of domicile.[xxxiii]

With respect to the factor regarding the retention of a permanent place of abode, there was no question that Taxpayer maintained his residence at the New York City apartment throughout 2012. Retention of a permanent place of abode in the location of the historic domicile is a factor in consideration of the domicile issue.

Furthermore, Taxpayer’s own tax filings reflected that he filed as a resident of New York the following year, 2013, with the address of the New York City apartment, his historic domicile.

Factors, including the location of business activity in Florida and not New York, the location of his family ties in Florida, and his ownership of a residence in Florida, showed evidence of Taxpayer’s interest in making Florida his domicile. Travel to Florida, moving a few prized possessions to Florida, changing his driver’s license and voting registration to Florida also showed evidence of an interest in changing his domicile.

The Court concluded, however, that those factors could not outweigh the fact that Taxpayer’s own tax filings showed he was a resident of New York City for both 2011 and 2013, the immediately preceding and subsequent years to the year in question. This fact combined with the fact that Taxpayer maintained a residence in New York City for the entire year at issue, spent significant portions of the year at issue traveling to several locations other than Florida, most of his near and dear possessions were not moved to Florida until after the year at issue, and he in fact spent a significant portion of the year at issue, 177 days, in New York weighed strongly against Taxpayer’s claim that, for 2012, he abandoned his New York domicile and established a new one in Florida.

Accordingly, the Court concluded that Taxpayer did not prove, by clear and convincing evidence, that he gave up his New York City domicile and acquired a domicile in Florida for the year at issue. As such, Taxpayer was taxable as a resident individual of New York State and New York City for 2012.

A Fool Indeed

What more is there to say about Taxpayer’s case? Not much.

Although the facts were somewhat entertaining, and the outcome was a foregone conclusion, they do demonstrate the importance of preparing one’s exit plan – one’s narrative, you might say – before implementing it.

Such forethought will be especially important for those who have not yet departed New York but are planning to do so before the inevitable tax hikes are enacted. The State has a well-deserved reputation for aggressively pursuing those who have left its fold, and it will probably increase its efforts if the hoped-for federal largess does not materialize.

[i] I confess that I didn’t even know the season had begun, let alone ended. Seriously, who has time or cares at this point, other than those states that have legalized sports betting and that are eagerly awaiting the tax revenues it brings?

That said, yesterday I learned that the Brooklyn Nets signed James Harden. Are they really a contender? So much has happened and continues to happen in spite of the crisis in which we find ourselves. Now, if only the Knicks had some good news to share – or have I missed that too?

[ii] Remember Shay’s Rebellion? How about the Whiskey Rebellion? No? Do the New York City Draft Riots ring a bell? They should – lots of parallels. Not that either? Then the more obscure Election Riot of 1874 is out of the question. Let’s get more current: The Coal Wars, the San Juan Nationalist Revolt? Still doesn’t ring a bell? Hmm. Wait, I have it. The Capitol Hill Autonomous Zone – summer of 2020.

[iii] .

[iv] .

[v] Any fan of the Greco-Roman Age (on which the Founding Fathers were educated, whether you like it or not) will tell you that the plague weakened Athens sufficiently to hasten her defeat by Sparta, the Antonine Plague killed the philosopher-emperor, Marcus Aurelius, and the Justinian Plague put the kibosh (so I snuck in a little Yiddish) on the Emperor Justinian’s plans to reunite the Roman world.

[vi] Hardly ideal, at least to my thinking.

[vii] For example, “We expect SALT to be removed from our wounds,” and “I know the height of the mountain.”

[viii] Mostly attacking the folks in Washington, and describing how they abused New York. For example, “Washington has savaged us,” ‘The abuse was unrelenting,” “Washington took even more funding from New Yorkers as a sheer exercise of political extortion,” and “Today, New York subsidizes 42 other states.”

As to the last point, he could have added, “regardless of the Party in power.”

[ix] .

[x] Query what brackets he’s talking about, and what rates he is applying.

[xi] .

[xii] These cuts are part of a plan that seeks to reduce the tax burden by 20% by 2025.

[xiii] The “big three” expenses are Medicaid, education and labor.

[xiv] Don’t laugh. A concept close to this was at the heart of Mr. Cuomo’s earliest plan to get around the limitation (enacted by the Tax Cuts and Jobs Act) on the itemized deduction for state and local taxes.

[xv] Allow me some license here.

[xvi] After all, “There is no printing press in Albany that makes money,” as the Governor once quipped. .

[xvii] .

[xviii] .

[xix] Speaking of which, in 1931 Mr. Rogers wrote: “If your Income Taxes go to help out the less fortunate, there could be no legitimate kick against it in the world. This is becoming the richest, and the poorest Country in the world. Why? Why, on account of an unequal distribution of the money.” Folks, today’s situation is old news.

[xx] There’s a story – a parable, some might say – that may have been attributed to President Reagan, or so I recall. In the two following scenarios, he asked, which is the better approach to saving a drowning man (I paraphrase): First, you toss into his hands a life preserver to which a rope of sufficient length is attached for you to pull him in, but then you let go of the rope, leaving the man in the water. Second, you toss the man a life preserver to which a shorter rope is tied, such that the preserver will not reach the drowning man, but you urge him to swim toward it, at which point you will pull him in.

[xxi] Miami is being hailed as the next “Tech Hub.” .

[xxii] .

[xxiii] The domicile factors have not yet been updated to account for such remote management. Query whether the State believes they need to? The Nonresident Audit Guidelines point to the Kartiganer decision, 194 AD2d 879, as an example of how a taxpayer’s active involvement in a New York business may continue from outside the State, thereby dooming the taxpayer to continued taxation as a resident of New York.

[xxiv] ADAMS, DTA NO. 828793.

[xxv] Yep. The decision came more than eight years after the year in question.

[xxvi] You can’t make this shit up, though I must confess that I, too, enjoy most “American suburban chain restaurants,” including the breakfast (for breakfast, lunch and dinner) at Bob Evans in Ohio. This is not a paid endorsement.

[xxvii] I hope you find this as entertaining as I do. “Vintage-styled” sneakers? Seriously? So they’re not really vintage? Would they be worth more if they had been? And people pay real dollars to purchase them? We used to tie old sneakers together by their laces, then throw them over the power lines by the MTA substation down the block and across the street from us. Why? No idea. There were plenty others there before ours. You used to see the such displays of sneakers throughout the City’s Boroughs. (I can’t speak for Staten Island which, I was told as a child, is a borough, though I never understood why. If I recall my history correctly, its residents sided with the English during the American Revolution).

[xxviii] It seems the previous owner did not want to pay for storage. Go figure – he was more comfortable leaving his things with a stranger.

[xxix] NY Tax Law Sec. 605 (b) (1) (A) and (B), and New York City Administrative Code Sec. 11-1705 (b) (1) (A) and (B).

[xxx] The definition of a New York City statutory resident is identical to the definition of a New York State statutory resident, except for substitution of the term “City” for “State.” New York City Administrative Code Sec. 11-1705 [b] [1] [B] and Tax Law Sec. 605 [b] [1] [B].

[xxxi] Tax Law Sec. 612 and Sec. 631.

[xxxii] 20 NYCRR 105.20(d).

[xxxiii] Basically, the primary factors set out in the State’s Nonresident Audit Guidelines.

Memory Lane

You may recall how clear it became, as the bill that would become the Tax Cuts and Jobs Act (“TCJA”)[i] moved through Congress in late 2017, that C corporations were about to realize a number of tax benefits, the most significant being the introduction of a flat federal corporate income tax rate of 21 percent.[ii]

In reaction to this development, many non-corporate taxpayers who were operating through partnerships (including LLCs treated as partnerships for tax purposes[iii]) or S corporations[iv] began to wonder whether they should incorporate their business[v] or revoke their “S” election,[vi] depending on their circumstances, in order to take advantage of what was seen as the C corporation’s newfound “preferred” tax status.

Eventually, Congress added a provision to the TCJA for the benefit of individuals, estates, and trusts (“non-corporate taxpayers”) that are partners of a partnership or shareholders of an S corporation that is engaged in a qualified trade or business (“QTB”).[vii]

In general, for purposes of determining their taxable income for a taxable year, a non-corporate taxpayer is permitted, under what was then “new” Sec. 199A of the Code, to claim a deduction equal to 20 percent of the taxpayer’s share of the qualified business income (“QBI”) of the partnership’s or S corporation’s QTB for such taxable year.

The new deduction was intended to be effective for taxable years beginning after 2017 and before 2026.[viii] Because of the provision’s complexity, however, and because of ambiguity in the meaning of certain terms and in the application of certain rules, many taxpayers and advisers were unsure as to the utility of the newly-minted deduction.

The business community pressed the IRS to issue guidance and, almost eight months after the law went into effect, the IRS proposed extensive regulations,[ix] which were then finalized a few months later, in February of 2019.[x]

The Biden Tax Plan

Fast forward to the summer of 2020, that most wonderful of times – geez, it feels like yesterday.

The then-Democratic Party standard-bearer (now-President-Elect), Mr. Biden, stated that he wanted to reverse the changes made by the TCJA; however, his own tax plan called for preserving the Sec. 199A deduction for those non-corporate taxpayers making less than $400,000 during a taxable year, while phasing out the deduction for higher-income taxpayers.[xi]

Assuming this plan continues to reflect the President-Elect’s views on Sec. 199A, then many of the issues raised by taxpayers prior to the 2020 general elections, and many of the strategies suggested by their advisers, will continue to be relevant.

One of these “strategies,” which involves a gambit relating to the definition of QBI in the context of a QTB operated by a partnership, has now been a subject of inquiry by several business acquaintances, and should be addressed.

Qualified Business Income

The QBI of a QTB means, for any taxable year, the net income or loss with respect to such trade or business, provided it is effectively connected with the conduct of a trade or business in the U.S.[xii]

It is fair to say, therefore, that the QBI of a QTB reflects the profitability or entrepreneurial return of the QTB.

The foregoing may explain why the trade or business of rendering services as an employee is not treated as a QTB.[xiii] The amount payable to the employee, and the time of its payment, are generally not subject to entrepreneurial risk or fluctuation.

Because the trade or business of rendering services as an employee is not a QTB, wage income received by an employee is not QBI.

What about the case of a shareholder of an S corporation who is also employed by the corporation? Or that of a partner who works in the QTB operated by the partnership?

If the QTB is carried on through a partnership or S corporation, the Sec. 199A rules are applied at the level of the partner or shareholder, with each partner or shareholder taking into account their share of the business entity’s QBI.[xiv] For purposes of determining such QBI, one must first identify any payments made to the shareholder or partner in their capacity as a service-provider, rather than as an owner.

Compensation for Services

Certain items of income arising from the conduct of a QTB through an S corporation or a partnership are not included in determining the entity’s QBI, or its owners’ shares of such QBI. Among these items of income are the following:[xv]

  • amounts received by a shareholder-employee from their S corporation as reasonable compensation for services rendered to the corporation’s QTB;[xvi]
    • even if an S corporation fails to pay a reasonable wage to a shareholder-employee, the shareholder-employee is nonetheless prevented from including an amount equal to reasonable compensation in QBI;
  • amounts received by a partner from a partnership as guaranteed payments – i.e., determined without regard to the income of the partnership – for services rendered to the partnership’s QTB;[xvii] and
  • payments received by a partner from a partnership for services rendered by the partner to the partnership’s QTB other than in their capacity as a partner;[xviii]
    • within the context of section 199A, such payments for services are similar to, and therefore, are treated similarly as, guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI.

The foregoing exclusions from QBI are derived from the rule, described above, under which the trade or business of performing services as an employee is not a QTB, even if the employee or employee-equivalent is also an owner of the employer/service recipient, and without regard to whether the latter is treated as an S corporation or as a partnership for tax purposes.

Because these items are determined without regard to the payor-entity’s income – i.e., they are not subject to entrepreneurial risk – Congress and the IRS determined that these payments should not be considered part of the owner-payee’s QBI.

In order to ensure this result – and to ensure that the payments are treated in the same manner as if they had been made to some unrelated party in exchange for services – it is necessary that the business entity deduct the amount paid in determining its QBI and, thus, the payee-owner’s share of such entity’s QBI.

Thus, the S corporation’s QBI is reduced by deducting the amount of the compensation paid to the shareholder, if it is properly allocable to the corporation’s QTB and is otherwise deductible (e.g., not required to be capitalized) for income tax purposes, and the partnership’s QBI is reduced by deducting the amount of the guaranteed payment if it is properly allocable to the partnership’s QTB and is otherwise deductible for income tax purposes.

A “Workaround?”

It appears that some folks have concluded that the above rule, as it relates to guaranteed payments by a partnership to a partner, is overly restrictive in that it limits the recipient-partner’s Sec. 199A deduction by omitting the payment from the partner’s QBI and by deducting the payment from the partnership’s income for purposes of determining its QBI, and the partner’s share thereof.

The fact that the legislative history, the statute, the preamble to the proposed regulations, and the final regulations all confirm that this is the intended result, does not appear to have dissuaded some from suggesting what is described as an alternative approach to structuring the payment by a partnership to a partner who provides services to the partnership.

A cursory examination of the suggested approach, however, recalls the aphorism that “calling something by a different name does not make it so.” In other words, in substance, the payment by a partnership to a partner in consideration of the partner’s services remains a “guaranteed payment” for purposes of Sec. 199A if the amount of the payment is not dependent upon the income of the partnership.

Priority Allocation

Specifically, these folks have asked whether the payments to a partner for services rendered to the partnership may instead be “structured” as a priority profit allocation, rather than as a guaranteed payment.

Under this arrangement, the partner who renders services to the partnership receives from the partnership a priority “distribution” of an amount equal to what otherwise would have been payable to the partner for their services.[xix] The partnership makes a corresponding and matching allocation of partnership income to the partner.

After the service-providing partner has received an aggregate amount of current and, if necessary, liquidating distributions, equal to the amount of their “priority” allocation – basically, what would have been the aggregate amount of their guaranteed payments – then all subsequent distributions by the partnership to the partners follow the partners’ adjusted capital accounts.

A variation on this approach provides that the service-providing partner be allocated a percentage of partnership income, subject to a floor – i.e., what would otherwise have been their guaranteed payment for services – expressed as a fixed dollar amount. Relying on one of guaranteed payment rules,[xx] proponents of this approach take the position that the partner will be treated as having received a guaranteed payment only to the extent the amount of the floor exceeds the partner’s allocable share of partnership income; however, if this share exceeds the floor, then no portion of the amount received by the partner is a guaranteed payment.

Framework for Analysis

Before considering the approaches described above, a quick review of how the Code treats allocations and distributions from a partnership to a partner who renders services to the partnership may be in order.

In general, such an allocation or distribution may be treated as: (1) a distributive share of partnership income; (2) a guaranteed payment; or (3) a transaction in which a partner provides services to the partnership other than in their capacity as a partner.

A partnership allocation that is determined with regard to partnership income, and that is made to a partner for services rendered by the partner in their capacity as a partner, is generally treated as a distributive share of partnership income.[xxi] This would cover, for example, a partner in a service-intensive business (say, a law firm).

To the extent the amount payable to a partner is determined without regard to the income of the partnership, the payment to the partner in consideration of the partner’s services is considered as made to a person who is not a partner – i.e., as a guaranteed payment.[xxii] A partner who is guaranteed a minimum amount for its services is treated as receiving a fixed payment in that amount.

If a partner performs services for a partnership and receives a related direct or indirect allocation and distribution, and the performance of the services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in its capacity as a partner, the transaction will be treated as occurring between the partnership and one who is not a partner.[xxiii] On the other hand, if the “distribution” to the service provider does not depend on an allocation of an item of income, then the payment is unrelated to partnership income and is treated as a guaranteed payment.

How is This Different?

If I understand the first of the approaches described above, it is grounded in the fact that the partnership’s transfer of a specified amount to the service-provider-partner is labeled and reported as a distribution of an amount equal to such partner’s priority interest in the net profit of the partnership.

How is that different from a guaranteed payment? In both cases, the partner is singled out for a payment from the partnership to which the other partners are not entitled. In both bases, the partner is entitled to a fixed amount – whether as “compensation” or as a “priority payment” – before other partners may participate. In both cases, the basis for distinguishing the payee-partner from the other partners is the fact that the payee-partner rendered services to the partnership. In both cases, the transfer to the partner in effect reduces the net income remaining to be allocated among all the partners: by way of a deduction in the case of the guaranteed payment, and by way of a “special allocation” of partnership net income in the case of the distribution.[xxiv]

As for the alternative described above, which relies on a hybrid approach of a “percentage interest subject to a floor,” the IRS stated in the preamble to proposed partnership regulations issued in 2015 that the treatment of this arrangement under the guaranteed payment rules was inconsistent with the concept that an allocation must be subject to significant entrepreneurial risk in order to be treated as a distributive share of partnership income.[xxv] Accordingly, the IRS proposed to modify the rule to provide that the entire amount of the floor would be treated as a guaranteed payment regardless of the amount of the income allocation.[xxvi]


The payments under the priority allocation schemes described above should be treated as guaranteed payments made in exchange for the partner’s services, within the meaning of the Code’s partnership rules. Accordingly, they should also be treated as guaranteed payments under Sec. 199A, and should not be treated as QBI to the recipient partner.


[i] Pub. L. 115-97.

[ii] IRC Sec. 11(b).

[iii] Reg. Sec. 301.7701-2 and Reg. Sec. 301.7701-3.

[iv] IRC Sec. 1361.

[v] IRC Sec. 351. See Rev. Rul. 84-111. Many states now have conversion statutes (e.g., DE).

[vi] IRC Sec. 1362.

[vii] IRC Sec. 199A.

[viii] That’s right – the provision was (and remains, at least for now) scheduled to sunset after 2025.

[ix] REG-107892-18, 83 FR 40884.

Also in 2018, as part of what was called “Tax Reform 2.0”, the House Ways and Means Committee proposed that Sec. 199A be made permanent.

However, following the November 2018 mid-term elections, in which the Democrats picked up 40 seats in the House, wiping out the Republicans’ majority in that chamber, it appeared that Sec. 199A’s tenure would be relatively short.

[x] More than a year after 199A’s passage. TD 9847, 84 FR 2952.

[xi] .

[xii] IRC Sec. 199A(c).

[xiii] IRC Sec. 199A(d).

[xiv] IRC Sec. 199A(f).

[xv] IRC Sec. 199A(c)(4).

[xvi] IRC Sec. 162; Reg. Sec. 1.199A-3(b)(2)(ii)(H). Under Rev. Rul. 74–44, S corporations must pay shareholder-employees ‘‘reasonable compensation for services performed.’’ Otherwise, S corporation shareholders who are employed by or otherwise provide services to the corporation could avoid employment taxes simply by not causing the corporation to pay them a fair salary in consideration of their services. Tell me, who works for free?

[xvii] IRC Sec. 707(c); Reg. Sec. 1.199A-3(b)(2)(ii)(I).

Under Rev. Rul. 69-184, a partner of a partnership cannot be an employee of that partnership.

[xviii] IRC Sec. 707(a).

Section 707(a) addresses arrangements in which a partner engages with the partnership other than in their capacity as a partner. Any payment described in Sec. 707(a) that is received by a partner for services rendered with respect to the trade or business is not included in QBI. However, the partnership’s deduction for such payment will reduce the partnership’s QBI if such deduction is properly allocable to the trade or business, and is otherwise deductible for income tax purposes. Reg. Sec. 1.199A-3(b)(2)(ii)(J).

[xix] Presumably the amount for which the partner negotiated in exchange for their services.

[xx] Reg. Sec. 1.707-1(c), Ex. 2.

[xxi] IRC Sec. 704.

[xxii] IRC Sc. 707(c).

Likewise, the Regulations provide that payments made by a partnership to a partner for services rendered in their capacity as a partner, are considered as made to a person who is not a partner – for the limited purpose of the partner’s inclusion of such payment in their income and the partnership’s deduction of the payment in determining its net income – to the extent such payments are determined without regard to the income of the partnership. 1.707-1(c).

[xxiii] IRC Sec. 707(a)(2)(A).

[xxiv] Both approaches direct a specific amount to a single partner, to whom this amount is taxed, and both approaches deduct this amount from the remaining partnership income before allocating this income among all of the partners.

[xxv] Which is required for QBI treatment.

[xxvi] IRS Proposed Regulations (REG-115452-14) on Disguised Payments for Services. The proposed regulations modify Ex.2 of Reg. Sec. 1.707-1(c).

These rules have not yet been finalized.