States’ Rights, State Taxation, And . . . New York “S” Elections?
February 03, 2020
How Did We Get Here?
On September 9, 1776, Congress officially adopted “United States” of America as the name of our then-newly-born nation. The former British colonies had previously referred to themselves as the “United Colonies.” In March of 1781, the Articles of Confederation went into effect, after having been ratified by all thirteen States.[i] According to Article 2, “Each state retains its sovereignty, freedom, and independence, and every power, jurisdiction, and right, which is not by this Confederation expressly delegated.” The Articles ensured a weak central government. For instance, Article 8 effectively denied Congress the right to tax; instead, Congress would request financial assistance from the States, which would raise and provide the necessary funds. We know how well that worked out.
In 1789, the Constitution replaced the Articles of Confederation. Article I, Section 8 of the Constitution bestowed upon Congress the “Power To lay and collect Taxes,” subject to certain limitations.[ii] It also gave Congress the power “to regulate Commerce . . . among the several States . . .” Two years later, the Tenth Amendment to the Constitution was ratified,[iii] to clarify that “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.” It was understood that, among the powers reserved to the States, was the right to impose any kind of taxes, except those forbidden by the Constitution.[iv]
Notwithstanding this reservation of rights, however, one implication of Congress’s power to regulate commerce was that States could not impose taxes that discriminated against, or that placed an undue burden” on, interstate commerce.[v]
With the ratification of the Fourteenth Amendment following the Civil War, the States were prohibited from depriving “any person of life, liberty, or property, without due process of law.” Many of you will recall from your law school classes that this provision was interpreted to prohibit a State from taxing a business unless the business had some minimal connection to the taxing State.[vi]
Fast forward, again.
In 1959, Congress enacted Pub. L. 86-272 in order to prohibit a state from imposing an income tax on the net income of an out-of-state business from the interstate sale of tangible personal property when the business had no physical presence in the State other than that of a salesman who solicited orders, provided the orders were approved and filled outside the State.
However, this statute does not apply where the income at issue was not generated by the sale of tangible personal property but, rather, by the sale of services or of intangibles.[vii] Thus, a State may tax an allocable portion of the net income of an out-of-state business engaged in selling services or intangibles into the taxing State.
Fast forward one more time.[viii]
After decades of jurisprudence that, by-and-large, restricted a State’s ability to tax the revenues of an out-of-state business, the Wayfair decision – and its elimination of a physical presence requirement from the “substantial nexus” test for the imposition of sales tax – may signal a relaxation of those restrictions and a move toward an “economic nexus” test.[ix]
In fact, recent history indicates that the trend toward economic nexus was already underway some time before Wayfair – as it was in New York, which in 2015 enacted an economic nexus standard for businesses with over $1 million in receipts from activities in the State.[x]
Today, it is not enough for a closely held business that engages in commercial activity on at least a regional scale to be aware of its tax situation under the Code[xi] and under the tax laws of its “home” jurisdiction; it must also consider the application of the tax laws of every other State or local jurisdiction with which the business may have a taxable nexus.[xii] This is no small matter.
Of course, not every issue to be considered will rise to the level of a constitutional debate. Most will be quite “ordinary;” yet the failure of the business or – in the case of a pass-through entity – of its owners to consult local tax counsel on even seemingly mundane matters may result in an expensive surprise, especially in the context of selling the business, as was illustrated by the case described below, which involved the proper treatment of the sale of the stock of two corporations (the “Targets”) under New York Tax Law.[xiii]
The Stock Sale
A corporation (“Buyer”) acquired 100-percent of the stock of the Targets from Sellers in exchange for cash and Buyer stock (the “Sale”). The Targets sold their products throughout the Northeast. Sellers resided outside New York. Each Target was treated as a subchapter S corporation for Federal income tax purposes.[xiv] Neither had filed a separate New York S corporation election.[xv]
In connection with the sale, Buyer and Sellers made valid elections under Section 338(h)(10) of the Code. As a result of these elections, Buyer’s acquisition of the Targets’ stock was treated as a sale of assets by the Targets, followed by a liquidating distribution to Sellers – at least for purposes of the Code.
For the year of the Sale, Sellers reported gains on their Federal personal income tax returns[xvi] from the deemed sale of Targets’ assets resulting from the Section 338(h)(10) elections. However, for New York tax purposes, Sellers treated the Targets as New York C corporations to which the Section 338(h)(10) elections would not apply for New York tax purposes. Accordingly, Sellers believed they did not have any New York source gain from the sale of the stock of the Targets.[xvii]
The Division of Taxation (the “Division”) audited Sellers, and concluded that both Targets should have been treated as New York S corporations, not New York C corporations.
The Division concluded that, for purposes of the New York corporation franchise tax, as well as the personal income tax, the Sale should not have been treated as a sale of stock but, rather, as a deemed sale of assets by the Targets in accordance with Section 338(h)(10) of the Code. Because S corporations are pass-through entities, the gain from the deemed asset sale would have flowed through to Sellers (as the shareholders of the Targets); and, to the extent any of such gain was sourced in New York, the Targets’ nonresident shareholders should have included in their New York income their pro rata share of such gain for purposes of determining their New York tax liability.
The Division issued notices of deficiency to the Sellers, who then timely filed protests with the Division of Tax Appeals (“DTA”).[xviii]
The DTA indicated that the Targets were New York State “eligible S corporations.”[xix] It explained that an S corporation was a flow-through entity in that its items of income, gain, etc., were included by its shareholders on their personal income tax returns for purposes of determining their individual tax liability. “Tax integrity,” the DTA explained, “is preserved by requiring shareholders to treat all income and deductions as if ‘realized directly from the source from which realized by the [S] corporation, or incurred in the same manner as incurred by the corporation.’”[xx]
The DTA observed that the states generally conform to the Federal pass-through treatment of an S corporation, but only if the corporation has filed a valid S corporation election for Federal tax purposes.[xxi] It noted that, although most states provide that the filing of a Federal S corporation election automatically qualifies the corporation as an S corporation for state tax purposes, a handful of states – including New York – require taxpayers to comply with additional procedures in order to make a valid S corporation election as a matter of state law.
IRC Section 338(h)(10)
The fact that certain states, including New York, do not accept the Federal S corporation election as determinative for state tax purposes, may have significant consequences for the shareholders of a Federal S corporation that is planning to sell its business.
In general, upon the sale of a shareholder’s S corporation stock to another corporation, the selling shareholder recognizes capital gain or loss on the sale.[xxii]
In the case of a “qualified stock purchase,” however, the purchaser and the seller(s)[xxiii] may make an election under Section 338(h)(10) of the Code whereby the sale of stock by the selling shareholders is disregarded for tax purposes;[xxiv] instead, the target corporation is treated as having sold all of its assets, following which the target is treated as having made a liquidating distribution to its shareholders. As a result of the deemed sale of its assets, the target S corporation recognizes gain or loss on the difference between the fair market value of its assets and their adjusted basis.[xxv]
Because of the pass-through nature of an S corporation, the tax attributes[xxvi] of the deemed asset sale flow through to its shareholders on the Federal level.[xxvii] If the corporation is also a New York S corporation, the same consequences will follow for New York tax purposes.[xxviii]
N.Y. S Corp. Election
In general, New York does not require a Federal S corporation to file as a New York S corporation; rather New York permits a Federal S corporation to be treated as a New York S corporation for State tax purposes if the corporation’s shareholders elect such treatment – in the absence of an election, the corporation is treated as a C corporation under New York law.[xxix]
The DTA explained that, for many years, the decision to remain taxable as a C corporation under New York Tax Law was completely up to the shareholders, as indicated immediately above. However, in 2007, New York enacted a provision[xxx] which mandates that certain Federal S corporations be treated as New York S corporations regardless of whether the shareholders elected to treat their corporation as such.
Specifically, the shareholders of a Federal S corporation will be treated as having made a New York S corporation election, effective for the corporation’s entire current taxable year, if the corporation’s investment income[xxxi] for the taxable year is more than fifty percent of its Federal gross income for such year. If the fifty percent test is not met for a taxable year, the corporation will be treated as a New York C corporation for that year, even if the corporation was treated as a New York S corporation under this provision for the prior year.[xxxii]
Sellers argued that the Targets were New York C corporations, and that application of the above provision, which compares a Federal S corporation’s “investment income” to its “Federal gross income” (the “Investment Income Ratio Test”), did not convert the Targets to New York S corporations.
Sellers asserted that, because the Targets did not elect to be New York S corporations, they were by default New York C corporations; thus, Sellers claimed, the Investment Income Ratio Test should be applied upon each corporation’s tax numbers as derived from pro forma New York C corporation returns. These pro forma returns calculated what the Targets’ return numbers would be if, rather than being Federal S corporations, the Targets were Federal C corporations.
The Division countered that the Investment Income Ratio Test should be calculated using the corporations’ actual Federal S corporation tax return numbers.
The DTA started its analysis by recognizing that both Targets were “eligible S corporations” under New York Tax Law. Thus, before they could file as New York C corporations, they had to run the gauntlet of the Investment Income Ratio Test.
The definition of an “eligible S corporation” as a “[Federal] S corporation” leads, the DTA stated, to the conclusion that when calculating an eligible S corporation’s “Federal gross income,” its actual Federal S corporation return is the return that is used for the Investment Income Ratio Test, not the pro forma New York C corporation tax numbers. If the latter were used, the DTA added, the deemed asset sale by the Targets would not be classified as gross income from the sale of assets but rather income to the shareholders directly from the sale of their stock in those corporations.
The DTA pointed out, given the fact that the Tax Law instructs parties to utilize “federal gross income” for completion of the Investment Income Ratio Test, the most logical answer was for an eligible S corporation’s Federal S corporation tax return information to be used for completion of the test, not New York C corporation pro forma tax numbers.
This conclusion was further supported by the Division’s longstanding public position that the Investment Income Ratio Test was performed using the eligible S corporation’s federal S corporation’s tax return numbers.[xxxiii]
Investment Income Ratio Test
The DTA then applied the test to calculate each Target’s investment income. “Investment income,” it stated, was defined to include “the sum of an eligible S corporation’s gross income from interest, dividends, royalties, annuities, rents and gains derived from dealings in property, . . . , to the extent such items would be included in federal gross income for the taxable year.”[xxxiv]
Although the Tax Law did not explicitly refer to the Federal definition of gross income,[xxxv] the DTA nonetheless decided that it was appropriate to utilize this definition to determine the individual components of investment income for the Investment Income Ratio Test.
Among the items included as investment income for purposes of the Investment Income Ratio Test were “gains derived from dealings in property.” These gains are also included in Federal gross income and, what’s more, the relevant Treasury Regulations specifically define “gains derived from dealings in property” to include the “gain realized on the sale or exchange of property . . . [including] . . . intangible items, such as goodwill.”[xxxvi]
The DTA observed that the Targets reported[xxxvii] the majority of their respective gains from the deemed sale of assets as gains from the “sale of intangibles and goodwill.” This self-reported classification of the income fell within the parameters of the gains derived from dealings in property and, thus, were properly classified as “investment income.” Likewise, the gains classified by the Targets as “4797” gains presumably related to gains from the sale of business property[xxxviii] and, as such, fell under the umbrella of “gains derived from dealings in property.” Because the gains from the above sales accounted for the majority of the total investment income calculated, the DTA concluded that the remaining components would be immaterial to the determination of the mandatory S corporation election.
The DTA then applied the Investment Income Ratio Test to each Target. After dividing each corporation’s investment income by its Federal gross income, it determined that the resulting ratio exceeded fifty percent.
New York Source
Finally, the DTA rejected Sellers’ argument – based on their position that the gain from the sale of the Targets’ stock should be treated as gain from the sale of an intangible – that they had no gain from New York sources, notwithstanding the deemed asset sale result afforded under Section 338(h)(10) of the Code. It pointed out that the Tax Law was amended in 2010 to address the issue of nonresident S corporation shareholders’ treatment of gains related to the deemed asset sale. Such gains, the DTA stated, were not excluded from a nonresident’s New York source income as gains from the disposition of stock but, rather, were included to the extent of the S corporation’s New York business allocation percentage.
With that, the DTA concluded that the Targets were required to file as New York S corporations because they triggered the mandatory election. Thus, the sale of their stock by the Sellers was treated as the sale of the Targets’ assets because of the election under Section 338(h)(10) of the Code. Furthermore, in determining their New York tax liability, the Sellers had to include the income from the deemed sale of assets as income from a New York source.[xxxix]
“State” of Confusion
The foregoing discussion touched upon one discrete example of how a nonresident business, or the individual owners of such a business, may incur an expensive tax bill because they failed to consider the tax laws of one of the “foreign” jurisdictions in which the business is conducted.
There are other situations in which a nonresident individual or corporation with respect to a State may unexpectedly find that they are a taxpayer of that State, or that their tax liability to that State was more than they had anticipated.
A business that is engaged in interstate commerce – or is thinking about it – should not assume that the tax laws of other jurisdictions are identical to the Federal tax rules, or to those of the business’s home jurisdiction, let alone to each other’s.
Moreover, the business and its owners should not assume that they will be allowed to credit the tax paid to one State against the tax owed to another – they are not necessarily looking at a zero-sum game.[xl]
This state of affairs is a natural by-product of our system of government and its reservation to the States of their power to tax, subject to certain limitations – some of which are being reduced.[xli]
For much of our history, the Federal government, including the Courts, sought to prevent what they believed would be the adverse effects on commerce arising out of the presence of differing tax rules among the States – and to thereby encourage greater uniformity across State lines – so as to facilitate the growth of interstate commerce.[xlii]
If Wayfair is representative of the direction in which the States, and the Courts, seem to be moving, it appears that a lack of uniformity may be the new norm in State taxation that affects interstate commerce.[xliii]
Thus, it will behoove a closely held business that is considering an expansion beyond its State of residence to consult with tax advisers who are well-versed in the laws of the jurisdictions that the business is targeting. The business needs to consider these laws and how they interact with those of its home State, and it should quantify the consequences thereof, before the business actually starts conducting any activities within these other jurisdictions.
[i] The defeat of Cornwallis at Yorktown wasn’t until October of 1781.
[ii] For example, Article I, Section 9 provides that “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.”
Of course, in 2013, the Sixteenth Amendment was ratified: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”
[iii] As part of the Bill of Rights.
[iv] For example, according to Article I, Section 10, “No State shall, without the Consent of the Congress, lay any Imposts or Duties on Imports or Exports.”
[v] This is referred to as the “dormant” commerce clause doctrine.
Apologies for having skipped over many years of our history, including Secession, the Civil War, the heavily litigated Fourteenth Amendment (one of the Reconstruction Amendments), and the Sixteenth Amendment, as well as the Supreme Court’s rulings on the New Deal, the expansion of Federal power, and the use of the “commerce clause” to restrain the exercise of certain state rights.
Speaking of secession, I recommend Colin Woodard’s July 30, 2018 opinion piece in the N.Y. Times. Mr. Woodard is the author of “American Nations: A History of the Eleven Rival Regional Cultures of North America.” He argues that the United States is effectively comprised of 11 nations, most of which correspond to one of the rival European colonial powers and their respective geographic settlement zones. He calls them: Yankeedom; New Netherland; the Midlands; Tidewater; Greater Appalachia; Deep South; El Norte; the Left Coast; the Far West; New France; and First Nation.
[vi] So much for original intent.
[vii] See, e.g., Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2nd 13 (S.C. 1993), cert denied, 114 S.Ct. 550 (1993), where the South Carolina Supreme Court found that the State could impose an income tax on the royalty income from the licensing of an intangible (a trade name) into the State notwithstanding the absence of a physical presence for the licensor.
[viii] As if we weren’t already rushing.
[ix] South Dakota v. Wayfair, 585 U.S. __ (2018). Stay tuned.
[x] NY Tax Law Sec. 209(1)(b). In other words, the State will tax corporations based upon where their customers are located, not where their employees or property are located.
Of course, New York will continue to tax on the basis of physical presence where the receipts test is not satisfied; for example, where the out-of-state business maintains an office in New York, or owns property in the State. NYCRR Sec. 1-3.2.
[xi] The Internal Revenue Code of 1986.
To my brothers and sisters of the bankruptcy bar, I say “There can be only one,” to borrow the tagline from The Highlander movie.
[xii] Whether in the way of physical or economic nexus.
Although Wayfair involved the imposition of sales tax, it may have a profound impact upon State income taxation of out-of-state business.
[xiii] In re LePage et al., N.Y. Div. Tax App., No. 828035 et al., 12/19/19.
[xiv] IRC Sec. 1361 and Sec. 1362. According to the agreement pursuant to which the Sale was completed, the Targets were valid S corporations under various state laws that were identified on a schedule attached to the agreement.
[xv] NY Tax Law Sec. 660 (a). NY Form CT-6.
[xvi] IRS Form 1040.
[xvii] In the case of a nonresident, gain from the sale of stock – intangible property – is sourced at the residence of the seller, unless the property is used in a business carried on in New York. NY Tax Law 631(b)(2).
One of the Sellers voluntarily filed a New York nonresident income tax return (NY Form IT-203) for the year of the Sale, and self-reported New York sourced income unrelated to the Sale.
[xviii] The DTA is separate from the Department of Taxation and Finance. It considers taxpayer petitions for relief following the issuance of a notice of determination. The DTA’s hearing function is performed by Administrative Law Judges, who conduct formal hearings and render written determinations. These determinations may, themselves, be appealed.
[xix] As defined under NY Tax Law Sec. 660 (a).
[xx] See IRC Sec. 1366(b).
[xxi] On IRS Form 2553.
[xxii] IRC Sec. 1001.
[xxiii] All of the shareholders of the S corporation, including any shareholders who have not sold their stock, and the acquiring corporation must consent to the election. Reg. Sec. 338(h)(10)-1.
[xxiv] The selling shareholders recognize no gain or loss on the disposition of their stock.
[xxv] See also IRC Sec. 336(e) and Reg. Sec. 1.336-2 through 1.336-5, effective for dispositions of stock on or after May 15, 2013.
[xxvi] For example, ordinary income or capital gain.
[xxvii] IRC Sec. 1366.
[xxviii] NY Tax Law Sec. 660.
[xxix] NY Tax Law § 660(a).
[xxx] NY Tax Law Sec. 660(i).
[xxxi] The term ‘investment income’ means, for this purpose, the sum of the corporation’s gross income from interest, dividends, royalties, annuities, rents and gains derived from dealings in property, including the corporation’s share of such items from a partnership, estate or trust, to the extent such items would be includable in Federal gross income for the taxable year.
[xxxii] See TSB-M-07(8)I.
[xxxiv] NY Tax Law Sec. 660(i)(3).
[xxxv] IRC Sec. 61.
[xxxvi] Reg. Sec.1.61-6.
[xxxvii] On IRS Form 8949, Sales and Other Dispositions of Capital Assets.
[xxxviii] Reported on federal IRS form 4797.
A nonresident will be subject to New York personal income tax with respect to their income from: (i) 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 New York State); (ii) services performed in New York; (iii) a business, trade, profession, or occupation carried on in New York; (iv) their distributive share of New York partnership income or gain; (v) 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 (vi) a New York 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 has made an election under Section 338(h)(10) of the Code.
[xli] See Federalist Papers Nos. 30 through 36 for Hamilton’s response to those opposing the power of the national government to impose taxes, in part on the belief that such a power would make it difficult for the States to raise revenues for their own needs.
[xlii] Yes, I may be overgeneralizing somewhat, but the statement is accurate.
[xliii] Sellers argued that the New York Tax Law violated the commerce and due process clauses of the Constitution, in part relying on the Wayfair decision. They also argued that the automatic S corporation election violated the equal protection clause. The DAT rejected these arguments. “As a general rule, “legislatures are presumed to have acted within their constitutional power despite the fact that, in
practice, their laws result in some inequity.”