New York Disallows Residents a Tax Credit on Intangible Income

By: Tina M. Chunnm, SALT Senior Manager

At a glance

• The main takeaway: Your state of residence may provide a credit for income tax you pay to another state, but that isn’t always the case.
• Impact on your tax obligations: A recent story out of New York sheds light on this issue, after taxpayers were denied resident tax credits (RTCs) claimed for income tax they paid in Connecticut on carried interest income, which resulted in tax paid to two states on the same income.
• Next steps: Aprio’s State and Local Tax (SALT) team can help assess whether or not you are entitled to an RTC, and also recommend alternative structures to mitigate unfavorable tax results.

Schedule a consultation with Aprio

The full story:

Did you know that your state of residence may not always be required to give you a credit for taxes paid to another state? This was the subject of a recent New York State Tax Division of Tax Appeals ruling that disallowed taxpayers’ resident tax credits (RTCs) claimed for income tax paid to Connecticut on carried interest income.[1] 

Take a closer look at the case

The taxpayers were New York residents and filed individual income tax returns that included flow-through income on a K-1 issued by a partnership operating as a hedge fund. The K-1 reported ordinary income of the partnership as well as carried interest representing interest income, dividends and capital. The taxpayers reported these amounts on both of their Connecticut nonresident returns as Connecticut source income under Connecticut laws. On their New York resident returns, the taxpayers claimed an RTC for the income taxes paid to Connecticut. New York accepted the RTC for the amounts related to ordinary income, but the state disallowed the portion related to taxes paid on the carried interest income. 

New York allows an RTC for income tax imposed by another state on income derived from that other state and that is subject to New York tax.[2] Thus, for taxpayers to receive a credit for taxes paid to Connecticut, they must prove that:

1. Connecticut imposed a tax on the income;
2. The income was derived from Connecticut; and,
3. The income was subject to New York State tax.

The parties did not dispute that the income was taxed in Connecticut and was subject to tax in New York; therefore, the ruling focuses on whether or not the income is derived from Connecticut.

Under New York regulations, “[t]he term income derived from sources within another state . . . is construed so as to accord with the definition of the term derived from or connected with New York State sources . . . in relation to the New York source income of a nonresident individual.”[3] In other words, New York looks to how it would source income earned by a nonresident to make the decision. For example, if a resident earns compensation for performing services in another state, any tax paid to another state would be eligible for the RTC because New York would view compensation earned by a nonresident performing services in New York as derived from New York sources.

In this case, the taxpayers earned intangible income, reported as interest income, dividends and capital gains flowing from the partnership. New York considers income from intangible personal property as derived from New York sources to the extent the income is from property employed in a business, trade, profession or occupation carried on in New York.[4] However, New York provides that trading for one’s own account is not considered to be carrying on a business, trade, profession or occupation.[5] As such, the intangible property was not employed in a trade nor business in any state, as the assets generating the income were from the taxpayers’ private hedge funds (i.e., the partnership owned the funds and traded intangible property for its own accounts). Therefore, the taxpayers were denied the RTC on that income. 

The taxpayers argued that they should be allowed the RTC to avoid double taxation on that income and that denying the RTC violated the Commerce Clause of the United States Constitution. When analyzing Constitutional double-taxation arguments, the focus is whether the state’s laws at issue — in this case, New York’s laws — create double taxation. Other states’ laws are not factored into the analysis. New York does not tax a nonresident on intangible income where the intangible asset is not employed in a business, trade, profession or occupation carried on in New York, as that income is taxed under New York rules based on the taxpayer’s residency. Accordingly, since New York would not tax a nonresident on such intangible income, there is no resulting Commerce Clause violation.

The bottom line

This ruling shows the importance of understanding the proper classification and sourcing of income in each state in which a taxpayer has a filing obligation. Depending on the taxpayer’s structure and the states at issue, the same income may end up being taxed in two states. 

Aprio’s SALT team has experience identifying these issues and recommending potential alternative structures in order to mitigate these types of unfavorable results. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Tina Chunn, SALT Senior Manager, at tina.chunn@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the August 2022 SALT newsletter.

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[1] Matter of Allison Greenberg and Scott J. and Martha M. Farrell, DTA Nos. 829737, 829738 (N.Y.S. Tax. App. Trib., July 14, 2022).

[2] New York State Tax Law Section 620(a).

[3] 20 NYCCR 120.4(d).

[4] New York State Tax Law Section 631(b)(2).

[5] New York State Regulation Section 132.10.

Disclosure

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.