Many of you may know that an individual who changes his status from New York (“NY”) resident to nonresident is required to accrue to the period of his NY residence – i.e., include in his final NY tax return – any items of income or gain accruing prior to the change of residence status. For example, assume a NY individual sold an asset in exchange for a promissory note, and was reporting the gain realized on the sale under the installment method, recognizing such gain for tax purposes only as principal payments were made under the note. Assume further that the individual successfully abandoned his NY domicile and established a new domicile in another state before the promissory note was fully satisfied. Under NY’s Tax Law, the individual would be required to include in his final NY income tax return the amount of gain from the sale that had not yet been recognized by the time he changed his residence status.
At this point, you may be wondering whether a similar “accelerated inclusion” rule applies with respect to a business entity that decides to cease its NY operations.
The Tax Law provides that the State may, “whenever necessary in order properly to reflect the entire net income of any [foreign corporate] taxpayer, determine the year . . . in which any item of income . . . shall be included, without regard to the method of accounting employed by the taxpayer.”
According to the regulations promulgated under this provision, however, if a foreign corporation sells its NY real estate on the installment basis (typically, in exchange for a promissory note under which principal payments – i.e., the sale price – are made over two or more tax years), and terminates its taxable status in NY in the year of the sale, the full gain on the sale must be included in the foreign corporation’s entire net income in the year of the sale, even though no portion of the sale price had yet been received by the foreign corporation. If the foreign corporation, instead, terminates its taxable status in NY in a subsequent taxable year, prior to the receipt of all of the installment payments of the sale price, the remaining gain on the sale would be included in the corporation’s entire net income in the year it terminates its taxable status in NY.
The regulation makes sense; otherwise, a foreign corporate taxpayer may, for example, sell NY real property in a taxable transaction, defer receipt of the cash sale price until after the taxpayer has withdrawn from NY, and thereby avoid tax that was properly owing to the State.
A recent decision demonstrated that New York City follows the same approach as the State in taxing a business that ceases to operate in the City.
Taxpayer was a corporation that owned and operated a Property for many years before selling it in 2009. Taxpayer filed its corporate tax return for the year of the sale, indicating that Taxpayer had ceased operations and that the return was its final return. Attached to this “final” return was a 2009 federal corporate income tax return that was also marked as “final.” On both returns, Taxpayer reported the net gain from the sale of the Property under the installment method, reporting a net gain of approximately $200,000 in 2009, out of a gross profit (total gain realized on the sale) of approximately $6.3 million.
In 2012, the City’s Dept. of Finance asserted a deficiency against Taxpayer based on the Dept.’s addition of approximately $6.1 million to Taxpayer’s 2009 NYC income; this amount represented the balance of the gain from the sale of the Property not yet reported by Taxpayer under the installment method.
According to the Dept., when a foreign corporation sells its assets on the installment basis, and then files a final tax return, it is required to report on its final return the entire gain realized on the sale.
Ongoing Business Activity?
In order to counter this argument, Taxpayer filed an amended 2009 tax return in 2013 (the year after the deficiency was asserted), which was not marked as a “final” return, and which included an amended federal return, also not marked as final. Unfortunately, Taxpayer failed to file any City corporate tax returns for any periods subsequent to the 2009 tax year.
Taxpayer also tried to demonstrate its ongoing operations in the City, submitting statements from a bank account that Taxpayer maintained at a branch in the City. Those statements showed that Taxpayer maintained a cash balance in the account during the years 2014 and 2015, and that Taxpayer made a recurring monthly deposit of approximately $54,000, representing the installment payments Taxpayer collected under its agreement to sell the Property.
On the basis of the foregoing, and the fact that Taxpayer had not been formally dissolved, Taxpayer argued that it did not cease doing business in the City and, thus, the Dept. could not disregard the installment method of reporting and tax the full amount of the gain in 2009.
The Courts: Immediate Inclusion
The Dept. argued that it properly exercised its discretionary authority, pursuant to the City’s Administrative Code, to disregard Taxpayer’s use of the installment method of accounting in order to ensure that Taxpayer’s deferred gain from the sale of the Property did not escape taxation after Taxpayer ceased to do business in the City.
The Administrative Law Judge (“ALJ”) sustained the deficiency, and the Tax Appeals Tribunal (“TAT”) affirmed the ALJ’s decision, concluding that Taxpayer had failed to establish that it was doing business in the City after 2009, and that the Dept. properly exercised its discretion under the Administrative Code to disregard the installment method of accounting for Taxpayer’s sale of the Property and include the entire gain from the sale of the Property in Taxpayer’s NYC income for 2009.
Taxpayer’s gain from the sale of the Property was properly subject to NYC corporate tax, the TAT continued. However, if Taxpayer were permitted to report the gain on the sale using the installment method for NYC tax purposes, Taxpayer would avoid paying NYC tax on the deferred gain reflected in the payments due under the installment sale of the Property after it ceased to do business in the City. With the exception of the gain reflected in the first installment payment (in 2009), the entire gain on the sale of the Property would permanently escape City tax.
The TAT noted that the Administrative Code allows the Dept. to disregard a taxpayer’s method of accounting where it results in the understatement of income subject to the corporate tax: “The [Dept.] may, whenever necessary in order properly to reflect the entire net income of any taxpayer, determine the year or period in which any item of income . . . shall be included, without regard to the method of accounting employed by the taxpayer . . .”
The TAT cited the following example interpreting the corresponding provision of the NY Tax Law: “A foreign corporation sells its [NY] real estate on an installment basis, and terminates its taxable status in [NY] in the year of the sale. The full profit on the sale must be included in entire net income in the year of the sale.”
Further, the TAT continued, “long-standing published statements of [Dept.] policy provide that the installment method of accounting should be disregarded when a corporation files a final return and ceases to do business in the City after selling its assets in an installment sale.” Unless Taxpayer can establish that it continued to do business in the City after 2009, the TAT stated, the Dept. was authorized under the Administrative Code to disregard Taxpayer’s use of the installment method and tax the entire gain from the sale of the Property in 2009.
As for Taxpayer’s argument that it remained in business by virtue of its maintenance of a bank account in the City, to which deposits from the sale of the Property were regularly made, the TAT replied that “[a] corporation will not be deemed to be doing business, employing capital, owning or leasing property in a corporate or organized capacity . . . in [the City] because of the maintenance of cash balances with banks . . . in” the City.
Thus, the maintenance of accounts at a bank branch in the City was insufficient, by itself, to establish that Taxpayer was doing business in the City after 2009. Taxpayer’s bank records provided no proof that Taxpayer was “doing business” in the City.
The only recurring item of any substance in Taxpayer’s bank records, the TAT noted, was the monthly deposit of $54,000. However, by asserting that these recurring receipts were the installment payments for the sale of the Property, Taxpayer brought itself squarely within earlier published Dept. rulings in which the taxpayer sold all of its assets under the installment method and its only activity was to collect the payments under the installment obligation. These rulings concluded that the taxpayer had ceased doing business in the City and that the Dept. properly exercised its authority to disregard the installment method and tax the entire gain in the year of the sale. The mere holding and collecting on an installment obligation received from the sale of property in the City did not constitute engaging in a trade or business in the City.
Finally, the TAT observed that Taxpayer did not file any corporate tax returns since the 2009 tax year. Thus, Taxpayer’s own actions served to confirm that it ceased doing business in the City when it sold the Property in 2009.
It pays to know; or, rather, if you know, you may not have to pay.
The foregoing provisions of NY and City law have certainly caught a number of unsuspecting – i.e., uninformed – taxpayers by surprise, resulting in their having to satisfy state and local income tax liabilities with respect to gain for which they have not yet received payment.
With appropriate planning, one may plan for such “phantom gain” and its effects may be alleviated.
What’s more, the acceleration of gain recognition applies only to taxable gain; for example, the disposition of NY/NYC real property in exchange for like-kind property outside the State/City (as part of a Sec. 1031 transaction) should not be affected by this rule – except to the extent gain is recognized because of the receipt of “boot” – at least for the moment; several states have considered the imposition of an “exit tax” in such cases, and NY may do so in the future as the need for revenues increases.