The Nonresident Taxpayer vs New York – “Know When to Fold ‘Em”[i]
November 13, 2018
NY’s Tax Jurisdiction
Last week we considered New York’s “statutory residence” rule pursuant to which an individual domiciled outside of New York may nevertheless be taxed by New York as to all of their income for a taxable year – including their business income – regardless of its source, by virtue of maintaining a permanent place of abode in the State for substantially all of the taxable year, and spending more than 183 days of the taxable year in New York.
Of course, New York’s taxing jurisdiction extends beyond those individuals who are domiciled or resident in New York, and covers nonresidents who have New York source income. Thus, a nonresident will be subject to New York 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 New York State);
- services performed in New York;
- a business, trade, profession, or occupation carried on in New York;
- their distributive share of New York 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 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 IRC section 338(h)(10).
Although the foregoing list encompasses a great many items of income, there are limits to the State’s reach; for example, New York 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 New York State; and
- as a shareholder of a corporation that is a New York C corporation.
A recent series of decisions, culminating in an opinion from the Third Department, considered one taxpayer’s futile attempt to fit within, or expand upon, these excluded items.
Income from “Intangibles”?
Spouse was a member of LLC, a company that was treated as a partnership for income tax purposes and that did business in New York. He assigned his entire 18.75% ownership interest in LLC to Taxpayer. Spouse and Taxpayer were residents of New Jersey[ii] during the periods at issue.
This assignment was challenged by other members of LLC, which resulted in litigation, and in a ruling that the assignment was valid.
Litigation and Settlement
Taxpayer then commenced an action against LLC seeking a valuation of her interest in LLC, including her share of its profits. After receiving an accounting report from a court-appointed referee, the trial court determined that Taxpayer was entitled to an award of approximately $600,000 for her ownership interest in LLC and a profit distribution of approximately $1 million, together with both pre- and post-judgment interest.
Shortly thereafter, Taxpayer settled her claim against LLC for just over $2 million, and the parties agreed that approximately $600,000 of that amount would be allocated as payment for her interest in LLC and “not as ordinary income.”
Tax Audit and Aftermath
Taxpayer and Spouse, being New Jersey residents,[iii] reported a capital gain of almost $600,000 and “other income” in the amount of almost $1.5 million on their federal return (IRS Form 1040), but none of the settlement was allocated to New York on their nonresident return (NY Form IT-203).
An audit by New York’s Department of Taxation and Finance ensued, and a notice of deficiency was issued assessing taxes and interest based on the $1.5 million that Taxpayer had identified as “other income.” Taxpayer and Spouse challenged the notice, but it was upheld by an Administrative Law Judge who noted that the litigation commenced by Taxpayer sought, among other things, her distributive share of LLC’s profits as the assignee of Spouse’s membership interest. The ALJ’s finding was, in turn, upheld by the Tax Appeals Tribunal.
Taxpayer brought an Article 78 proceeding in the Appellate Division of the Third Department to challenge the Tribunal’s decision upholding the deficiency.[iv]
The crux of Taxpayer’s challenge was that the “other income” was not taxable to them as nonresidents because it was a “return on an intangible asset” and not a distributive share of profits from a partnership doing business in New York.
The Court began by explaining that New York may tax a nonresident only on income that is “derived from or connected with New York sources.”[v] New York source income, the Court continued, includes a taxpayer’s “distributive share of partnership income, gain, loss and deduction.”
Further, the Court continued, “only the portion [of source income] derived from or connected with New York sources of such partner’s distributive share of items of partnership income . . . entering into [her] federal adjusted gross income”. . . is included as the source income of a partner or limited liability company member.[vi] The Court noted that this includes income “derived from or connected with . . . a business . . . carried on in this state.”[vii]
However, Taxpayer contended that the Tribunal was incorrect in upholding the assessment because she was neither a “partner” nor a member of LLC, and she did not receive a distributive share of profits from LLC. According to Taxpayer, her assignee interest did not allow her to participate in the management and affairs of LLC, or to exercise any rights or powers of a member. Thus, Taxpayer argued, she should not be subject to tax as a member of LLC.
Taxpayer also asserted that her assignee interest in LLC was an intangible asset, and that income from such an asset should not be considered New York source income.
The Court disagreed, stating that the “membership interest” assigned to Taxpayer included “the member’s right to a share of the profits and losses of the [LLC]”. As the assignee of a membership interest, Taxpayer was not automatically entitled to participate in the management or affairs of LLC, but she was entitled “to receive . . . the distributions and allocations of profits and losses to which the assignor would be entitled.”[viii] Considering these provisions, the fact that Taxpayer was not a member of LLC had no bearing on whether the profit distribution to her was taxable. Further, it was undisputed that LLC “carried on” business in New York.
Origin of the Claim?
According to the Court, to determine the taxable status of a sum reached by settlement of the litigating parties, it is generally necessary to consider “[i]n lieu of what were the damages awarded?”[ix] The record showed that the settlement payment was made in consideration of Taxpayer withdrawing the causes of action in her complaint seeking her share of LLC profits. The parties, through counsel, expressly allocated approximately $600,000 of the total settlement as payment for Taxpayer’s ownership interest in LLC and “not as ordinary income,” without further characterization.
Consistently therewith, Taxpayer and Spouse reported the balance of almost $1.5 million as “other income” on their tax returns.[x] Pointing to the award in the underlying litigation, they also claimed that a portion of the settlement was attributed to interest and, therefore, not taxable in New York.
The Court pointed out that while interest income is generally not taxable as nonresident personal income, it was Taxpayer’s burden to establish that the assessment was erroneous. However, no portion of the settlement payment was expressly attributed to interest.
The Court then observed that the litigation was resolved by settlement, not court order. Given this structure, the Court continued, the Tribunal reasonably concluded that $1.5 million of the settlement was for lost profits. As such, the Court declined to disturb the Tribunal’s finding in this regard.
Having found that the Tribunal’s determination had a rational basis and was consistent with the statutory language, and that Taxpayer’s interpretation was not the “only logical construction” of the relevant provisions,[xi] the Court decided to defer to the Tribunal’s construction, and concluded that the determination by the Department of Taxation to issue the notice of deficiency was reasonable and supported by substantial evidence.
Did Taxpayer actually believe that the income at issue was not taxable to a nonresident? The settlement payment was clearly attributable to Taxpayer’s interest in LLC’s profits, which were generated by the business that LLC conducted in New York. Accordingly, the “other income” was derived from New York sources and, as such, was taxable.
Yet Taxpayer stuck by her position through the audit, through the proceeding before the ALJ, through the Tax Appeals Tribunal, and through the Appellate Division.[xii]
The fact that the income at issue was not specifically addressed in the settlement, that is was paid “in exchange for” Taxpayer’s claims for her share of LLC profits, that Taxpayer labeled it as “other income” on her tax returns, and that she treated it as ordinary income for federal purposes, sealed the matter and forced Taxpayer to defend her position with fairly desperate arguments, like the one based upon her assignee status, described above.
Now, don’t get me wrong. There are times when perseverance in the face of many challenges may be commendable. There are also times, however, when advisers have to be blunt with their clients, when they cannot continue to stoke their hopes for a miracle, when no amount of legal creativity will save the day, when they simply have to throw in the proverbial towel.[xiii]
The moment for structuring a plausible argument for not taxing the settlement proceeds began when Taxpayer filed her first cause of action; it passed when the settlement was executed. Having failed to establish a basis for exclusion of the proceeds at that time, Taxpayer should have saved herself the additional interest, penalties and legal fees; she should have known “when to walk away.”[xiv]
[i] Apologies to Kenny Rogers, The Gambler.
[ii] I am told that people who live in New Jersey or who come from New Jersey are called New Jerseyites or New Jerseyans.
[iii] You may recall that last week’s post began with a review of the Tax Foundation’s State Business Tax Climate Index. You may also recall that NY did not fare too well with respect to individual income taxes, ranking 48th in the nation. Well, here’s some consolation: New Jersey ranked 50th.
[iv] Decisions rendered by the Tribunal are final and binding on the Department of Taxation and Finance, i.e., there is no appeal to the courts. Taxpayers who are not satisfied with the decision of the Tribunal have the right to appeal the Tribunal’s decision by instituting a proceeding pursuant to Article 78 of the Civil Practice Law and Rules to the Appellate Division Third Department of the State Supreme Court.
[v] Tax Law Sec. 631. https://codes.findlaw.com/ny/tax-law/tax-sect-631.html
[vi] Tax Law Sec. 632(a). https://codes.findlaw.com/ny/tax-law/tax-sect-632.html
[vii] Tax Law § 631(b)(1)(B). https://codes.findlaw.com/ny/tax-law/tax-sect-631.html
[viii] NY Limited Liability Company Law § 603. https://codes.findlaw.com/ny/limited-liability-company-law/llc-sect-603.html
[ix] What federal tax jurisprudence refers to as “the origin of the claim.”
[x] Indeed, they reported this amount as ordinary income on their federal tax return.
[xi] The Court was being kind.
[xii] “Please sir, may I have another?”
[xiii] Remember what happened to Apollo Creed in Rocky IV when the eponymous Rocky hesitated?
[xiv] As the refrain says:
You’ve got to know when to hold ’em
Know when to fold ’em
Know when to walk away
And know when to run