Last week, we considered NY’s income tax treatment of the gain realized by a non-resident of NY on his or her sale of stock in a corporation that owns NY real property. Although the strength of the NY real property market cannot be ignored, there are a number of other NY-based businesses in which nonresidents have invested significant sums of money, especially technology start-ups.
In the case of such investors, it is not enough to consider where and how to invest their money – it is equally important that they consider how they will be able to withdraw their investment so as to minimize the resulting tax impact and, thereby, to maximize the economic return on the investment.
A recent decision by NY’s highest court illustrated the plight of one nonresident investor who learned this lesson too late.
The Stock Sale and The 338(h)(10) Election
Taxpayer was one of several nonresident shareholders of Corp, which was organized as an S corporation for federal and New York State tax purposes. In 2007, Corp’s shareholders, including Taxpayer, sold their Corp. stock to Yahoo, Inc., realizing over $88 million in gain.
The shareholders and Yahoo decided to treat this transaction as a “deemed asset sale” for income tax purposes under IRC Sec. 338(h)(10). Consequently, the stock sale was ignored and, instead, Corp was treated as having first sold its assets to a Yahoo-owned subsidiary, and then as having made a liquidating distribution of the sale proceeds to its shareholders.
Under the S corporation rules, the gain realized on the deemed asset sale flowed through the corporation and was taxable to Corp’s shareholders. The basis in their shares of Corp stock, in turn, was increased to reflect the flow-through of this gain. On the deemed liquidation of Corp, the resulting gain, if any, to the Corp shareholders was determined by subtracting this adjusted stock basis from the amount deemed distributed by Corp.
Corp reported its gain from the deemed asset sale, and the amount that passed through to Taxpayer, as part of its federal tax return, but Corp excluded the amount deemed distributed to Taxpayer from its 2007 NY S corporation franchise tax return. For his part, taxpayer reported and paid federal taxes for the 2007 tax year on his share of the asset sale gain, as required by federal law, but did not report or pay any NY income taxes associated with the sale.
Based on the results of a subsequent audit, NY assessed a deficiency in state income taxes on Taxpayer’s gain from the Corp transaction, relying on a 2010 amendment to NY’s tax law that provides, in relevant part, that “any gain recognized on [a] deemed asset sale for federal income tax purposes will be treated as New York source income.”
Taxpayer paid the tax deficiency and, thereafter, demanded a tax refund, stating that the 2010 amendment was unconstitutional and claiming that his corporate-derived gain was obtained from the sale of Corp stock, which is considered intangible personal property and nontaxable as to a nonresident.
NY Taxation of Nonresidents, In General
In general, a nonresident of NY is subject to NY personal income tax on his or her NY source income that enters into his or her federal adjusted gross income.
NY source income is defined as the sum of income, gain, loss, and deduction derived from or connected with NY sources. For example, where a non-NY resident sells real property or tangible personal property located in NY, the gain from the sale is taxable in NY.
Under NY tax law, income derived by a nonresident from intangible personal property, including gain from the disposition of such property, constitutes income derived from a NY source only to the extent that the property is employed in a business, trade, profession, or occupation carried on in NY.
NY’s History With Sec. 338(h)(10)
In 2009, NY’s Tax Appeals Tribunal considered a nonresident’s sale of stock in a NY S corporation. The Tribunal confirmed that, even though the selling shareholders and the purchaser elected under IRC Sec. 338(h)(10) to treat the stock transaction as an asset sale for purposes of the federal income tax, the transaction would still be treated as a stock sale with respect to the nonresident shareholders. Because the gain derived by a nonresident from the sale of intangible personal property, such as stock, does not constitute income derived from NY sources (except to the extent that the property was employed in a business, trade, profession, or occupation carried on in NY), it was not subject to NY tax.
The next year, NY’s legislature amended the tax law – retroactively for all open tax years – to reverse this result. (Why should Congress have all the fun?) Specifically, the law was changed to provide that a nonresident’s share of the NY-source portion of the gain realized by a target S corporation as a result of a Sec. 338(h)(10) election would be taxable to the nonresident shareholder.
The Court of Appeals
The Court rejected Taxpayer’s constitutional challenge to the amended tax law and also upheld its retroactive effective date. (See also here.)
The Court explained that an S corporation is structured so that its corporate income, losses, deductions, and credits pass through to its shareholders, based on their individual percentage ownership in the corporation. The shareholders, in turn, report their pro rata share of the income and losses on their personal income tax returns in accordance with federal and state tax laws, and are assessed taxes at their individual tax rates. Thus, the corporation does not pay corporate income taxes and avoids double taxation on both the corporation and the shareholders.
The Court noted that deemed asset treatment is not automatic or mandated by statute, but instead requires a voluntary election by both the selling shareholder and the purchaser to treat the transaction as an asset sale. Thus, Taxpayer freely chose to proceed with the Corp stock transfer as a deemed asset sale, presumptively aware of the income tax consequences of his choice.
A deemed asset sale, the Court stated, provides “counter-balanced advantages and disadvantages” for purchaser and seller.
On one side of the equation, the deemed asset sale makes possible significant future tax benefits to the purchaser because the assets are treated as sold at fair market value and the assets obtain a “stepped up,” rather than a carryover, basis for the purchaser’s future depreciation and amortization deductions .
On the other side, the deemed asset sale may result in negative tax consequences for the selling shareholders, who are responsible for personal taxes on their share of the gains. However, the Court added, even this can be offset by an agreement to a higher purchase price to account for the additional tax cost as compared to a stock sale without a Sec. 338(h)(10) election.
Turning to the constitutionality of the assessment, the Court recognized “as a foundational tenet” of NY tax law that NY seeks to achieve a certain amount of parallel treatment of state and federal taxation. Thus, NY S Corporation shareholders must report for state income tax purposes the same “income, loss, deduction and reductions … which are taken into account for federal income tax purposes.”
Furthermore, under both federal and state law, deemed asset flow-through income is taxed based on the character of the income when earned by the corporation, meaning the income is treated as coming from the same source as received by the corporation. Gains passed to the S corporation shareholders retain “the same character” for state income tax purposes as held for federal income tax purposes, the Court stated. Thus, if the corporation’s income source is located in NY, it is taxable to the extent allowed under NY law. For example, a nonresident’s pass-through income is taxed based on the percentage of the income “derived from or connected with New York sources.” (In contrast, the entirety of a NY resident’s pass-through income is taxable.)
The NY tax law further provides that nonresidents are subject to tax on income “derived from or connected with New York sources,” such as income derived from an S corporation.
As amended in 2010, the tax law includes as NY source income any gains from a deemed asset sale under IRC Sec. 338(h)(10). That section provides, in relevant part: “[I]f the shareholders of the S corporation have made an election under section 338(h)(10) of the Internal Revenue Code, then any gain recognized on the deemed asset sale for federal income tax purposes will be treated as New York source income allocated in a manner consistent with the applicable methods and rules for allocation under article nine-A of this chapter in the year that the shareholder made the section 338(h)(10) election.”
In accordance with these provisions, NY treated Taxpayer’s gain from Corp’s deemed asset sale as NY source income, and assessed taxes in proportion to the Corp income derived from NY sources. This assessment, the Court found, was wholly in line with the statutory scheme and, so, Taxpayer was without grounds to demand a refund.
Many readers of this blog may be tired of this refrain, but it pays to plan ahead. In the case of an investment in a closely-held business, that means that the investor has to educate him- or herself as to the tax consequences – federal, state and local – that may arise upon the investor’s disposition of the investment, and how these will affect the net economic return on the investment.
Armed with this knowledge, the investor will be in a better position either to structure the disposition in a more tax efficient manner, or to negotiate transaction terms to ameliorate any adverse economic impact caused by taxes.