Statutory Resident? Selling Your New York Business? Welcome to Double Taxation?
October 15, 2019
General Principles
Many business owners who reside in New York, and whose business is headquartered in the state, pay income taxes not only to New York, but to other jurisdictions as well.
For example, the resident owners of a business may operate through a corporation that has elected to be treated as an S corporation,[i] or through a limited liability company that is treated as a partnership for tax purposes.[ii] This pass-through entity[iii] may be doing business outside New York. Because of the entity’s pass-through nature, the owners themselves may be considered as engaging in business within those jurisdictions.[iv] Thus, the New York owners may be required to file a nonresident income tax return in such a “foreign” jurisdiction in order to report their share of the business’s income that is sourced in that jurisdiction, and to pay the resulting tax liability.[v]
Of course, each resident owner will also file a resident income tax return with New York. These returns will report the owner’s entire income, regardless of source,[vi] and will determine the New York tax thereon.[vii]
The resident return will also report the income taxes paid by the resident owner to other jurisdictions on account of the owner’s deemed “business activities” therein.[viii]
Tax Credits
These “foreign” taxes generally will be credited against the tax owing by the resident owner to New York, in order to ensure that the same items of income are not taxed twice – once by New York and once by the source jurisdiction.[ix]
Specifically, the resident owner will be allowed a credit against the tax otherwise due New York only for that portion of any personal income tax imposed by the other jurisdiction that is “applicable to the income derived from sources within such other taxing jurisdiction.”[x]
Generally speaking, the term “income derived from sources within” another state is construed so as to limit the income for which New York will allow a credit to income that is attributable to real property in the other state, or to a trade or business carried on in the other state.[xi]
Income from intangible property is not treated as “income derived from sources within” another state unless the intangible property is employed in a business carried on in that other state.[xii] Thus, gains from the disposition of intangible personal property – for example, from the sale or exchange of shares of stock – will not constitute income derived from within another state except to the extent that the property is employed in a business carried on in the other state.[xiii]
Consequently, New York’s credit for “foreign” taxes generally does not extend to investment income from intangible personal property that is taxed by other states. For all intents and purposes, such income is without a geographical situs insofar as New York is concerned.
“Dual Residence”
New York’s tax credit rules may seem “limited” in that a large category of taxable income is excluded from their purview.
It should be noted, however, that a state – including New York[xiv] – will generally not impose a tax on a nonresident’s income from intangible personal property except to the extent the property is used in a business in that state. The taxation of such income is left to the individual’s state of residence, which renders moot the question of a credit for taxes paid by that individual on such income to another state.
But what happens when an individual taxpayer is a resident of two states?
Statutory Residence
There are instances in which an individual taxpayer who is not domiciled[xv] in New York will nonetheless be treated as a resident of New York for a particular tax year. Specifically, if the individual maintained a permanent place of abode[xvi] in the state for substantially all of the taxable year[xvii] and spent more than 183 days in the state during such year, they will be taxed a New York resident.[xviii]
In that case, the taxpayer is required to file as a resident of their state of domicile and as a resident of New York.[xix] In most cases, that means they have to report all of their income, from whatever source, to both states, and they have to pay tax on the same income to both states.
Unfortunately for most taxpayers, they are not aware of their classification as a “statutory resident” of New York until they have been audited by the state’s Department of Taxation and Finance, at which point they face not only a tax deficiency,[xx] but also interest and penalties.
And if that isn’t enough of a shock, the newly anointed statutory resident also learns at that time that the credit which New York extends for taxes paid to other states, on income derived from those states, is generally not available for intangible income because that income has no identifiable situs. In other words, such income generally is not deemed to have been derived from the taxpayer’s efforts in any jurisdiction outside of New York, and it cannot be traced to any jurisdiction outside New York. Rather, it is treated as investment income which is subject to tax in New York as the taxpayer’s state of residence.
In the case of a New York statutory resident who is domiciled in another state, these tax rules may cause the individual taxpayer to actually be taxed twice – by New York and by their state of domicile – on the same income from intangible property.
Sounds outrageous, doesn’t it?
The Edelman Case
One taxpayer certainly thought it did.
“Taxpayer” was domiciled in Connecticut in the years 2010 and 2013, but also maintained a home in New York City, where they had worked for thirty years and where, in 2003, they had formed a corporation (“Corp”), with its only office in New York City.
Both before and after they sold Corp to Buyer in 2010, Taxpayer – who commuted from Connecticut – served as an executive in New York City of what prior to the sale was Corp, and thereafter was a division of Buyer. Taxpayer was physically present in New York City for more than 183 days during both 2010 and 2013.
In the transaction with Buyer in 2010, Taxpayer sold their shares of Corp’s outstanding stock, of which they owned 95-percent, generating significant capital gains. In addition, in both 2010 and 2013, Taxpayer had interest and dividend income from investments in securities, in addition to their wage income from either Corp or Buyer.
Taxpayer filed Connecticut Resident Income Tax Returns for 2010 and 2013, and paid Connecticut tax on the income reported.
In their New York income tax returns for 2010 and 2013, Taxpayer claimed to be a “nonresident” of New York, and reported a substantial part of their wage income as “New York source,” because it resulted from Taxpayer’s work in New York City.
However, Taxpayer failed to treat any of their interest, dividends or capital gain income in either year as “New York source” because, as Taxpayer alleged, “it constituted income from intangible property.”[xxi]
New York’s Position
In 2014, the Department of Taxation and Finance commenced an audit of Taxpayer’s 2010 and 2013 New York tax returns, and concluded that Taxpayer was a “statutory resident” of New York State and of New York City during those years. As such, Taxpayer became subject to New York tax on their worldwide income regardless of the source of such income. This included the gain derived from the sale of their Corp stock to Buyer in 2010.
The Department issued a Notice of Deficiency asserting additional New York State and New York City income tax due from Taxpayer in excess of $4 million, plus interest of almost $2 million. Taxpayer had paid these amounts prior to the Notice of Deficiency, under protest, in order to stop the accumulation of interest.[xxii]
The Courts
In 2016, Taxpayer commenced a declaratory judgement action in the Supreme Court of New York,[xxiii] New York County, in which they claimed that New York’s statutory residence scheme – under which taxpayers who were treated as statutory residents were denied credits for taxes actually paid to their state of domicile in respect of intangible income – violated the U.S. Constitution by discriminating against, or unduly burdening, interstate commerce.[xxiv]
Well, it didn’t go too well for Taxpayer.
The Department asked the Supreme Court to dismiss Taxpayer’s action for failure to state a cause of action. The Department contended that Taxpayer’s intangible income was being taxed solely because they were New York residents. It further claimed that Taxpayer’s status as a commuter was not at issue, only their “degree of permanence” in New York. The Department also argued that the double taxation issue had no merit because Taxpayer enjoyed the privileges of protection of two states, and were given tax credits in New York for taxes paid for income “derived from” the other states.
The Court observed that Taxpayer owned an apartment in New York City, worked in New York City, and had a presence in New York for more than 183 days. Thus, Taxpayer was being taxed as a New York statutory resident. Taxpayer described themselves as domiciled in Connecticut and paying taxes in that state, but the intangible income being taxed by New York, the Court noted, was not specifically derived from employment or business conducted outside New York. Therefore, the taxation in New York did not involve income derived from Connecticut.
Accordingly, the Court dismissed Taxpayer’s complaint.[xxv]
Undeterred, Taxpayer appealed the Supreme Court’s decision to the Appellate Division[xxvi] but, in 2018, this Court upheld the lower court’s decision in a one-page opinion.[xxvii]
Perhaps thinking that the third time would be the charm, earlier this year Taxpayer asked New York’s highest court to consider its case. The Court of Appeals, however, denied Taxpayer’s motion for leave to appeal, upon the ground that no substantial constitutional question was directly involved.[xxviii]
Finally, Taxpayer asked the U.S. Supreme Court to review the decisions of the New York courts. Last week, the Taxpayer’s petition for writ of certiorari was denied.[xxix]
So Where Are We?
The refusal by the U.S. Supreme Court (i) to review the New York Court of Appeals’ refusal (ii) to review the Appellate Division’s decision (iii) to uphold the New York Supreme Court’s decision (iv) to dismiss Taxpayer’s action for failure to state a cause of action – take a deep breath – leaves intact New York’s scheme for taxing the intangible income of statutory residents.
That means a business owner who is domiciled in another state – say, in any of the states that are contiguous to New York (Connecticut, Massachusetts, New Jersey, Pennsylvania or Vermont) – and whose business is in New York, who works in New York in excess of 183 days during a taxable year, and who has a permanent place of abode in New York, whether or not such place of abode is located anywhere near the place of business, will be subject to New York income tax with respect to all of their income as if they were a resident of New York.
If the owner disposes of their business during a period of statutory residence – a status of which the owner may not become aware until a couple of years later, and only after an audit by New York – their gain realized from the sale will be subject to New York income tax as though the owner were a New York resident. Thus, the gain would be taxed at the state level at a tax rate of 8.82-percent and, if the owner is also treated as a statutory resident of New York City, an additional tax at a rate of 3.876-percent will be imposed on such gain.
Can it get any better than this? Yep. The “pièce de résistance” is New York’s denial to the statutory resident of any credit for tax paid by the owner on this very same gain to the owner’s state of domicile.
Ah, the bliss of double taxation.
I ask you: is the New York tax on the sale of a non-domiciliary’s New York business worth the apartment in New York City, or the lodge in the Adirondacks, or the beach house in Montauk, or the cabin near the Finger Lakes?[xxx]
Before such an individual disposes of their New York business in a taxable transaction, they need to address the issue of their permanent place of abode.
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[i] IRC Sec. 1361 and Sec. 1362.
[ii] IRC Sc. 761; Reg. Sec. 301.7701-3.
[iii] The entity’s income is generally not taxed at the entity-level but, rather, passes through to its owners who report it on their own tax returns. IRC Sec. 701, Sec. 702, Sec. 1363, Sec. 1366.
[iv] There is a comparable rule with respect to non-U.S. persons who are partners of a partnership doing business in the U.S. See IRC Sec. 875.
[v] In some cases, the entity may have to make estimated tax payments to the “foreign” jurisdiction on behalf of its nonresident partners.
[vi] I.e., from all jurisdictions.
[vii] Tax Law Sec. 612(a).
[viii] I.e., through the pass-through entities of which they are a shareholder or a member/partner.
[ix] Assuming that income is subject to tax in New York. Tax Law Sec. 620(a).
[x] 20 NYCRR Sec. 120.1(a)(2).
[xi] 20 NYCRR Sec. 120.4(d). It may also include income related to a business previously carried on in that state, including, for example, payments under a covenant not to compete.
[xii] Tax Law Sec. 631.
[xiii] A business owner’s shares of stock in the corporation through which the owner operates their business do not fall within this category.
[xiv] Tax Law Sec. 631(b)(2).
[xv] “Domicile” refers to an individual’s “permanent” home. An individual can have only one domicile. One’s domicile does not change unless one can demonstrate that they have abandoned such domicile and have established a new domicile elsewhere. NYCRR Sec. 105.20(d).
[xvi] NYCRR Sec. 105.20(a).
[xvii] Generally speaking, at least eleven months.
[xviii] Tax Law Sec. 605(b). So-called “statutory residence.” It “serves the important function of taxing those ‘who, while really and [for] all intents and purposes [are] residents of the state, have maintained a voting residence elsewhere and insist on paying taxes to us as nonresidents.’” Tamagni, 91 N.Y. 2d at 535 (quoting Bill Jacket, L.1922, ch 425).
[xix] https://www.taxlawforchb.com/2019/09/statutory-residence-in-ny-the-permanent-place-of-abode-test-is-in-need-of-repair/
[xx] For which a federal itemized deduction may not be presently available, courtesy of the Tax Cuts and Jobs Act (P.L. 115-97).
[xxi] Which is not taxable to a nonresident of New York unless the property is used by the nonresident in a New York trade or business.
[xxii] The power of compound interest.
[xxiii] The trial-level court in New York.
[xxiv] The “dormant commerce clause.”
[xxv] Edelman v. New York State Department of Taxation and Finance, 2017 WL 2537050 (N.Y.Sup.) (Trial Order), Supreme Court of New York, New York County.
[xxvi] This court hears appeals from lower courts in New York, including the Supreme Court.
[xxvii] Edelman v. New York State Department of Taxation and Finance, 162 A.D.3d 574, Supreme Court, Appellate Division, First Department, New York.
[xxviii] Edelman v. New York State Department of Taxation and Finance, 32 N.Y.3d 1216, Court of Appeals of New York.
[xxix] Edelman v. New York State Department of Taxation and Finance, 2019 WL 4921468, Supreme Court of the United States.
[xxx] What’s wrong with the Vermont side of Lake Champlain, or the Poconos, or the Berkshires, or the Connecticut shore? What’s wrong with staying in a New York City hotel? I’m just saying.