Out of New York, But Still Being Taxed By New York? Look to the Source
July 06, 2020
New York Diaspora?[i]
Like most every other state in the Union, New York has experienced its share of fiscal stress over the last few decades. The source or cause of its problems? Well, that may depend upon the respondent to whom this question is posed and, unfortunately, the side of the political aisle on which they place themselves.[ii] However, almost everyone agrees that there are many factors and forces to which the State’s long-standing economic issues may be attributed.[iii]
What’s more, there is no denying that the State’s fiscal situation has been exacerbated by the unexpected expenditures that were necessarily incurred in combating the recent coronavirus outbreak, and by the reduction in badly needed tax revenues caused by the resulting economic shutdown.
What does this state of affairs portend for New York’s taxpayers, especially those who are often described by the media as the “affluent?”[iv]
These folks already pay personal income tax to the State at a top rate of 8.82 percent; if they are residents of New York City, they pay City income tax at a rate of 3.876 percent. The State’s sales tax is 4 percent,[v] but they also have to factor in their local tax; in New York City, that means a sales tax of 4.5 percent plus a Metropolitan Commuter Transportation District surcharge of 0.375 percent, for a total sales tax of 8.875 percent; Nassau County’s sales tax is 8.63 percent and Westchester’s is 8.38 percent. These last two counties regularly take top five honors, nationally, for real property taxes. Then there is New York’s cost of living. And as a parting gift, there is New York’s 16 percent estate tax.[vi]
Well before the shutdown triggered by COVID-19, New York began taking the initiative in examining taxpayers’ personal income tax returns, including – to the extent New York’s Tax Law (the “Tax Law”) conforms to the Code – the Federal tax issues presented in those returns. The obvious goal of this increased audit activity is the collection of more New York income tax.[vii]
With the shutdown, however, the State’s economic situation has only gotten worse, and the pressure to recover lost tax dollars has only increased.[viii]
Query what impact this new fiscal reality will have upon New York’s individual residents, especially those who have always been able to move their business elsewhere but chose to remain in New York anyway, as well as those who just discovered during the recent quarantine that they can effectively manage and operate their business remotely.[ix]
Will It Matter?
Of course, most New Yorkers will stay put[x] – and all of their income will remain subject to New York income tax regardless of its source – but a not insignificant number of individual residents can be expected to emigrate from the State.[xi]
New York’s Department of Taxation and Finance (the “Department”) will audit many of these “emigres”[xii] and will determine that they are still domiciled in the State because they have failed either to abandon New York as their permanent home or to establish a new domicile elsewhere.
More disciplined or committed taxpayers – who are actually willing to do what it takes[xiii] – as well as better-organized taxpayers,[xiv] will succeed in becoming nonresidents of New York.[xv]
Among these soon-to-be former New York residents will be some who will continue to participate, to varying degrees, in a New York business, or who will have a substantial investment in a New York business.[xvi] For many of these individuals, even if they successfully defend their status as nonresidents, their New York source income will continue to represent the largest part of their gross income, and they will continue to pay substantial personal income tax to New York, albeit as a nonresident.[xvii] Pyrrhic victory?
For that reason, it will behoove former residents and their advisers to familiarize themselves with New York’s source rules; only in this way can they organize their New York business or investment, and plan for recognition events with respect to those assets, so as to reduce their New York tax burden.
New York’s Source Rules
In general, nonresidents are subject to New York personal income tax on their New York source income, which is defined as the sum of income, gain, loss, and deduction derived from or connected with New York sources.[xviii] For example, where a nonresident sells real property or tangible personal property located in NY, the gain from the sale is taxable in New York.[xix]
If a nonresident carries on a trade or business party within and partly outside New York, the nonresident must determine the items of income, gain, loss and deduction that are derived from or connected with New York sources.[xx]
However, income derived from intangible personal property, including dividends and interest, as well as the gains from the disposition of such property, constitute income derived from New York sources only to the extent that the intangible property is employed in a business carried on in New York.[xxi]
From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned New York real property. Thus, generally speaking, a nonresident who owned an interest in a close corporation, for example, that owned New York real property, could sell such interest without realizing New York source income and incurring New York income tax.
However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with New York sources included items attributable to the ownership of any interest in real property located in New York.
For purposes of this rule, the term “real property located in” New York was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in New York and has a fair market value (“FMV”) that equals or exceeds 50 percent of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.[xxii]
In accordance with an “anti-stuffing” rule, only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on such date.
The gain or loss derived from New York sources from a nonresident’s sale or exchange of an interest in an entity that is subject to this rule is the total gain or loss for federal income tax purposes from that sale or exchange multiplied by a fraction, the numerator of which is the FMV of the real property located in New York on the date of the sale or exchange and the denominator of which is the FMV of all the assets of the entity on such date.
For Example
With that background, let’s turn to a recent Advisory Opinion which illustrated the consequences of failing to fully consider or appreciate the impact of the State’s sourcing rules.[xxiii]
Petitioner was a limited partnership that was formed under the laws of another state for the purpose of investing in U.S. real estate. Petitioner had a large number of limited partners, many of whom were nonresident individuals as to New York.
Petitioner invested in real estate and owned land and improvements in several states, including a New York building that it owned and actively managed for over two years.[xxiv] In connection with the ownership of the building, each of Petitioner’s limited partners was allocated a distributive share of income, gain, loss and deduction[xxv] that was reported as attributable to a business carried on by Petitioner in New York.[xxvi]
Upon the sale of the building on the Closing Date, Petitioner recognized a taxable gain and paid, on behalf of its nonresident limited partners, any required estimated taxes relating to their distributive share of its New York source income associated with the building’s sale.[xxvii] At the time of the sale, the building was the only material asset held by Petitioner, other than any undistributed cash remaining from the disposition of other land and improvements. All of the cash was held for less than two years at the time of the sale of the building through the winding up of Petitioner.
After the building was sold, Petitioner wound up its operations and liquidated. The net proceeds from the sale were transferred on Closing Date to a bank account maintained by an affiliate of Petitioner’s general partner (the “Affiliate”). Affiliate distributed the net proceeds to Petitioner’s limited partners one day after the Closing Date. According to Petitioner, the proceeds were distributed one day after the sale of the New York property because the Closing Date was a bank holiday in the jurisdiction in which its limited partners were located.
Upon Petitioner’s liquidation,[xxviii] each limited partner was expected to recognize a capital loss in an amount equal to the excess of each limited partner’s outside tax basis in Petitioner over the amount of liquidation proceeds received.[xxix]
The Opinion
Petitioner asked the Department whether the loss realized by its nonresident individual limited partners upon the liquidation of Petitioner one day after the Closing Date was derived from or connected with New York sources, such that the loss would offset at least part of the New York source gain allocated to these limited partners from the Petitioner’s sale of the building.[xxx]
Unfortunately for Petitioner’s limited partners, the Department concluded that the loss was not derived from or connected with New York sources.
The Department explained that, under the Tax Law, the New York source income of a nonresident individual includes the individual’s net amount of items of income, gain, loss and deduction entering into the individual’s Federal adjusted gross income that is derived from or connected with New York sources, including the individual’s distributive share of partnership income, gain, loss and deduction.[xxxi]
According to the Department, items of income, gain, loss and deduction derived from or connected to New York sources include items attributable to the ownership of any interest in real property located in the State.[xxxii]
The term “real property located in this state,” the Department stated, includes an interest in a partnership that owns real property that is located in New York and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of sale or exchange of the taxpayer’s interest in the entity. “Only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are to be used in determining the fair market value of all the assets of the entity on the date of sale or exchange.”[xxxiii]
“The gain or loss derived from New York sources from the taxpayer’s sale or exchange of an interest in an entity that is subject to” these provisions, the Department continued, “is the total gain or loss for federal income tax purposes from that sale or exchange multiplied by a fraction, the numerator of which is the fair market value of the real property … located in New York on the date of the sale or exchange and the denominator of which is the fair market value of all the assets of the entity on the date of the sale or exchange.”
As stated above, Petitioner sold its New York building at a gain on the Closing Date. It then wound up its affairs, settled its accounts, and liquidated.
Petitioner asked whether each limited partner’s loss, required to be recognized for Federal tax purposes upon liquidation, would also be recognized for New York tax purposes as a loss derived from New York sources that was attributable to the ownership of an interest in real property in New York.[xxxiv]
The Tax Law[xxxv] provides that items of loss are attributable to New York sources if those items are attributable to the ownership of any interest in real property in New York. This includes, the Department stated, an interest in a partnership that owns real property that is located in New York and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of sale or exchange of the taxpayer’s interest in the entity.
In this case, the Department observed, Petitioner sold its interest in the New York building on the Closing Date, and transferred the net proceeds from that sale to Affiliate, not to its limited partners. Thereafter, Petitioner was liquidated, and the net proceeds were delivered to the limited partners, the day after the Closing Date.
Therefore, any loss recognized by Petitioner’s limited partners from their interests in Petitioner were not attributable to the Partnership’s ownership of real property in New York because Petitioner did not own New York real property on the date on which those partnership interests were liquidated; i.e., the day after the Closing Date.[xxxvi]
Ouch
Harsh result? Seems so. One day seems to have made all the difference with respect to the source of the loss realized on the liquidation of the nonresident limited partners’ interests in the partnership. Consequently, there was a mismatching of the New York source capital gain that was allocated to these nonresident partners from the sale of the partnership’s New York real property on the Closing Date, and the non-New York source capital loss realized by these same partners on the liquidation of their partnership interests the day after the Closing Date, with the result that Petitioner’s nonresident partners owed New York income tax on the gain.
Query what Petitioner could have done differently so as to avoid this outcome? Perhaps it could have created a liquidating trust to accept the liquidation proceeds?[xxxvii] Such vehicles are often used to facilitate the time-sensitive liquidation of a corporation. In the case of the Petitioner, the limited partners would have been designated as the beneficiaries of the trust. Petitioner and the partners would have agreed to treat the limited partners as having received the liquidating distribution, followed by their having contributed the proceeds thereof to the trust for the purpose of completing the legal dissolution (as opposed to the liquidation for tax purposes) of the partnership. Because the partners would have “contributed” assets to the trust while retaining the beneficial interest in such assets, the trust would have been treated as a grantor trust for tax purposes.[xxxviii]
The bottom line here is that a closer analysis of New York’s source rules may have afforded Petitioner an opportunity to avoid the conclusion reached by the Department in its advisory opinion.
This result also highlights the importance of understanding the operation of the State’s source rules if one is seeking to change their status as a New York resident for the purpose of avoiding the reach of the New York income tax. Failing to do so may not affect one’s nonresident status, but it can make a huge difference in one’s tax bill.
[i] From the Greek, to scatter about, as in the case of seeds.
[ii] See the conservative Cato Institute’s January 2020 comparative analysis, which places the blame squarely upon what it describes as New York’s “excessive” government spending. https://www.cato.org/blog/new-york-government-twice-size-floridas
[iii] Justifiable or not, there is no denying that the wages, overtime, and retirement benefits paid to civil servants represent an enormous expenditure of public funds. For example, the “traditional” retirement plan for union-represented public employees is a defined benefit plan that provides life-time benefits determined under a formula based upon one’s final average salary and years of service. The cost of such a plan is borne by the employer – i.e., the taxpayer. Defined contribution plans, by contrast, are funded primarily by the employee, though many employers also contribute to such a plan.
In the private sector, defined benefit plans have been a thing of the past for several years. They are just too expensive to maintain and administer. Stated differently, they are injurious to the profits of a business and its owners. No moral statement here. Just a fact. “It’s not personal, Sony, it’s strictly business,” as Michael said.
[iv] Talk about relative. Talk about overbroad. In 2019, the national cutoff for the top 1 percent of household income (gross) was approximately $475,000. The cut-off in New York State was approximately $586,000; in NYC, approximately $2.2 million. Visit DQYDJ’s website.
Net worth is another story; it does not correlate neatly to income.
Then there’s the cost of living; for example, under almost any measure, the cost of living is lower in FL than in New York.
[v] Of course, if an affluent person and a less-than-affluent person purchase the same item for the same price from the same store, the sales tax imposed upon these retail purchases will have a disproportionately greater impact upon the less-than-affluent individual, all other things being equal.
[vi] Ready to pack the car? I just told my mother-in-law that I’m planning to move. The very picture of stoicism, she is – or was that the hint of a smile? I can’t tell. Probably just . . .
What’s more, let’s not forget the $6 trillion that the Federal government has just spent over the course of approximately only five months. Someone has to pay for that, and there really is only one viable option.
[vii] https://www.taxlawforchb.com/2020/06/conformity-the-lockdown-and-new-yorks-audit-of-like-kind-exchanges/#_edn15
The State appears to have relaxed its “wait-and-see-what-the-IRS-finds” attitude, notwithstanding that the applicable N.Y. statute of limitations on the assessment of a deficiency in income tax owed by a taxpayer (normally three years from filing) is suspended (“tolled”) if the taxpayer fails to timely inform the State that the IRS has adjusted their Federal taxable income.
New York has displayed a similar approach with respect to the N.Y. estate tax after decoupling from the Federal estate tax exemption amount.
Can you blame New York? Not really. The IRS’s recently released annual data book (for 2019) states that, “For the past decade, the IRS has seen an increase in the number of returns filed as well as a decrease in resources available for examinations.” For example, in fiscal year “2010, the IRS received 230.4 million returns and employed 13,879 revenue agents, compared to 253.0 million returns and 8,526 revenue agents in FY 2019.”
[viii] And, thereby, avoid cuts in services.
[ix] Fortuitously for them, not for N.Y. The same can be said for many New York City residents who have decamped not only to neighboring states during the virus, but also Upstate or the East End.
[x] According to the U.S. Census Bureau, approximately 70 percent of Americans live in or close to the place where they grew up. There are probably many reasons for this, including familiarity and the presence of family.
[xi] The pace of southern- or southwestern-bound “former” New Yorkers had picked up well before the recent developments. The newspapers have been highlighting the more “significant” departures. Anecdotally, however, it appears that we can expect an additional increase.
[xii] Obviously, I use this word facetiously. I don’t believe there is anything political motivating their move.
[xiii] It is no easy thing to abandon one’s place of domicile; it requires much more than merely purchasing a condo apartment elsewhere, registering to vote in the new jurisdiction, and registering one’s car there. In some cases, it may require withdrawing one’s business from N.Y., among other things.
[xiv] After all, the taxpayer has the burden of proof to establish their abandonment of N.Y. and their establishment of a new domicile elsewhere.
[xv] Readers may recall that the State employs a “five principal factors” test to determine an individual taxpayer’s domicile. The five factors it will consider and weigh as between N.Y. and the state the taxpayer claims as its new home are the following: (i) the taxpayer’s physical residences in the two jurisdictions, (ii) the time the taxpayer spends in each of the two jurisdictions, (iii) the taxpayer’s active involvement in a N.Y. business, (iv) the location of the taxpayer’s near and dear items, and (v) the location of the taxpayer’s family connections.
[xvi] Indeed, the State has long recognized that the extent of an individual’s control and supervision over a New York business can be such that their active involvement in the business continues even during times when they are not physically present in New York.
https://www.taxlawforchb.com/2019/07/escape-from-new-york-it-will-cost-you/
[xvii] The Form IT-203, Nonresident and Part-Year Resident Income Tax Return, includes two columns, one on which the nonresident taxpayer enters their Federal income and the other on which they enter their New York income. I can’t tell you the number of cases I have seen where the two columns are almost identical, but for some investment income, yet the State fought to establish that the taxpayer was a resident. It no longer surprises me, but I continue to be disappointed at how public resources are being utilized.
Speaking of investment income, see https://www.taxlawforchb.com/2018/11/the-nonresident-taxpayer-vs-new-york-know-when-to-fold-em/
[xviii] NY Tax Law Sec. 631(a) and (b).
[xix] A nonresident will be subject to N.Y. personal income tax with respect to their income from:
- real or tangible personal property located in the State, (including certain gains or losses from the sale or exchange of an interest in an entity that owns real property in N.Y.);
- services performed in N.Y.;
- a business, trade, profession, or occupation carried on in N.Y.;
- their distributive share of N.Y. partnership income or gain;
- any income received related to a business, trade, profession, or occupation previously carried on in the State, including, but not limited to, covenants not to compete and termination agreements; and
- a N.Y. S corporation in which they are a shareholder, including, for example, any gain recognized on the deemed asset sale for federal income tax purposes where the S corporation’s shareholders have made an election under Sec. 338(h)(10) or Sec. 336(e) of the Code.
Although the foregoing list encompasses a great many items of income, there are limits to the State’s reach; for example, N.Y. income does not include a nonresident’s income:
- from interest, dividends, or gains from the sale or exchange of intangible personal property, unless they are part of the income they received from carrying on a business, trade, profession, or occupation in N.Y.; and
- as a shareholder of a corporation that is a N.Y. C corporation.
[xx] NY Tax Law Sec. 631(c). New York provides special allocation and apportionment rules for this purpose.
[xxi] NY Tax Law Sec. 631(b)(2). I should be noted that a nonresident who buys, holds, and sells securities for their own account (not a dealer) will not, by virtue of this activity alone, be treated as engaged in a N.Y. trade or business. NY Tax Law Sec. 631(d).
[xxii] NY Tax Law Sec. 631(b)(1)A)(1).
[xxiii] TSB-A-20(3)I. An Advisory Opinion is issued by the Department’s Office of Counsel at the request of a person or entity. It is limited to the facts set forth therein and is binding on the Department only with respect to the person or entity to whom it is issued and only if the person or entity fully and accurately describes all relevant facts. An Advisory Opinion is based on the law, regulations, and Department policies in effect as of the date the Opinion is issued or for the specific time period at issue in the Opinion.
In other words, it may not be cited as precedent. Nevertheless, such opinions provide a glimpse into the Department’s thinking with respect to a particular issue.
[xxiv] Remember the anti-stuffing rule described above?
[xxv] IRC Sec. 704.
[xxvi] NY Tax Law Sec. 631 and 632.
[xxvii] NY Tax Law Sec. 658(c)(4).
[xxviii] It should be noted that the liquidation of a partnership for tax purposes is not the same as its formal dissolution under state law. See, e.g., Reg. Sec. 1.332-2(c) which recognizes that the liquidation of an entity (a corporation, in that case) may be completed before its dissolution.
[xxix] IRC Sec. 731(a)(2) provides that a partner may recognize capital loss on a cash-only distribution in liquidation of their interest in the partnership. This loss is treated as loss from the sale or exchange of the partner’s interest in the partnership, which is generally treated as loss from the sale of a capital asset. IRC Sec. 741.
[xxx] NY Tax Law Sec. 631(a)(1) and Sec. 631(b)(1). https://www.taxlawforchb.com/2018/04/new-york-reminds-us-sale-of-intangible-property-may-be-taxable-as-sale-of-real-property/
[xxxi] NY Tax Law Sec. 631(a)(1), Sec. 632(a)(1).
[xxxii] NY Tax Law Sec. 631(b)(1)(A).
[xxxiii] NY Tax Law Sec. 631(b)(1)(A)(1).
[xxxiv] Under NY Tax Law Sec. 631(b)(1)(A).
[xxxv] NY Tax Law Sec. 631(b)(1)(A).
[xxxvi] Petitioner also argued that, upon the sale of the building, Petitioner was considered “functionally liquidated” and dissolved when it transferred its net proceeds to an account maintained by Affiliate. Therefore, Petitioner claimed it should be treated as having liquidated on the date of sale and its limited partners should be treated as having sold their partnership interests on that date. The Department, however, expressed no opinion as to whether Petitioner was considered to be functionally liquidated on that date.
[xxxvii] Reg. Sec. 301.7701-4(d); Rev. Proc. 94-45. https://www.taxlawforchb.com/2018/03/trusts-and-the-corporate-lawyer/
[xxxviii] IRC Sec. 671.