Departing Individuals

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.

Departing Businesses?

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.

Leaving NYC?

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.

“Final Return”

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.

Please Note

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.

NYC Never Sleeps – But It Does Tax

“If I can make it there, I’ll make it anywhere.”  So begins one of the most iconic of musical tributes to New York City. It is sung at every Yankees game. It sums up the feelings of thousands of aspiring artists. As it turns, out, however, it also captures the reaction of many closely-held businesses that choose to make a go of it in The Big Apple.

No, I am not referring to the intensely competitive business environment that is NYC, nor am I referring to the high cost of rent and labor in NYC that reduce the margins of every business and challenge the bottom line of every business owner.

Rather, I am referring to the many different kinds of taxes that NYC imposes on closely-held businesses. No business owner can afford to begin operations in NYC without first educating himself as to the taxes that may be imposed upon his business for the privilege of operating in NYC, and the economic cost that these taxes represent.

What follows is a brief summary of these taxes. Some taxes will be familiar to most readers; others will come as a surprise to some readers. Still other taxes are unique to NYC. In some cases, different taxes are imposed upon the same base amount; in others, the application of the tax will depend upon the “tax residence” of the business owner.

Personal Income Tax (the “PIT”)

An individual who is a resident of NYC is responsible for paying NYC Personal Income Tax (at a maximum rate of 3.876%, inclusive of a special surcharge) on the income he derives from all sources, regardless of where the income is generated, and regardless of the nature of the income; for example, it includes a NYC resident’s operating income generated through a sole proprietorship or partnership, as well as dividends received by the NYC resident from a corporation.

On the other hand, a nonresident individual is not subject to PIT, notwithstanding that his income is generated within NYC; for example, a nonresident who is a member of a partnership that does business in NYC is not subject to PIT as to his share of partnership income attributable to NYC; whereas a NYC resident of that same partnership would be subject to PIT on his share of the partnership’s income.

Resident Status

A business owner who calls NYC home – who is “domiciled” in NYC – is a resident taxpayer. One who owns and operates a business in NYC, but who lives outside NYC, and who does not maintain a so-called “permanent place of abode” in NYC, is not a City resident.

However, if the business owner, or if the business, owns or rents an apartment in NYC that the owner may use personally, the business owner could be treated as a City resident for purposes of the personal income tax by virtue of the number of days (more than 183) he spends working in NYC, even if he uses the apartment only infrequently (and even if the apartment is located in a borough other that the one in which the business is located).

Business Corporation Tax (the “BCT”)

Effective for tax years beginning on or after January 1, 2015, several significant changes were made to NYC’s corporate income tax, including, for example, with respect to the nexus, the primary tax base, combined reporting (based on ownership rather than intercorporate transactions), and the apportionment/sourcing of income to NYC.

Unlike the PIT, which is based on residency, a corporation is subject to the BCT based on whether it is “doing business” (i.e., doing business, employing capital, owning or leasing property, or maintains an office) in NYC, for all or any part of its taxable year.  The BCT is imposed at a maximum rate of 8.85%. A corporation may be considered to be “doing business” in NYC if it is a partner/member in a partnership/LLC that does business in NYC.

A “corporation” for this purpose includes any entity that is formed as a corporation under state law, as well as an entity that elects (under the “check the box” rules) to be taxable as a corporation for federal tax purposes.

A foreign corporation is not treated as doing business (and thus, would not be subject to the BCT by virtue of certain de minimis activities, including, for example, (1) maintaining cash balances with NYC banks; (2) owning shares of stock or securities that are kept in NYC (as in a safe deposit box, safe, or vault); (3) the maintenance of an office in NYC by a director or officer of the corporation who is not employed by the corporation, provided the corporation is not otherwise doing business in NYC; (4) keeping books or records of the corporation in NYC if they are not kept by employees of the corporation and the corporation does not otherwise do business in NYC; (5) or any combination of the foregoing activities.

The tax is generally determined upon the basis of the corporation’s business income, or the portion thereof that is allocated within NYC. The term “business income” means the corporation’s entire net income, minus investment income and other exempt income. The term “entire net income” generally means total net income from all sources that the taxpayer is required to report to the IRS.

An “S corporation” and its “qualified subchapter S subsidiaries” are not subject to the Business Corporation Tax, but remain subject to the pre-2015 provisions of the General Corporation Tax. NYC does not recognize “S-Corporation” elections, and thus, the S corporation itself is subject to the entity-level BCT (unlike for federal and New York State purposes).

Unincorporated Business Tax (the “UBT”)

NYC imposes the UBT on the unincorporated business taxable income of an unincorporated business (e.g., a partnership) that is wholly or partly carried on within NYC at a rate of 4%. If an unincorporated business is carried on both within and without NYC, a portion of its business income must be allocated to NYC. The UBT is an entity-level tax, and thus, unincorporated business taxable income is subject to both the UBT and, in the case of a NYC resident, the PIT (unlike for federal and New York State purposes, which generally do not impose an entity level tax on unincorporated business income).

An “unincorporated business” means any trade or business conducted or engaged in by an individual (a sole proprietorship) or unincorporated entity, including a partnership. If an individual or an unincorporated entity carries on two or more unincorporated businesses in NYC, all such businesses will be treated as one unincorporated business for the purposes of the tax.

An unincorporated entity will be treated as carrying on any trade or business carried on in whole or in part in NYC by any other unincorporated entity in which the first unincorporated entity owns an interest.

An individual or other unincorporated entity, except a dealer, shall not be deemed engaged in an unincorporated business solely by reason of (A) the purchase, holding and sale of property for his or its own account, (B) the acquisition, holding or disposition, other than in the ordinary course of a trade or business, of interests in unincorporated entities that are themselves acting for their own account, or (C) any combination of such activities. The term “property” generally means real and personal property, including, for example, stocks or bonds.

An owner of real property, a lessee or a fiduciary will not be deemed engaged in an unincorporated business solely by reason of holding, leasing or managing real property. In general, if an owner, lessee or fiduciary (other than a dealer) who is holding, leasing or managing real property, is also carrying on an unincorporated business in NYC, whether or not such business is carried on at, or is connected with, such real property, such holding, leasing or managing of real property shall not be deemed an unincorporated business if, and only to the extent that, such real property is held, leased or managed for the purpose of producing rental income from such real property or gain upon the sale or other disposition of such real property.

In general, the term “unincorporated business gross income” means the sum of the items of income and gain of the business includible in gross income for federal income tax purposes (with certain modifications), including income and gain from any property employed in the business, or from the sale or other disposition by an unincorporated entity of an interest in another unincorporated entity if, and to the extent, such income or gain is attributable to a trade or business carried on in NYC by such other unincorporated entity.

The term “unincorporated business deductions” of an unincorporated business generally means the items of loss and deduction directly connected with or incurred in the conduct of the business, which are allowable for federal income tax purposes for the taxable year (with certain modifications).

If an unincorporated business is carried on both within and without NYC, a portion of its business income must be allocated to NYC.

Commercial Rent Tax (the “CRT”)

NYC requires most tenants to pay the CRT based on the tenant’s base rent (generally at an effective rate of 3.9%) where the annual base rent exceeds $250,000. The CRT is imposed only with respect to “taxable premises.”

The term “taxable premises” generally means any premises located south of the center line of 96th Street in Manhattan that are occupied or used for the purpose of carrying on any trade, business, or other commercial activity, including any premises that is used solely for the purpose of renting the same premises in whole or in part to tenants. Physical occupancy of the premises by the tenant is not required – a tenant’s possessory right to the premises makes them taxable.

The term “base rent” means the amount paid, or required to be paid, by a tenant for the use or occupancy of premises for an annual period, whether received in money or otherwise, including all credits and property or services of any kind, and including any payment required to be made by a tenant on behalf of a landlord for real estate taxes, water rents or charges, sewer rents, or any other expenses (including insurance) normally payable by a landlord who owns the realty, other than expenses for the improvement, repair or maintenance of the tenant’s premises, with certain adjustments.

Sales and Use Tax (the ‘SUT”)

In general, the Sales Tax applies to retail sales of tangible personal property made, and to certain services rendered, where such property or services are delivered within NYC. The SUT also applies to tangible personal property or services that are purchased outside NYC and then used within NYC. The SUT is imposed in addition to, and is administered together with, the New York State sales and use tax.

The SUT rate is 4.5%. Every vendor of property and services subject to the SUT is required to collect the SUT from the purchaser of such property or services. In addition to the SUT, taxable “retail sales” are also subject to the NYS sales and use tax of 4% and a Metropolitan Commuter Transportation District surcharge of 0.375%, thereby bringing the total NYC sales and use tax rate to 8.875%.

Real Property Transfer Tax (the “RPTT”)

The RPTT is imposed on the conveyance of real property, including certain economic interests in real property, situated in NYC. The RPTT is imposed in addition to the NY State Real Estate Transfer Tax.

The RPTT, which is payable by the grantor, applies whenever the consideration for the sale or other transfer is more than $25,000. The tax – which is usually paid as part of the closing costs at the sale or transfer of real property – is imposed as follows: in the case of an interest in non-residential real property, if the value is $500,000 or less, the rate is 1.425% of the consideration; if the value is more than $500,000 the rate is 2.625%.  (The New York State Real Estate Transfer Tax applies to transfers in excess of $500, and is imposed at a rate of 0.40% of the consideration.)

A taxable sale includes, among other things, the sale of real property, the grant of a lease of real property (unless the only consideration paid constitutes rent), and the sale of a leasehold interest. The tax is also imposed with respect to the sale or transfer of at least 50% of the ownership in a corporation, partnership, or other entity that owns or leases real property in NYC (and there have been legislative proposals to impose RPTT on all transfers of interests in entities that own or lease real property in NYC, not just those transfers of at least a 50% interest).

Certain transfers are exempted from the tax; among these are the following: a pledging of real property solely as security for a debt; a transfer from an agent or “straw man” to its principal (or vice versa); a transfer that effects a mere change of identity or form of ownership or organization, with no change of the beneficial ownership.

“Hand[s] in the Air for the Big City”? (apologies to Alicia Keys)

No, it’s not a hold-up – more likely a plea for divine intervention – but based upon the above description of some of NYC’s business-related taxes, it certainly may feel that way to a business owner operating in NYC. The number of different taxes for which returns must be filed and taxes paid, and the magnitude of the tax rates, will certainly make some businesses pause before venturing into NYC – even after accounting for the deductibility of some of these taxes for federal income tax purposes, for example – especially when one factors in the other costs involved.

That being said, there may be valid business reasons for a “taxable presence” in NYC, including the panache and visibility of a City address, the proximity to a sophisticated market, and the convenience afforded to certain clients or customers.

These business reasons need to be weighed against the costs of a NYC presence, and that includes City taxes.

Last month, Governor Cuomo presented his budget proposal for NY State’s 2017- 2018 fiscal year. Included in the proposal were a number of tax provisions that should be of interest to closely-held businesses and their owners.

S-Corporation Conformity with IRS Return

Under current NY law, a federal S-corporation that is subject to tax in NY (e.g., the corporation is doing business or owns property in NY) can “elect” to be taxed as an S-corporation or as a C-corporation for NY purposes. If a federal S-corporation is taxed as a NY S-corporation, the corporation is responsible only for the fixed dollar minimum tax, and the corporation’s income is passed through, and taxed, to its shareholders. Conversely, if a federal S-corporation is taxed as a NY C-corporation, it computes and pays tax on its apportioned entire net income or capital base.

Further, if a federal S-corporation has elected to treat its wholly-owned corporate subsidiary as a “qualified subchapter S subsidiary” (QSSS) for federal purposes, the QSSS is ignored as a separate taxable entity, and the assets, liabilities, income and deductions of the QSSS are included on the parent’s return. However, for NY purposes, the tax treatment of the QSSS is not required to be conformed to the federal treatment and the QSSS under certain circumstances can be a stand-alone C-corporation taxpayer.

While the Tax Law was amended a few years back to mandate that a federal S-corporation be treated as a NY S-corporation in any tax year in which its investment income exceeded 50% of its federal gross income, this mandate did not cover the entire universe of federal S-corporations that have elected to be taxed as NY C-corporations.

According to the budget proposal, the failure to mandate consistent treatment at the State level has resulted in a tax avoidance opportunity, as well as confusion and tax filing errors, for S-corporation shareholders.

For example, a federal S-corporation generally may choose to pay tax as a NY C-corporation when paying tax at the entity level reduces the corporation’s tax liability. It also may choose to pay corporate income tax in order to shield its nonresident shareholders from having a NY tax liability.

Under the budget proposal, NY’s tax law would be amended to require a federal S-corporation that is subject to tax in NY, or that has a QSSS subject to tax in NY, to be treated as an S-corporation for NY tax purposes.

According to the proposal, requiring conformity to the federal S-corporation status would simplify the corporation’s and its shareholders’ NY tax filings, and eliminate potential tax avoidance schemes. It would also result in NY-source income for nonresident shareholders.

Real Estate Transfer Tax on the Transfer of a Business Interest

Under current law, the transfer of a “controlling interest” in an entity that owns NY real property is subject to the real estate transfer tax (“RETT”), with the taxable consideration being determined by reference to the relative fair market value (FMV) of the entity’s NY real property. The RETT applies even where the FMV of the NY real property is not a significant part of the entity’s total FMV.

However, members of a closely-held business entity that owns real property are not subject to the RETT when they sell a minority (non-controlling) interest in the entity, even where the primary asset held by the entity is an interest in NY real property.

The budget proposal would amend the definition of “conveyance” to include the transfer of an interest in a partnership, LLC, S-corporation, or non-publicly traded C-corporation with fewer than 100 shareholders that owns an interest in NY real property with a FMV that equals or exceeds 50% of the FMV of all the assets of the entity on the date of the transfer of the interest in the entity. Only those assets that the entity owned for at least two years before the date of the transfer of the taxpayer’s interest in the entity would be used in determining the FMV of all the assets of the entity on the date of the transfer.

The consideration for such a conveyance would be calculated by multiplying (i) the FMV of the NY real property that is owned by the entity; and (ii) the percentage of the entity that is being conveyed.

As an aside, the proposal would effectively align the treatment of these conveyances, for purposes of RETT, with the personal income tax rules for determining the NY-source income of a nonresident individual when that individual sells an interest in an entity that owns NY real property.

Non-Resident Asset Sale “Loophole”

There are instances in which the purchase of a partnership interest may be treated, for federal tax purposes, as a purchase of the partnership’s underlying assets. In those situations, the consideration paid for the partnership interest must be allocated among the partnership’s underlying assets (which are deemed to have been acquired). As a result of this tax treatment, the buyer of the interest may receive a basis step-up with respect to his share of the partnership’s underlying assets. This step-up may afford the buyer additional depreciation deductions against his share of partnership income, and also may reduce the gain allocated to the buyer upon the partnership’s sale of the assets to which the basis step-up is allocated.

The selling partner, however, may nevertheless be treated as having sold his partnership interest, and not the underlying assets. Thus, a NY resident partner who sells his partnership interest will be subject to tax on the gain realized. On the other hand, the sale of an intangible – such a partnership interest – by a nonresident partner is not a taxable transaction, notwithstanding that the buyer may achieve a basis step-up in the partnership’s assets. As a result, non-residents are afforded an opportunity to avoid NY taxation on transactions that, in effect, involve the purchase of NY-source assets.

The budget proposal seeks to close this loophole by treating the transaction as a sale of the partnership’s underlying NY-based tangible assets for both the buyer and seller, so that the gains realized from the sale of an interest in the partnership by nonresident partners would be subject to NY tax as NY-source income.

Extend the Personal Income Tax Top Bracket

Currently, the top personal income tax bracket in NY, along with its associated tax rate of 8.82%, is scheduled to expire for taxable years beginning after 2017. Without legislative action, the top marginal tax rate will decline to 6.85%.

The budget proposal would extend the top tax bracket and the associated 8.82% personal income tax rate for taxable years 2018, 2019 and 2020.

Sales Tax Related Entity “Loopholes”

With certain exceptions, existing NY tax law allows a purchaser to buy tangible personal property or services that are intended for resale without paying sales tax. According to the budget proposal, however, certain related business entities have exploited this exemption by purchasing expensive property “for resale” and then leasing the property to a member or owner of the entity using long-term leases or lease payments that are a small fraction of the FMV of the property.

The budget proposal would amend the sales tax definition of “retail sale”, which currently contains the exception for resale, to include any transfer of tangible personal property to certain entities when the property would be resold to a related person or entities, including: (1) sales to single-member LLCs or subsidiaries that are disregarded for federal income tax purposes, for resale to a member or owner; and (2) sales to a partnership for resale to one or more partners. This change is intended to remove the incentive to use or create such entities to avoid sales tax.

In addition, current law allows a person or entity that is not a resident of NY to bring property or services into the State for use therein without incurring use tax. However, this construct has led to situations where a resident person or entity creates a new, non-NY entity, such as a single-member LLC, to purchase expensive property out-of-state and then bring the property into NY to avoid the use tax.

The budget proposal would provide that the use tax exemption does not apply when a person (other than an individual) brings property or services into NY unless that person has been doing business outside of NY for at least six months prior to the date the property is brought into the State. This amendment would still allow ongoing businesses to move into NY without incurring use tax on property or services brought into the State.

Looking Ahead

And you thought that tax relief was just around the corner. Silly rabbit.

While most eyes are focused on Washington, D.C. and the promised, but yet to be disclosed, “tax reduction and/or reform” legislation, states like NY are busy reviewing and amending their own tax laws and regulations to ensure the collection of much-needed revenues. Thus, in the case of NY, it may be that closely-held businesses and their owners will be faced with increased tax liabilities. We’ll know soon enough – the deadline for approving NY’s budget is April 1, 2017.

Speaking of Washington, the States themselves are undoubtedly waiting to see what comes out of the new administration and Congress and how it will impact them and their finances.

As always, until legislation is passed, it is imperative that taxpayers keep abreast of tax-related legislative developments that may impact their business and wallets. Increased tax liabilities will reduce the yield realized from one’s business efforts and investments; thus, it will be advisable for taxpayers to formulate a plan for addressing these developments and any resulting taxes.

It will be equally important that any business plans considered by a taxpayer be flexible enough to respond to, and accommodate, a changing tax environment, provided that doing so does not compromise business decisions.

Stay tuned.

A couple of weeks ago, we considered a situation in which an unscrupulous partner (perhaps in cahoots with an IRS agent) tried to stick one of their partners with the federal employment taxes owed by their failing business. This week, we encounter a somewhat similar situation involving the imposition of personal liability on an innocent employee for a corporation’s N.Y. sales taxes.

Personal Liability for Sales Tax?

Many taxpayers fail to appreciate that, under certain circumstances, a shareholder, officer, director or employee of a corporation may be held personally liable for the sales tax collected or required to be collected by the entity.

In general, the sales tax is a transaction tax, with the liability for the tax arising at the time of the transaction. The person required to collect the tax – the seller – must collect it from the buyer when collecting the sales price for the transaction to which the tax applies.

The seller collects the tax for and on account of the State, then holds it in trust for the State until the seller remits the tax to the State.

In the case where the seller is a corporation, N.Y. State imposes personal responsibility for payment of the sales tax on certain shareholders, officers, directors, or employees (“responsible persons”) of the corporation.  More than one person may be treated as a responsible person.

A responsible person is jointly and severally liable for the tax owed, along with the corporation and any other responsible persons.  This means that the responsible person’s personal assets may be taken by the State to satisfy the sales tax liability of the corporation (the corporate “shield” is ignored).

Personal liability attaches whether or not the tax imposed was collected by the corporation – it is not limited to tax that has been collected but has not been remitted. The personal liability applies even where the individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful.

Moreover, the personal liability of a responsible person for sales tax is separate and distinct from that of the business – it extends beyond the corporation.   For example, a corporate bankruptcy does not affect the responsible person’s liability for the tax because the latter involves a separate claim than the one that is asserted against the corporation.

The Responsible Person

Every officer or employee of a corporation who is under a duty to act for the corporation in complying with any requirement of the N.Y. sales tax law is a responsible person required to collect, truthfully account for, and pay over the sales tax.

Holding a corporate office or being a shareholder does not, in and of itself, warrant the imposition of personal liability. Only those who were “under a duty to act” on behalf of the corporation may be assessed the tax, with the main inquiry being whether the individual in question had sufficient authority and control over the affairs of the corporation.

Whether such officer or employee is a responsible person is to be determined in every case on the basis of particular facts involved. Generally, a person who is authorized to sign a corporation’s tax returns, or who is responsible for maintaining the corporate books, or who is responsible for the corporation’s management is under a duty to act. However, it is actual, rather than titular, control that counts.

Fact or Fiction?

A recent decision considered whether an individual who was both an officer and a shareholder of a corporation may be held responsible for the corporation’s sales tax liability where he was precluded from taking action with regard to the financial and management activities of the corporation, and whether the significance of his officer and shareholder status may be offset by the circumstances relating to control of the corporation.

Taxpayer was an employee of Corp X during the audit period. During the same period, he was the president and sole shareholder of  Corp Y, a separate purchasing company that was effectively operated by Corp X.

During the audit period, Taxpayer signed several sales tax returns as president of Corp Y and was listed as the sole shareholder of Corp Y on its N.Y. “S” corporation tax return.

Corp Y filed the sales tax returns but did not remit the tax due.

N.Y. issued to Corp Y notices and demands for payment of the tax due. The corporation was also assessed penalties and interest.

N.Y. also issued notices to Taxpayer, arguing that the facts in evidence justified holding him liable for the sales taxes due from Corp Y: he was an officer and shareholder who signed checks and corporate documents for Corp Y.

In response, Taxpayer argued that he was “young and naïve” when Corp Y was “put in his name.” He was not aware of what his boss, Mr. X, had done. (It should be noted that, by the time of the audit, Mr. X had died.) He did not contribute any capital to the business. He was being used without knowing or understanding what was being done in his name. The sales and taxes generated were as a result of his recently deceased boss’s efforts.

In short, Taxpayer claimed that he was not a person responsible for the collection and payment of sales tax on behalf of Corp Y.

The matter was then presented to an administrative law judge, where the question to be resolved was whether Taxpayer had or could have had sufficient authority and control over the affairs of Corp Y to be considered a responsible officer or employee.

Here Comes the Judge

N.Y. imposes upon any person required to collect sales tax personal liability for the tax imposed, collected or required to be collected. A person required to collect tax is defined to include, among others, corporate officers and employees who are under a duty to act for such corporation in complying with the requirements of the sales tax law.

According to the Court, the determination of whether an individual is a person under a duty to act for a business is based upon a close examination of the particular facts of the case. Among the factors to be considered were the following: whether Taxpayer was authorized to sign corporate tax returns; was responsible for managing or maintaining the corporate books; was permitted to generally manage the corporation; was an officer, director, or shareholder; was authorized to write checks on behalf of the corporation; had knowledge of and control over the financial affairs of the corporation; was authorized to hire and fire employees; and had an economic interest in the corporation.

The Court determined that Taxpayer was not an individual who had or could have had sufficient authority and control over the affairs of the corporation to be considered a responsible officer or employee for Corp Y.

There was no dispute that Taxpayer signed checks, tax returns and corporate documents for Corp Y, or that he was the sole shareholder, as listed on the Corp Y S corporation tax return. However, he never received a salary or any remuneration or distribution from Corp Y. The real question, the Court stated, was whether Taxpayer, as a young man with no business background or education, had any meaningful control of the affairs of the corporation.

Taxpayer credibly testified that he was under the direction and control of Mr. X in all his dealings with Corp Y. He was directed to sign checks and other corporate and tax documents at Mr. X’s direction. All the business operations of Corp Y were handled by Mr. X’s personal assistant and bookkeeper. These facts were buttressed by the testimony of others who worked at Corp X at the same time, who credibly testified that Taxpayer was hired by Corp X to conduct mundane and routine tasks, and that Mr. X controlled both Corp X and Corp Y and made all decisions for both. He did not delegate duties to his employees. Everything was done on his direction.

On the basis of the foregoing, the Court found that Taxpayer was not in a position to have any kind of meaningful control over the business, and it determined that he was not responsible for the sales tax due on behalf of Corp Y.

Know Your “Partners”

Now, you may be thinking, “why two posts in three weeks on the dire tax consequences that may befall someone who goes into business with an unscrupulous partner?”

The answer is simple: to stress the importance of a business person’s knowing his partner – his finances, experience, reputation, personality, etc. – before going into business with him.

Even after conducting a due diligence review, it will behoove the business person to memorialize the relationship with the new partner in a written agreement, such as a shareholders’ agreement, that covers, among other things, the allocation of duties between them, decision-making procedures, distributions, buyouts, etc. Yes, it will cost more upfront, but it will help to avoid more expensive surprises down the road, especially if the business is not going well.

Last week’s post explored the federal income tax consequences to a taxpayer who failed to timely file an election for the classification of his wholly-owned business entity.

Today’s post considers how one taxpayer sought to utilize the IRS’s business entity classification rules to reduce his estate’s exposure for NY estate tax. Individuals who are not domiciled in NY (“nonresidents”), but who operate a NY business, should familiarize themselves with NY’s response to the taxpayer’s proposed plan.

Situs of an LLC Interest
NY had previously ruled in an advisory opinion that a membership interest in a single-member LLC (“SMLLC”) that owned NY real property, and that was disregarded for federal income tax purposes, would be treated as real property – not as an intangible – for NY estate tax purposes.

The opinion also held that when a SMLLC makes an election to be treated as an association (taxable as a corporation) pursuant to the IRS’s “check-the-box” rules, the membership interest in the SMLLC would be treated as intangible property.

It concluded that the election that is in place on the date of the single member’s death is the election that will be used to determine whether the interest in the SMLLC is treated as real property or as intangible property for purposes of NY’s estate tax.

A recent NY advisory opinion addressed Taxpayer’s question whether a membership interest in a SMLLC would be treated as intangible property for NY estate tax purposes where the SMLLC initially elects to be disregarded for income tax purposes but, immediately upon the single member’s death, retroactively elects to be treated as an association taxable as a corporation.

Electing to Change Tax Status – and Situs?
Taxpayer represented that he was currently a NY resident, but that he planned to move to another state. At that time, Taxpayer would transfer his NY real property into a SMLLC, of which he would be the sole member. This SMLLC would not elect to be treated as an association for federal income tax purposes. Thus, it would be treated as a disregarded entity, and Taxpayer would continue to be treated as the owner of the real property.

Taxpayer also represented that he intended to remain the sole owner of the LLC for the remainder of his life, and to continue to have the SMLLC treated as a disregarded entity until his death. This would enable Taxpayer to claim on his personal income tax return the income and deductions associated with the real property.

Upon his death, Taxpayer’s Last Will and Testament would direct his executor to elect that the SMLLC be taxed as an association, and as an S-corporation, for income tax purposes. These elections would have retroactive effect to at least one day prior to the date of Taxpayer’s death.

Before we consider NY’s response to Taxpayer’s proposal, let’s first review the application of NY’s estate tax to nonresident decedents, as well as the IRS’s entity classification rules, the interplay of which is key to NY’s opinion.

The NY Estate Tax
NY imposes an estate tax on the transfer by the estate of a nonresident decedent of real property located in NY.

However, where the real property is held by a corporation or partnership, an interest in such entity has been held to constitute intangible property.

The NY Constitution prohibits the imposition of an estate tax on a nonresident’s intangible property, even if such property is located in NY. For example, securities and other intangible personal property within the state, that are not used in carrying on any business within the state by the owner, are considered to be located at the domicile of the owner for purposes of taxation.

NY’s tax law likewise provides that the NY taxable estate of a nonresident decedent does not include the value of any intangible personal property otherwise includible in the decedent’s gross estate.

The Entity Classification (“check-the-box”) Rules
Pursuant to the IRS’s entity classification rules, an entity that has a single owner, such as a SMLLC, is disregarded as an entity separate from its owner unless it elects to be classified as an association taxable as a corporation.

In other words, where no election is filed, the default classification of the SMLLC is that of a disregarded entity, one that is not deemed to be an entity separate from its owner. The SMLLC will retain this default classification until it makes an election to change its classification.

If the SMLLC is disregarded for tax purposes, its assets and activities are treated in the same manner as those of a sole proprietorship, branch, or division of the owner – the sole member is treated as the direct owner of the LLC’s assets, and is treated as conducting the LLC’s activities himself, for tax purposes.

A SMLLC may elect to be classified as other than its default classification by filing an entity classification election with the IRS. Specifically, a SMLLC may elect to be classified as an association, and thus treated as a corporation for tax purposes, by making such an entity classification election.

Such an election would be effective on the date specified by the entity on the election form, or on the date the form was filed if no such date is specified on the form. The effective date specified on the form cannot be more than 75 days prior to the date on which the election is filed, or more than 12 months after the date on which the election is filed.

NY’s Opinion
“A membership interest in a SMLLC owning New York real property, which is disregarded for income tax purposes, is not treated as ‘intangible property’ for purposes of New York State estate tax purposes. However, where a SMLLC makes an election to be treated as a corporation pursuant to [the ‘check-the-box’ rules], rather than being treated as a disregarded entity, such ownership interest would be considered intangible property for New York State estate tax purposes.”

The opinion noted that there is no provision in NY law applicable to the estate tax that provides for retroactively changing an entity’s classification, in this case to be treated as an association/corporation, after the death of its sole owner. Consequently, any post-mortem, retroactive classification election would be disregarded and not treated as a valid election for NY estate tax purposes.

Based on the above analysis, the advisory opinion stated that where a SMLLC is disregarded for Federal income tax purposes, the assets and activities of the SMLLC are treated as those of the deceased nonresident sole member without regard to any post-mortem election directed by his Last Will and Testament.

Therefore, under the circumstances described above, the interest in the SMLLC owned by Taxpayer would not be treated, for NY estate tax purposes, as an intangible asset. Instead, the NY real property held by the SMLLC would continue to be treated as real property held by the Taxpayer for NY estate tax purposes, even after the retroactive classification election was filed.

The Right Answer
Although an advisory opinion is limited to the facts set forth therein, and is binding on NY only with respect to the person to whom it is issued, it is pretty clear that NY’s position regarding Taxpayer’s proposed gambit stands on fairly solid ground.

The proposal described above is premised on the fact that Taxpayer has no idea of when he will die. He wants to enjoy the flexibility of operating through a SMLLC during his life and, upon his demise, take advantage of the opportunity afforded by the entity classification rules to make a retroactive change to the LLC’s tax status and, thereby, to change the situs of his membership interest in the LLC.

Although there are several statutorily-approved post-mortem planning opportunities (for example, the 6-month alternate valuation rule), the ability to elect to change the situs of a nonresident decedent’s property for NY estate tax purposes is definitely not one of them.

A nonresident business owner who operates in NY through a SMLLC certainly should not rely upon his executor’s making a post-mortem entity classification election to “remove” his tangible assets from the reach of the NY estate tax.

An S-corporation is a viable alternative, though it is more restrictive than a SMLLC, and the S-corporation election would have to be made while the owner was still alive.

Alternatively, the owner could choose to admit a second member to the LLC – perhaps an S-corporation, wholly-owned by him, that would hold a de minimis membership interest. The LLC would be treated as a partnership for tax purposes, thereby affording the owner the desired flexibility and pass-through treatment. The LLC interest would also be treated as an intangible in the hands of the nonresident owner under the NY estate tax.

Fortunately, Taxpayer sought professional guidance, as well as NY’s opinion, before implementing the proposed gambit. It’s a lesson to be remembered.

The Adviser’s Dilemma

The tax adviser to a closely held business is often “encouraged” by his client to find ways to reduce the client’s federal, state and local tax bills. One obvious way of accomplishing this goal is by claiming a deduction for a business-related expense. NYC UBT

In considering whether such an expense is, in fact, deductible by his client, the adviser must bear in mind two basic principles of tax law: provisions granting a deduction are construed in favor of the taxing authority, and the extent to which a deduction is allowed is a matter of legislative grace to which the taxpayer must prove entitlement.

Sometimes, in his eagerness to save a client money, an adviser may fail to consider an issue thoroughly, including the arguments that a taxing authority may raise against the client’s position. As a result, additional professional fees are incurred in defending the taxpayer’s position, the desired tax benefit is lost, and penalties are often imposed. These consequences were illustrated in a recent decision involving a deduction claimed in calculating a taxpayer’s liability for New York City’s unincorporated business tax (“UBT”).

The UBT

The UBT is imposed on the unincorporated business taxable income of every unincorporated business carried on within the City. An unincorporated business includes a partnership.

The unincorporated business taxable income of an unincorporated business is defined as the excess of its unincorporated business gross income over its unincorporated business deductions.

The unincorporated business deductions are the items of loss and deductions directly connected with or incurred in the conduct of the business, and which are allowable for federal income tax purposes for the taxable year, subject to certain modifications.

One of those modifications provides that no deduction is allowed to a partnership for amounts paid to a partner for services rendered by the partner. This is to be contrasted with payments by a partnership to partners that represent the value of any services provided to the partnership by the employees of the partner, for which a deduction is allowed.

Partner or Employee Services?

Limited Partnership (“LP”) had no employees – all of its activities were performed by its sole general partner (“GP”), an S corporation. GP’s employees serviced LP’s clients.

GP charged LP an annual management fee (the “Fee”) for the services it provided to or on behalf of LP. The amount of the Fee was based on the expenses the GP incurred to provide its services. The largest component of those expenses was the compensation GP paid to its employees for the services rendered to LP.

GP did not report the Fee as income for the Tax Year on its federal and UBT tax returns. Nor did it deduct the related expenses, including the compensation paid to its employees. Instead, LP reported each of GP’s operating expense items comprising the Fee, including the compensation GP paid to its employees who performed services for LP, as deductions on the corresponding lines of LP’s federal partnership income tax return (IRS Form 1065) and UBT return (Form NYC-204). As a result, all of the expenses GP incurred to operate LP were reported by LP as if LP had incurred them.

Although LP had no employees of its own, on its tax returns LP deducted as salary and wages the portion of the Fee it paid for the services of GP’s employees. GP, however, issued forms W-2 and filed employment tax returns to report the compensation paid to its employees.

At the beginning of the Tax Year, GP underwent a restructuring in which its employee-shareholders redeemed their shares in GP and were given limited partnership interests in LP. On the same date, additional employees of GP were given limited partnership interests in LP. As a result, following the restructuring, many of GP’s employees became limited partners in LP.

On LP’s UBT return for the Tax Year, LP deducted compensation paid to GP’s Employee-Partners.

The ALJ Disagreed . . .

The City audited LP’s UBT return for the Tax Year and disallowed LP’s deductions for salaries paid to the Employee-Partners and for amounts paid to the Employee-Partners’ pension plans.

The City asserted a UBT deficiency against LP, and an ALJ sustained the deficiency, concluding that LP’s payments to the Employee-Partners for their services were not deductible under the UBT rules.

The ALJ concluded that under the statute it was irrelevant that the payments were for services performed in a dual capacity, as employees of GP and as partners of LP, or that the payments were made to GP rather than directly to the Employee-Partners.

LP contended that the amounts it paid to GP for the services of the Employee-Partners were not amounts paid or incurred to a partner for services under the UBT rules because the Employee-Partners were employed by GP and performed the services for their employer (GP), not LP.

LP further contended that its payments fell within an exception to disallowance of the deduction under the UBT rules (the “Exception”). The Exception provides that payments to a partner for services are allowed as a deduction to the extent attributable to the services of the partner’s employees. LP argued that it satisfied the requirements of the Exception because the Employee-Partners were employees of GP. In addition, LP asserted that it was irrelevant to the operation of the Exception that the Employee-Partners are also partners in LP.

The City countered that, as a matter of substance, the payments in question were made to GP for the services of the Employee-Partners (who were partners in LP) and, therefore, were not deductible under the UBT rules.

. . . So Did the Tribunal And . . .

The NYC Tax Appeals Tribunal affirmed the ALJ’s determination, and LP appealed to the Appellate Division, which affirmed the Tribunal in a summary decision.

LP paid a management fee to GP for its services. According to the Tribunal, because the payment was to a partner for services, the UBT rules denied a deduction for the entire amount of the payment.

The Exception carves out an exception to the denial of the deduction where the partner’s services are performed by employees of the partner. The Exception provides:

. . . payments to partners for services do not include amounts paid or incurred by an unincorporated business to a partner of such business which reasonably represent the value of services provided the unincorporated business by the employees of such partner, and which . . . would constitute allowable business deductions . . . . The amounts paid or incurred for such employee services must be actually disbursed by the unincorporated business and included in that partner’s gross income for Federal income tax purposes.

Strike One

LP read the Exception broadly to include compensation paid to any employee of GP, regardless of whether the employee was also a partner in LP. Thus, LP contended that, under the Exception, LP could deduct the portion of its payment to GP representing compensation for the services of the Employee-Partners.

The Tribunal rejected LP’s reading of the Exception. LP’s reading of the Exception, it stated, was incompatible with a clear statutory policy to deny a deduction for payments to a partner for services.

Significantly, the UBT rules provide:

Amounts paid or incurred to an individual partner of the unincorporated business for services provided the unincorporated business by such an individual shall not be allowed as a deduction . . . .. The fact that the individual is providing such services not in his capacity as a partner within provisions of Sec. 707 of the Federal Internal Revenue Code will not change the result. (emph. added)

Under the UBT rules, LP’s payments to an individual partner for services were not deductible. The Employee-Partners were not merely employees of GP but were also individual partners in LP.

According to the Tribunal, the UBT rules made it clear that LP’s payment to GP for the services of the Employee-Partners was not deductible. Similarly, LP’s overly broad interpretation of the Exception, to allow a deduction for the services of a partner’s employees who are also partners, had to be rejected as contrary to the statute.

Strike Two

The Tribunal also rejected LP’s related argument that the portion of the Fee paid to GP representing compensation to the Employee-Partners was deductible because it was paid for services of the Employee-Partners in their capacity as employees, not as partners. The Tribunal pointed out that General Partner did not report the Fee as income on its federal and UBT tax returns. If the payment was not reported as income, it was rational for the UBT rules to deny the deduction, it stated.

Furthermore, because LP reported GP’s employees, including the Employee-Partners, as its own employees on its federal and UBT tax returns, the Exception did not apply. It applies only to payments for the services of a partner’s employees, not employees of the unincorporated business. The form in which LP reported its income and expenses removed it from the scope of the Exception.

Strike Three

LP argued that it did not pay the Employee-Partners for their services. Instead, it paid a Fee to GP which, in turn, compensated its employees for the work performed for GP. Therefore, LP argued the payments were not amounts paid to a partner. The Tribunal responded that this argument ignored the fact that LP paid the Fee directly to GP, who performed the services directly for LP.

In advancing this argument, LP took the position that payments to GP for the services of the Employee-Partners were payments to a third party and not within the scope of UBT Rules, which LP read as applying only to amounts paid directly to a partner. LP argued that the City had no authority to elevate substance over form to disallow third-party payments for partner services.

The Tribunal rejected this argument, holding that the taxing authority was not bound by the form of the payments, and could look to the economic substance of an arrangement to determine its tax consequences:

Tax legislation should be implemented in a manner that gives effect to the economic substance of the transactions . . . and the taxing authority may not be required to acquiesce in the taxpayer’s election of a form for doing business but rather may look to the reality of the tax event and sustain or disregard the effect of the fiction in order to best serve the purposes of the tax statute . . . .

The Tribunal considered the substance of the payments and found that they were not deductible, regardless of whether they were made directly to the Employee-Partners or to GP for their services.

Did You Notice?

LP had one argument that it presented in three slightly different ways. This argument failed at the audit stage, it was rejected by the ALJ, and then by the Tax Appeals Tribunal. Was it any surprise that the Appellate Division dismissed it with a summary decision?

It bears repeating: a deduction is a matter of legislative grace, and the provision granting it will be construed in favor of the taxing authority.

To make matters worse, in the present case, the UBT rules expressly stated that amounts paid to a partner for services were not deductible by the partnership regardless of the capacity in which such services were provided.

As always, it will behoove the tax adviser, and ultimately the closely held business client, to proceed with caution and to be thorough in his approach toward the issue being addressed before recommending a course of action. This includes a consideration of the arguments that will be presented in defense of one’s position in the event it is ever challenged by a taxing authority. No time like the present.

The Responsible Person

Many taxpayers fail to appreciate that a member of a partnership or LLC may be held personally liable for the sales tax collected or required to be collected by the entity.

New York State Tax Law (the “Tax Law”) imposes personal responsibility for payment of sales tax on certain owners, officers, directors, employees, managers, partners, or members (“responsible persons”).

A responsible person is jointly and severally liable for the tax owed, along with the business entity and any of the business’s other responsible persons. This means that the responsible person’s personal assets could be taken by the State to satisfy the sales tax liability of the business. An owner can be held personally responsible even though the business is an LLC.

Personal liability attaches whether or not the tax imposed was collected. In other words, it is not limited to tax that has been collected but has not been remitted. Thus, it will also apply where a business might have had a sales tax collection obligation, but was unaware of it. Along the same lines, the personal liability applies even where the individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful. In addition, the penalties and interest on the entity’s unpaid sales tax passes through to the responsible person.

Partnerships/LLCs

Under the Tax Law, every person who is a member of a partnership is a person required to collect tax. A strict reading of this provision concludes that any member of a partnership or of an LLC is per se liable for unpaid sales tax, plus interest and penalties, and this was, in fact, the State’s position for years. One can imagine the surprise of a minority partner upon learning that he was being held responsible for taxes far in excess of his investment in the business.

However, in 2011 New York provided partial relief to the per se personal liability for certain limited partners and LLC members. Under this policy, set forth in a Technical Memorandum, certain limited partners and LLC members who would be considered responsible persons under the Tax Law may be eligible for relief from personal liability for the entity’s failure to remit taxes. Specifically, a qualifying partner or member will not be personally liable for any penalties due from the business entity relating to its unpaid sales taxes, and the member’s liability for sales tax will be limited to his pro rata share of the tax.

An LLC member who can document that his ownership interest and distributive share of the profits and losses of the LLC is less than 50% may qualify for relief, if he can also demonstrate that he was not “under a duty to act” on behalf of the LLC in complying with the Tax Law.

Another One Bites the Dust

A recent ALJ decision considered whether an individual taxpayer (“Taxpayer”) was personally liable for the sales taxes due from an LLC of which he was a member.

NW LLC purchased Hotel in early 2005. Taxpayer executed the purchase agreement on behalf of NW LLC as a member of the LLC. NSP LLC was created by NW LLC to operate Hotel.

NSP LLC entered into a management agreement with Manager. Taxpayer signed the agreement on behalf of NSP LLC. Under the agreement, Manager had the right to hire, fire and supervise Hotel employees. NSP LLC was accorded the right to review Hotel’s books and records.

Taxpayer executed and filed a sales tax registration form, and an application for a liquor license, on behalf of NSP LLC, in his capacity as a manager of the business. Taxpayer subsequently signed sales tax returns on behalf of NSP LLC.

In 2007, NSP LLC refinanced its loan with Lender, and Taxpayer executed the document on behalf of NSP LLC. Among other things, the loan agreement provided Lender with a first priority security interest in all monies deposited into NSP LLC’s bank accounts. The agreement with Manager was also collaterally assigned to Lender as security for the loan.

NSP LLC fell into arrears in property taxes for the years 2007 and 2008. It also fell behind in its sales tax obligations for three quarters of 2008.

In 2008, NSP LLC was declared to be in default of the mortgage because it had failed to remain current in satisfying its sales and real property tax obligations. Lender advised NSP LLC that the failure to pay the taxes was an event of default.

As a result of this default, Lender stopped releasing funds to NSP LLC from the lockbox to the operating account and, together with Manager, assumed complete control over the operations and operating revenue of Hotel. Manager determined who would be paid and that decision was conveyed to NSP LLC and Lender. The people who collected, counted and delivered the money to the bank were all Manager employees. Lender would release money into a bank account that only Manager had access to and then Manager would write the checks. NSP LLC reminded Lender of its obligation to pay sales taxes, but Lender chose not to release the funds.

In 2009, the Supreme Court appointed a receiver for the revenues of NSP LLC. The receiver was ordered to pay only current taxes and not the taxes due from the time of Hotel’s seizure by Lender.

The State then assessed the sales taxes owing by NSP LLC against Taxpayer as a responsible person.

Taxpayer argued that he should not be held liable for the failure to collect and remit sales tax since he was precluded from being involved in Hotel once Lender seized control of Hotel in 2008. Taxpayer maintained that he could not be derivatively liable as a minority owner in NSP LLC because NSP LLC itself was not liable since it was “cut out of the financial decisions of the Hotel once [Lender] seized the Hotel.” He also stated that the sales tax arrearage did not arise until after Lender took over Hotel.

The State responded that, during the period in issue, Taxpayer was a member of NSP LLC and was, therefore, subject to per se liability for the taxes due from the LLC; that Taxpayer participated in the management of the business; and that Taxpayer had the burden of showing that he was not a responsible person.

The ALJ’s Opinion

The ALJ stated that, under the Tax Law, “every person required to collect [sales tax] shall be personally liable for the tax imposed, collected or required to be collected…”

The Tax Law defines a “person required to collect [sales tax]” to include:

“any employee of a partnership, any employee or manager of a limited liability company, . . . who as such . . . employee or manager is under a duty to act for such . . . partnership, limited liability company . . . in complying with any requirement of [the sales tax]; and any member of a partnership or limited liability company.”

The ALJ indicated that the foregoing language has generally been interpreted to impose strict liability upon members of an LLC for the failure to collect and remit sales tax.

Accordingly, as a member of NSP LLC, Taxpayer was personally liable for the sales taxes due from NSP LLC.

The ALJ considered Taxpayer’s contention that the foregoing analysis did not apply to him because Lender had seized Hotel and, as a result, neither NSP LLC nor its members could be held liable for the sales taxes due from Hotel. It contrasted Taxpayer’s position with the State’s contention that Hotel was not seized but, rather, that NSP LLC voluntarily yielded control to Lender.

In general, according to the ALJ, where a taxpayer’s lack of control over the financial affairs of a business entity arises from a choice not to exercise that authority, liability for sales taxes is imposed. However, where a person is precluded from acting on behalf of the business through no fault of his own, the obligations of a responsible person have not been imposed.

The ALJ acknowledged Taxpayer’s position that Taxpayer lacked control over the financial affairs of Hotel once Lender had taken over. It then considered Taxpayer’s position that NSP LLC did not willfully fail to pay and, therefore, could not be liable for the unpaid taxes. However, the question presented was whether this situation arose because of decisions made by Taxpayer.

Prior to the assumption of control by Lender, Taxpayer was clearly involved in the management and financial affairs of NSP LLC. For example, Taxpayer signed the management agreement that gave Manager the authority to manage Hotel. Significantly, NSP LLC retained the right to review Hotel’s books and records. https://www.taxlawforchb.com/2014/12/responsible-persons-sales-tax-issues-part-ii/

The ALJ determined that NSP LLC voluntarily entered into an arrangement that ultimately led to its inability to pay sales tax. There was an act that permitted Lender to exercise rights that directly resulted in the nonpayment of taxes. The inability to act was Taxpayer’s own creation and was foreseeable in the event of financial difficulties.

Accordingly, the arrangement with Lender amounted to a dereliction of Taxpayer’s duty under the Tax Law, as a responsible person, to properly safeguard the interests of the State with regard to sales taxes. Since the inability of NSP LLC to determine the disposition of funds after Lender assumed control was a situation of NSP LLC’s own making, it could not be relied upon, the ALJ said, to absolve NSP LLC of liability. It followed that Taxpayer’s argument, that he could not be held responsible since NSP LLC could not collect and remit sales tax, was without merit.

Finally, the ALJ explained that the policy set forth in the Technical Memorandum, to alleviate some of the harsh consequences of being found to be a responsible officer pursuant to the Tax Law, did not apply to Taxpayer. Specifically, the memorandum provided:

“In the case of a partnership or LLC, [the Tax Law] provides that each partner or member is a responsible person regardless of whether the partner or member is under a duty to act on behalf of the partnership or company. This means that these persons can be held responsible for 100% of the sales and use tax liability of a business. The department recognizes that this provision can result in harsh consequences for certain partners and members who have no involvement in or control of the business’s affairs.”

On its face, the ALJ stated, the policy did not apply to a member of an LLC who had substantial involvement in the financial affairs and management of the business. Here, Taxpayer exercised substantial authority over the business and financial affairs of NSP LLC until there was an event of default, which led to Lender’s utilization of the lockbox.

Lessons?

Was the ALJ’s decision unexpected? No. It certainly highlights the very difficult choice that confronts the responsible person in a struggling business: either pay the sales tax and give up the business, or continue to operate and risk personal liability.

Economic difficulties do not excuse an individual from his responsibility to collect and remit sales tax on behalf of a business entity. The Courts have often stated that individuals may not continue to operate a business “at the expense of ensuring that sales tax was paid.”

The ALJ noted that Taxpayer voluntarily entered into the arrangement on behalf of the LLC and thereby created the scenario which led to LLC’s inability to pay sales tax. In other words, Taxpayer, on behalf of the LLC, gave Lender the authority to determine which liabilities would be paid. Such a grant of authority was in direct contravention of Taxpayer’s duty as a trustee to “properly safeguard the interests of the State with regard to such taxes.” He voluntarily acceded to the terms of the agreement, notwithstanding his knowledge that, under the arrangement, sales taxes were not being paid.

They’re Not Making Any More of It
Many of our clients own significant interests in real property, both on Long Island and in New York City. Some of these clients are more active investors than others. They may engage in like-kind exchanges in order to diversify their holdings. They may enter into relatively complex joint ventures with other investors. They may spin-off parts of their portfolios in order to obtain better financing, or to address management or ownership issues.

In every case, they are keen on reducing any tax liability that may otherwise be incurred as a result of the particular transaction. After all, they want to maximize the economic return on their investment. The more that they pay in taxes as a result of a particular investment or transaction structure, the lower their economic return will be.

A Recent Development
A recent decision by N.Y.’s Division of Tax Appeals may be of particular interest to real estate investors and their advisers. In this case, an Administrative Law Judge (the “Court”) considered whether the real estate transfer tax (“RETT”) was properly asserted in the transactions described below.

The Transactions
Taxpayer and Partner acquired real property (the “Property”) in N.Y.C. as tenants-in-common (“TIC”). Upon acquisition, Taxpayer held an undivided 45% TIC fee interest in the Property and Partner held an undivided 55% TIC fee interest in the Property. RETT was paid in connection with the acquisition of the Property.

Approximately three-and-one-half years later, Taxpayer and Partner formed Owner LLC.

On Date 1, one week after the creation of the LLC, Taxpayer and Partner contributed their respective 45% and 55% TIC interests in the Property to Owner LLC, in exchange for which Taxpayer received a 45% membership interest in Owner LLC, and Partner received a 55% membership interest.

Immediately thereafter, and on the same day, Taxpayer sold its 45% membership interest in Owner LLC to Partner in exchange for approximately $111 million.

Taxpayer and Partner filed a New York State Combined Real Estate Transfer Tax Return (Form TP-584) reporting the contribution of Taxpayer’s fee interest to Owner LLC, and the sale to Partner of Taxpayer’s membership interest in Owner LLC. Both transfers were reported as tax-exempt transactions: (i) the contribution of Taxpayer’s fee interest to Owner LLC as a conveyance that consisted of a mere change of identity or form of ownership or organization; (ii) the sale of Taxpayer’s 45% membership interest to Partner as the transfer of a less-than-controlling interest.

The Parties’ Positions
New York (the “State”) audited Taxpayer in connection with these real estate transactions. Based on its findings, the State asserted that Taxpayer was liable for RETT, plus interest and penalties.

Taxpayer filed a Request for Conciliation Conference with the Bureau of Conciliation and Mediation Services (“BCMS”), but BCMS issued a conciliation order that upheld the tax assessment.

Taxpayer then filed a petition with the Division of Tax Appeals, where it contended that the State erred in asserting a tax deficiency because Taxpayer’s and Partner’s contributions of their respective interests in the Property to Owner LLC on Date 1 were each exempt from RETT as a “mere change in form.”

Taxpayer also contended that its “subsequent” sale of its 45% membership interest in Owner LLC to Partner, also on Date 1, was not subject to RETT because it did not constitute a transfer of a controlling interest in an entity that owned real property.

The State contended that, with the transfer of Taxpayer’s 45% interest in Owner LLC to Partner, Partner obtained a 100% controlling economic interest in the Property, which resulted in a 55% nontaxable mere change in ownership and a 45% taxable change in beneficial ownership.

The Decision
The Court explained that RETT was “imposed on each conveyance of real property or interest therein.” All conveyances were presumed subject to the tax, it stated, until the contrary was proven, and the burden of proving the contrary was on the taxpayer responsible for the tax.

The term “conveyance,” it continued, is defined as “the transfer or transfers of any interest in real property by any method, including but not limited to sale, exchange, . . . or transfer or acquisition of a controlling interest in any entity with an interest in real property.” The term “controlling interest,” in turn, is defined, in the case of a partnership, as “fifty percent or more of the capital, profits or beneficial interest in such partnership . . .”

However, even where a transfer constitutes a “conveyance,” RETT does not apply to the extent that the conveyance effectuates “a mere change of identity or form of ownership or organization,” without a change in beneficial ownership.

The State conceded that Taxpayer’s and Partner’s contributions of their respective TIC interests in the Property to Owner LLC in exchange for membership interests in Owner LLC, standing alone, were exempt from the RETT as mere changes in form of ownership.

The State argued, however, that because of the subsequent sale of Taxpayer’s 45% membership interest to Partner, the combined transactions became subject to RETT. According to the State, “[i]t is [Taxpayer’s] sale of its 45% interest in Owner LLC to [Partner] in aggregation with [their] conveyances of their interests in the [Property] to Owner LLC, and the RETT implications of aggregating those transactions, that are at issue in this case.”

The State attempted to “aggregate” what the Court stated were “three nontaxable transactions,” namely (1) the transaction between Partner and Owner LLC, which effectuated a mere change in form of ownership, (2) the transaction between Taxpayer and Owner LLC, which also effectuated a mere change, and (3) Taxpayer’s transfer of its 45% membership interest in Owner LLC to Partner, in order to impose RETT on the transfer of this 45% interest.

The Court rejected this attempt, pointing out that the third transaction did not meet the definition of a transfer of a “controlling interest” because Taxpayer did not sell more than 50% of Owner LLC. As such, that transaction, by definition, could not be considered a transfer or acquisition of a controlling interest in an entity with an interest in real property.

The State nevertheless contended that adding the transfer of Taxpayer’s 45% interest in Owner LLC with Partner’s 55% interest in Owner LLC resulted in Partner’s “acquisition” of a controlling interest in Owner LLC. In support of its position, the State pointed to the RETT regulations, which provide:

“Where there is a transfer or acquisition of an interest in an entity that has an
interest in real property, . . . , and subsequently there is a transfer or acquisition of an additional interest or interests in the same entity, the transfers or acquisitions will be added together to determine if a transfer or acquisition of a controlling interest has occurred. Where there is a transfer or acquisition or a controlling interest in an entity . . . , and [RETT] is paid on that transfer or acquisition and there is a subsequent transfer or acquisition of an additional interest in the same entity, it is considered that a second transfer or acquisition of a controlling interest has occurred which is subject to [RETT].”

While the Court acknowledged that the regulation provides for adding together multiple transfers or acquisitions of interests in an LLC with an interest in real property to determine if a transfer or acquisition of a controlling interest has occurred, it also noted, contrary to the State’s argument, that the regulation does not authorize or provide for adding such a transfer or acquisition together with a nontaxable “mere change in form of ownership” conveyance in order to achieve a taxable transaction.

The regulation provides that aggregation applies to multiple transfers or acquisitions of interests in an entity with an interest in real properly that occur within a three-year period. The “fallacy of the State’s argument for aggregation,” the Court continued, was that the initial transaction between Partner and Owner LLC, wherein Partner exchanged its 55% TIC interest in the Property for a 55% interest in Owner LLC was not a “transfer or acquisition of an interest in an entity with an interest in real property.” Rather, it was a mere change in the form of ownership of the Property. Since the transaction between Partner and Owner LLC was not a transfer or acquisition of an interest in an entity, that transaction could not be aggregated with Taxpayer’s subsequent transfer of a non-controlling interest.

The Court then noted that, under the above regulation, where there is a transfer or acquisition of a controlling interest in an entity with an interest in real property, “and [RETT] is paid on that transfer or acquisition,” followed by a subsequent transfer or acquisition of an additional interest in the same entity within three years, “it is considered that a second transfer or acquisition of a controlling interest has occurred which is subject to [RETT].” Because the initial transfer between Partner and Owner LLC was not a transfer or acquisition of a controlling interest, but merely a change in form of ownership, no RETT was required to be paid. The State’s argument that the subsequent transfer of Taxpayer’s 45% interest to Partner was considered a second transfer or acquisition of a controlling interest that was subject to the RETT ignored the language of the regulation requiring that RETT was paid on the initial transaction for aggregation to apply.

Thus, the Court concluded that Taxpayer did not owe any RETT as a result of the above transactions.

Did the Court Get It Right? Did the State?
There is no doubt that if Taxpayer had sold its 45% TIC fee interest (not a partnership interest) to Partner, the sale would have been subject to RETT, and Partner would have become the sole owner of the Property.

However, nowhere in its opinion does the Court describe the nature of the TIC arrangement between Taxpayer and Partner for income tax purposes. Did it represent a mere co-ownership of property that was maintained, kept in repair, and leased, and did not constitute a separate entity for federal tax purposes?

Or did the TIC owners treat their arrangement as that of a partnership, for which they filed partnership income tax returns and received K-1s? If they had, then the Court would likely have reached the same conclusion as above, without regard to the contribution of the Property to Owner LLC – rather, it would have based its decision solely on Taxpayer’s not having transferred a controlling interest in a partnership.

But in that case, neither the Court nor Taxpayer would have had to rely upon the “mere change” exemption. For example, see N.Y.’s Limited Liability Company law, which provides, in the case of the conversion of a partnership into an LLC, that all the real property of the converting partnership remains vested in the converting LLC – in other words, there is no “conveyance.”

Enter Owner LLC. Why was it needed? In form, it represented a partnership: a non-corporate business entity with two members.

But can we say that this “partnership” had any substance? It was funded by Taxpayer and Partner on Date 1 (after having been formed only one week earlier), and Taxpayer also sold its newly acquired membership interest in LLC to Partner on Date 1 – presumably pursuant to an earlier binding agreement – following which Partner owned 100% of Owner LLC and the Property.

Although it appears that the parties utilized Owner LLC for the sole purpose of characterizing Taxpayer’s sale of its LLC interest to Partner as a transfer of a non-controlling interest, the State does not appear to have argued that the substance of the above transactions should have determined their RETT consequences.

The State will likely appeal this decision – indeed, it should. Until it does, and unless the Appellate Division agrees with it, taxpayers may have been given a simple way to circumvent the otherwise taxable transfer of a TIC interest.

One Day . . .
It is the dream of so many New York business owners: build a successful business, get your kids involved in the business, transition the operation, management and – eventually – the ownership of the business to the kids, move to Florida (or another warm, tax-friendly venue), successfully fend off New York’s inevitable challenge to your claimed change of domicile, stay involved in the business, pay no New York income tax on any income derived from the business, and pass away – yes, that is a morbid thing to say, but “death and taxes” – happy in the knowledge that your estate will not be subject to New York’s estate tax. Not much to ask for, right?

Earlier posts have described the factors that New York considers in determining an individual’s domicile or residence. See, e.g., “New York Business, the Federal Tax Return, and New York Domicile.”

Escape from NY . . .
The resolution of a taxpayer’s resident status vis-à-vis New York is of paramount importance to the taxpayer.

A New York State resident taxpayer is responsible for reporting and paying New York State personal income tax on income from all sources regardless of where the income is generated, or the nature of the income.

A nonresident taxpayer, however, is given the opportunity to allocate income, reporting to New York State only that income actually generated in New York. In addition, the nonresident need only report to New York income from intangibles which are attributable to a business, trade or profession carried on in the State.

Thus, significant benefits may be derived from filing as a nonresident.

. . . Not Entirely
Because a taxpayer’s New York source income will remain subject to New York’s tax jurisdiction even where the taxpayer has successfully established his or her status as a non-resident, it behooves the taxpayer to become familiar with New York’s sourcing rules. A nonresident taxpayer’s New York income will include the taxpayer’s income from:
• real or tangible personal property located in New York State, (including certain gains from the sale or exchange of an interest in an entity that owns real property in New York;
• services performed in New York;
• a business, trade, profession, or occupation carried on in New York;
• his or her distributive share of New York partnership income or gain;
• his or her share of New York estate or trust income or gain;
• any income he or she received related to a business, trade, profession, or occupation previously carried on in New York State, including but not limited to covenants not to compete and termination agreements; and
• a New York S corporation in which he or she is a shareholder.
Some of these source rules are more easily applied than others. In those cases where the facts are disputed, the taxpayer can count on New York to assert the requisite nexus.

In a recent decision, an Administrative Law Judge (“ALJ”) rejected New York’s somewhat creative attempt to tax a Florida resident’s consulting fees. [Carmelo and Marianna Giuffre, DTA NO. 826168)

Unfortunately, the ruling is light on facts and, so, leaves several questions unanswered.

Father Knows Best?
The Taxpayer resided and was domiciled in Florida during the year at issue. He was employed by Consulting LLC (Consulting). Consulting was a Florida limited liability company with its principal place of business located in Florida. Taxpayer was its sole member.

Prior to his employment by Consulting, Taxpayer was the president Family Corp., located in New York City. Family Corp. was a family-owned company that operated Business in New York and New Jersey. During the year at issue, Taxpayer’s sons and nephew owned and operated Business.

Consulting provided “management consulting” services for Business. Taxpayer rendered these services as an employee of Consulting, from its offices in Florida.

By agreement between Consulting and Family Corp., Consulting agreed to perform consulting work for Family Corp. The agreement explicitly provided that the consulting services “shall be provided via telephone or electronically” and that it is not anticipated that the consulting services would require any Consulting employee to travel to New York City or any of Business’s other locations.

Under the agreement, Consulting acted in an advisory role, and neither it nor Taxpayer was involved in the day-to-day management or decision-making process of Family Corp. The consulting services were performed, and the business of Consulting was conducted, from its Florida office. Taxpayer was paid an annual salary for his services by Consulting.

Taxpayer visited New York during the year at issue. The primary purpose of his visits were personal in nature. He visited family members who resided in the New York metropolitan area. Although he also visited the Business locations owned by Family Corp., these visits also were personal in nature. Taxpayer did not maintain a desk or office in any of the locations. He was not involved in any daily operations of Business during the year at issue.

New York’s Unsuccessful Play
New York asserted that Taxpayer had New York source income for the year at issue, based upon an allocation formula that used the number of Business locations in New York, divided by the total number of Business locations, to arrive at an allocation of 10/17, or approximately 59%. The State then multiplied that percentage by the amount of Taxpayer’s salary from Consulting for that year to arrive at a net allocation of almost $800,000 as New York income.

The only issue before the ALJ was whether Taxpayer had income that was derived from, or connected to, New York sources; in other words, whether Taxpayer had rendered consulting services in New York during the year at issue. According to the ALJ, he did not.

The ALJ explained that New York imposes personal income tax on the income of nonresident individuals to the extent that their income is derived from or connected to New York sources (Tax Law Sec. 601[e][1] http://codes.findlaw.com/ny/tax-law/tax-sect-601.html ). A nonresident individual’s New York source income includes the net amount of items of income, gain, loss and deduction entering into the individual’s federal adjusted gross income derived from or connected with New York sources, including income attributable to a business, trade, profession or occupation carried on in New York (Tax Law Sec. 631[a][1]; [b][1][B]).

The ALJ also observed that, under New York’s tax regulations, a business, trade, profession or occupation is carried on in New York by a nonresident when:
“such nonresident occupies, has, maintains or operates desk space, an office, a shop, a store, a warehouse, a factory, an agency or other place where such nonresident’s affairs are systematically and regularly carried on, notwithstanding the occasional consummation of isolated transactions without New York. (This definition is not exclusive.) Business is carried on within New York if activities within New York in connection with the business are conducted in New York with a fair measure of permanency and continuity” (20 NYCRR 132.4[a][2]).

The ALJ found that Taxpayer was employed by Consulting, the offices of which were located in Florida. There was no evidence that Taxpayer or Consulting maintained any office or place of business within New York.

In fact, as noted above, the consulting agreement specifically stated that the services provided by Taxpayer would be rendered via telephone or electronically. The agreement did not mention any work space located in New York nor did it contemplate Taxpayer providing any services within New York.

The State relied on case law that involved nonresident individuals who were employed by a New York employer, yet for convenience worked both within and without the State. According to this precedent, a nonresident who performs services in New York, or has an office in New York, is allowed to avoid New York tax liability for services performed outside the State only if they are performed of necessity in the service of the employer. Where the out-of-State services are performed for the employee’s convenience, they generate New York tax liability.

The ALJ rejected the State’s reasoning, finding this case law distinguishable from the Taxpayer’s situation. Taxpayer was a nonresident who worked for a Florida company, not a New York employer. Moreover, Taxpayer did not render services in New York and he did not have an office in New York. As such, the “convenience of the employer” analogy was inapplicable to the Taxpayer.

Any Takeaways?
Although the ALJ’s opinion does not state that Taxpayer was previously a New York resident, it is safe to assume that he was domiciled in New York before moving to Florida.

However, query over what period of time, and how (gifts, sales, GRATs, etc.), Taxpayer transitioned the management of Business, and transferred the ownership of Family Corp., to his sons? This would have been an important consideration in establishing that Taxpayer was no longer domiciled in New York.

According to the opinion, Taxpayer was not involved in the day-to-day management or decision-making process of Family Corp., and his “management consulting” services were to be rendered “via telephone or electronically.” The ALJ based its opinion on these “facts.”

That being said, Family Corp. nevertheless must have determined that Taxpayer’s ongoing services were important to its continued well-being. After all, New York sought to tax $800,000 (or 59%) of Taxpayer’s salary from Consulting for just one tax year. What, then, was the nature of the advice given? (I should tell you, Business operated car dealerships.)

Query also why the ALJ does not seem to have asked whether the fee payable to Consulting (and thereby to Taxpayer) represented reasonable compensation for the services rendered? What if the fee was excessive? To what would the excess amount be attributed? A form of continuing equity participation in Business? Additional, deferred, purchase price for Taxpayer’s equity in Family Corp.? Payment for Taxpayer’s promise not to compete against Family Corp.? Deferred compensation for services rendered by Taxpayer to Family Corp. when he was still a New York resident?

I don’t believe that I would be going out on a limb to suggest that at least one of these elements was at play. In any case, each of these re-characterizations would have generated New York income.

Or was the Family Corp.’s payment made simply to accede to Taxpayer’s demand for some cash flow from “his” business (not an uncommon occurrence) and to thereby remain in Taxpayer’s good graces? After all, a “last” will and testament (or revocable trust) may be changed at any time before the testator’s (or grantor’s) death. (Back to death again.)

As always, it is best for related parties to treat with one another on an arm’s-length basis. Taxpayer undoubtedly gave up ownership and control of Family Corp. and Business in order to support his claim that he had abandoned his New York domicile, and to achieve certain income and estate tax savings.

Yet Taxpayer appears to have required significant cash flow from Business – he could not afford to part with all the economic benefits associated with Family Corp. Granted, that reality is difficult to reconcile with the ends desired (e.g., no New York tax), but “you can’t always get what you want,” but with a little planning, . . . (you know how it goes).

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.

Plan Ahead

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.