New York Rules That a Nonresident’s Sale of S-Corporation Stock Constituted New York Source Income

Some states are moving away from the historical rule that sales of ownership interests in flow-through entities are taxed by the individual’s state of residence only.

By Jeff Glickman, SALT partner

As the real estate market is seeing a revival from the Great Recession, more and more transactions involving real property can be expected in the near future. Flow-through entities, such as partnerships or S corporations, are popular vehicles used to hold real estate interest or for estate planning because of the flexibility these entities offer. When the time comes to cash out on these investments, nonresidents need to consider the tax rules in the states where the real estate was held.

Generally, when an individual sells an intangible interest, such as stock in a corporation or an interest in a partnership or other flow-through entity (FTE), the gain from that sale is typically sourced to the individual’s resident state, even if the FTE did business outside such state. However, in certain instances, the state where the FTE does business may tax the nonresident investor on such income.

A recent Advisory Opinion from the New York State Department of Taxation and Finance (DTF) demonstrates the need to examine the rules in each state in which the FTE does business to determine whether or not such state would tax the nonresident in income from a sale of an interest in the FTE. [1] The taxpayer in the opinion, a Georgia resident, inherited 33 percent of the shares of a New York S-corporation that owned New York real estate and derived all of its income from operating parking lots and real estate rentals. The taxpayer did not actively participate in the business. All of the taxpayer’s shares in the S-corporation were redeemed by the FTE in exchange for an installment note. Part of the proceeds from the installment note represented the redemption price, while part of it represented interest income. The question presented was whether gain on the redemption of the stock and the interest income would be subject to New York State personal income tax.

In New York, a nonresident is subject to personal income tax based on New York source income. [2] “New York source income” is defined as “the sum of income, gain, loss, and deduction derived from or connected with New York sources.” [3] In analyzing the proceeds from the installment note, the DTF viewed the portion representing gain from the redemption separately from the interest income. For the interest income portion, the ruling determined that such income was not New York source income because income from intangible personal property, “shall constitute income derived from New York sources only to the extent that such income is from property employed in a business, trade, profession, or occupation carried on in New York.” [4] Based on New York case law, interest income from a note is income generated from an intangible personal property not employed in a business, trade, profession or occupation carried on in New York, and thus is not taxable to the nonresident in New York. [5]

With respect to the portion of the note representing the gain from the sale of the S-corporation interest, the opinion determined that a portion of such income was attributable to the nonresident’s ownership of a New York real property interest, and thus was New York source income taxable to the nonresident. New York tax law has a special rule that defines “real property located in this state” to include an interest in a FTE that owns New York real estate with a fair market value that is at least 50 percent of the fair market value of all the assets owned by the entity. [6] This calculation is done on the date of the sale or exchange and takes into account only those assets owned by the FTE for at least two years prior to such sale or exchange. [7] The amount of such gain attributable to New York is equal to the gain reported for federal purposes multiplied by a fraction, the numerator of which is the fair market value of the New York real property on the date of the sale or exchange and the denominator of which is the fair market value of all of the assets of the FTE on the date of the sale or exchange.

This ruling highlights the fact that not all states follow the general rule that an individual’s sale of an intangible interest in a FTE is sourced to the taxpayer’s state of residence. Taxpayers should understand the rules in states where they file as nonresidents due to owning an interest in a FTE doing business outside the taxpayer’s state of residence to determine the state tax impact of selling that interest. This would be a particular concern for individual taxpayers that live in states that do not impose a personal income tax or those that do at a relatively low rate since there would not be a full credit to offset the taxes paid to those states.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the September 2016 SALT Newsletter. To view the newsletter, click here.

[1] New York Department of Taxation and Finance, Advisory Opinion TSB-A-15(5)I. The opinion can be accessed by clicking here.

[2] New York Tax Law § 631(a).

[3] New York Tax Law § 631(a).

[4] New York Tax Law § 631(b)(2).

[5] Matter of Epstein v. State Tax Commission, 89 A.D.2d 256 (1982).

[6] New York Tax Law § 631(b)(1).

[7] New York Tax Law § 631(b)(1)(A)(1).

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 this matter.

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