Goodbye New York

Late last year, the U.S. Census Bureau released data showing population shifts across the country during 2021.[i] According to this information, New York lost 1.8 percent of its population.[ii]

It appears New York’s experience was not an isolated case. In a report issued earlier this month, the Tax Foundation – relying not only upon the Census Bureau’s data but also upon the data sets of some major moving companies – concluded that “[t]he picture painted by this population shift is a clear one of people leaving high-tax, high-cost states for lower-tax, lower-cost alternatives.”[iii]

The Governor

Within a day or so of the “think tank’s” report, New York’s Gov. Hochul[iv] delivered her first State of the State address, in which she outlined her legislative agenda. In her briefing book,[v] the Governor acknowledged the departure of many residents:

“As we embark on this New Era for our state, we need to take a hard look in the mirror and deal with a harsh reality. Nearly 300,000 New Yorkers left our state last year. That is the steepest population drop of any state in the nation.”

Although the Governor’s budget proposal will be delivered this week, she used the opportunity afforded by the State of the State to highlight her plans to provide tax relief for small businesses (by “reducing” their taxable income) and “middle-income” households (by accelerating to 2023 the phase-in of tax cuts that is otherwise scheduled to run through 2025).[vi]

The Middle Market

This is all well and good, but what about closely held mid-market businesses, those that generate annual revenues of between $10 million and $1 billion? “While the middle market represents barely 3 percent of all U.S. businesses, it’s responsible for roughly one-third of private sector GDP and employment. If it were its own country, it would be the fifth-largest economy in the world!”[vii]

It so happens the New York metro area is probably home to more mid-market businesses than any other part of the country.[viii] However, it is also the case that the last nine months have seen the sale of what may have been an unprecedented number of these businesses – all too often to private equity firms.

A number of factors converged to produce this outcome, including the pandemic,[ix] the blatant hostility demonstrated by government officials toward business, private equity firms with a lot of “dry powder,”[x] and low interest rates.[xi] Another factor, the importance of which cannot be understated, was the prospect of significant tax increases at the federal level.[xii]

New York

In the case of New York business owners, if the rate hikes proposed at the federal level had been enacted, they would have come on the heels of the boost in taxes already visited upon business owners (with retroactive effect) by New York’s 2021-2022 budget; for example, an increased corporate tax rate (from 6.75 percent to 7.25 percent), the reinstatement and increase of the alternative tax on business capital, and the addition of new personal income tax brackets ranging from 9.65 percent to 10.9 percent.[xiii]

Many owners who sold their businesses last year came to that decision after considering whether the return on the continued investment of time, effort, and money in their businesses – not to mention the associated risks – was worthwhile in view of what appeared to be a very bleak tax horizon; others even worried whether they could withstand the combined economic burden of these three taxing jurisdictions following the above-described tax increases.[xiv]

New Year

One may have expected a marked reduction in the number of closely held mid-market businesses in search of suitors following the apparent collapse of the Administration’s Build Back Better plan.[xv] Not quite.

It seems many owners remain concerned over their tax situation – especially at the state level – and its potential impact on their future plans.[xvi]

During the last two weeks – basically, the first two weeks of the new year – I have had calls from several owners of mid-market businesses based in New York who wanted to explore the possibility of changing their personal residence for state and local tax purposes.

This is not an out-of-the-ordinary discussion. New York business owners, like other owners around the country, are always considering how they may reduce their tax burden – which almost always represents a significant economic expense – and thus keep more of their profit. In some cases, the owner is considering a change in residence from New York City to elsewhere in the state; in others, the owner may be giving up their status as residents of the Empire State[xvii] altogether.

Although this is a topic that comes up regularly – often at the planning stage, but all too often only after the owner has been selected for an audit[xviii] – each of the recent instances mentioned above shared another factor: the change desired by the owner was directly connected to the sale of their business in the not-too-distant future; specifically, the goal was to cease being treated as a New Yorker prior to the sale of the business and, thereby, to avoid the state tax liability.

Know the Rules

Before one can successfully apply New York’s residency rules – and appreciate the import of their tax adviser’s directions – one must be aware of the rules and of the state’s enforcement posture.

Under New York’s Tax Law, an individual’s “domicile” is defined as the place the individual intends to be their permanent home.[xix] It is a subjective inquiry because it goes to one’s state of mind.

Once an individual’s New York domicile has been established, it continues until the individual abandons it and moves to a new location with the bona fide intention of making their permanent home at the new location.

Whether or not an individual’s domicile has been replaced by another depends on an evaluation of their circumstances.  According to the state, certain “primary” factors must be considered in determining the individual’s intent as to domicile – these factors are viewed as objective manifestations of such intent.

Each primary factor must be analyzed to determine if it points toward proving a New York or other domicile.  In conducting this analysis, an individual’s New York ties must be explored in relationship to the individual’s connection to the new domicile claimed.  Each factor is weighed separately, and then collectively.

No one factor is by itself determinative and, as a practical matter, it is probably unlikely that only one factor – the active business factor, for purposes of this post – will be identified by the state as supporting a continuing connection to New York.

The primary factors considered are as follows: (i) the individual’s use and maintenance of a New York residence, (ii) their active business involvement, (iii) where they spend time during the year, (iv) the location of items which they hold near and dear, and (v) the location of family connections.[xx]

The individual seeking to establish a change in domicile has the burden of proving their change of domicile by clear and convincing evidence. Thus, a taxpayer who has been historically domiciled in New York, and who is claiming to have changed their domicile, must be able to support their intention with unequivocal acts.

This is where the nature of the business owner’s continuing connection to their New York business – when weighed against their connection to any current or planned business activity in the jurisdiction they claim is their new home – may put them at a disadvantage in establishing the abandonment of their New York home.

Chicken and Egg

Which comes first? Does it matter?

Is the sale of the New York business required before a business owner who is a resident of the state can successfully abandon their New York domicile? In that case, the gain from the sale would be taxable to the owner as a resident.

Stated differently, is it possible for a New York business owner to give up their resident status prior to the sale of their business?[xxi] In this case, the nonresident would be taxed only on that portion of the gain from the sale that is sourced in New York, which will depend on a number of factors, including the nature of the transaction (a sale of assets or of stock, for example) and the type of business entity (a C corporation or a pass-through entity).

In theory, one’s continued ownership of their New York business should not, by itself, adversely affect their ability to change their domicile, though much would depend upon how heavily weighted toward the other jurisdiction (say, Florida[xxii]) the remaining so-called primary factors are, as well as the nature of the owner’s continuing involvement in the business after the purported change of domicile; for example, will a passive owner-investor, who has turned over the day-to-day operation of the business and no longer receives a salary, be viewed differently than one who remains actively engaged in the business?[xxiii] It seems very likely.[xxiv]

The Exit Tax

If the owner has successfully established domicile elsewhere notwithstanding their continued ownership of a New York business, the amount of time that passes between the date as of which such domicile was established and the date of the subsequent sale of the business may also impact the way in which New York taxes the gain from the sale.

For example, what if the former New Yorker sells all the outstanding shares of their C corporation within one month of their departure from New York?

Practically speaking, this time frame indicates that, as of the former resident’s departure date, a letter of intent has already been executed, due diligence is almost completed, the economic terms are set, and the relevant documents have been prepared and are being finalized. Under these circumstances, will New York view the sale in question as having occurred at the time the C corporation shares have “ripened” from an interest in an ongoing business into a fixed right to receive cash from the actual sale of such business?[xxv]

In that case, the change in domicile may mean little to the individual owner. Under New York law, if an individual changes their status from resident to nonresident, they are required to report for the period during which they were still a resident any items of income and gain accruing prior to the change of status.[xxvi] In other words, their gain from the sale – which actually occurred while they were a nonresident – will be taxed by New York as though recognized while they were a resident.

New York’s Source Rules

The foregoing indicates it may be difficult for a business owner to abandon their New York domicile and thereby avoid New York tax on the sale of their business.

However, even if the business owner were able to successfully change their residency status, New York’s source rules may turn their success into a Pyrrhic victory.[xxvii]

In general, nonresidents are subject to New York personal income tax on their New York source income, which is defined as the sum of income, gain, loss, and deduction derived from or connected with New York sources.[xxviii] For example, where a nonresident sells New York real property – which for this purpose is defined to include the sale of equity in certain business entities that own such real property[xxix] – or tangible personal property located in NY, the gain from the sale is taxable in New York.[xxx]

If a nonresident individual carries on a trade or business party within and partly outside New York, the nonresident must determine the items of income, gain, loss, and deduction that are derived from or connected with New York sources.[xxxi]

However, income derived from intangible personal property, including dividends and interest, as well as the gain from the disposition of such property, including shares of stock in a corporation, constitute income derived from New York sources only to the extent that the intangible property is employed in a business carried on in New York.[xxxii]

If the intangible is not “employed” in a New York business, the gain from its sale will be sourced to the nonresident’s state of domicile.

Goodwill

What about the gain from the sale of goodwill that is associated with a New York business, and which often represents the primary or single-largest asset being sold? How is the gain from the sale of this business asset sourced for purposes of determining the New York income of a nonresident owner?[xxxiii]

There is no point denying that the goodwill of a business is employed in that business. The question of its situs may be something else, though. In general, the gain from the sale of the goodwill should be apportioned according to the business’s apportionment percentage which, according to proposed regulations,[xxxiv] is determined by including business receipts from customers located in New York in the numerator of the apportionment fraction and including receipts from customers within and without the state in the denominator of the fraction.[xxxv]

What about a business that is headquartered in New York, with most of its officers and key employees (the folks with relationships to the customers) located in New York, but the revenues of which are spread throughout the country? If it appears that the apportionment fraction determined pursuant to the above rule does not result in a proper reflection of the taxpayer’s business income or capital within the state, the state is authorized in its discretion to adjust it.[xxxvi]

In other words, even if the individual owner is successful in moving their domicile out of New York, much (and possibly most) of the gain from the later sale of their business will be sourced in, and taxed by, New York. Consider it a parting gift.

The House Always Wins?[xxxvii]

Not always, though it sure feels that way at times – the rules are certainly “stacked” in favor of the state.

The point is the removal of one’s domicile from New York cannot be undertaken on a whim or for short-term advantage – there is no such thing.

Rather, it needs to be meticulously planned for, with a clear appreciation that one may still fail.

Moreover, even in victory, there may be a significant price to pay.

Thus, the change should be undertaken only for a genuine, non-tax, motive. In that case, one may plan for the tax consequences in order to reduce their impact, and thereby cut the cost of moving.

[i] https://www.census.gov/newsroom/press-kits/2021/2021-national-state-population-estimates.html.

[ii] As a younger man, I had an aversion to poetry of any kind. It was too soft, cluttered, or indistinct for my liking. Over the last few years, however, I have been drawn to some poems for those very reasons. (Could also be the onset of dementia, I suppose.) Because we’re on the subject of leaving New York, I recommend this one: “New York City: A Goodbye Poem,” by Marieke Vreeken. https://medium.com/poets-unlimited/new-york-city-a-goodbye-poem-5a7a4f12b30b .

[iii] https://taxfoundation.org/state-population-change-2021/?mc_cid=fca141b83b&mc_eid=6d8b136209. Among the states which lost residents, California, New Jersey, and New York have double-digit personal income tax rates; among those which gained residents, Florida, Texas, Nevada, Tennessee, South Dakota, and New Hampshire have no personal income tax.

It’s worth remembering that New York’s sales tax is 4 percent, but one must also factor in their local tax; in New York City, that means a sales tax of 4.5 percent plus a Metropolitan Commuter Transportation District surcharge of 0.375 percent, for a total sales tax of 8.875 percent; Nassau County’s sales tax is 8.63 percent and Westchester’s is 8.38 percent. These last two counties regularly take top honors for real property taxes. Then there is New York’s cost of living. And as a “de-parting” gift, New York imposes a 16 percent estate tax.

Interestingly, during the same week as the Tax Foundation’s report, New York, New Jersey, and Connecticut petitioned the U.S. Supreme Court to review the Second Circuit’s decision to affirm a District Court ruling that rejected a constitutional challenge to the $10,000 SALT cap enacted by the Tax Cuts and Jobs Act. See New York v. Yellen , U.S., petition 1/3/22. The states claim the SALT cap will drive residents to lower-tax jurisdictions.

[iv] Still no response to my letter: https://www.rivkinradler.com/publications/an-open-letter-to-the-incoming-ny-governor-kathy-hochul/. Perhaps I should have included a stamped, self-addressed envelope. Old school . . . for some.

[v] https://www.governor.ny.gov/sites/default/files/2022-01/2022StateoftheStateBook.pdf .

[vi] As currently drafted, the tax cuts to be implemented are as follows: the rate on income up to $161,550 is reduced from 5.85% in 2022 to 5.5% by 2025, and the rate on income up to $323,200 is reduced from 6.25% in 2022 to 6% in 2025.

[vii] https://hbr.org/2021/03/the-middle-market-is-stressed-but-resilient .

[viii] https://ventureneer.com/wp-content/uploads/2018/02/mmpi-growth-smart-1.pdf.

[ix] The surge of YOLO attitudes. (Are you impressed I know, let alone used, that acronym? C’mon, admit it.)

[x] Basically, cash reserves to fund acquisitions, especially following 2020 (the “pandemic year”).

[xi] With the recent inflation reports, that party may be over.

[xii] In case you’ve forgotten: The President’s tax plan sought, at various times, to: increase the rate on long-term capital gains; increase the top rate on ordinary income; increase the corporate rate; remove the cap on the 6.2 percent Social Security Tax; eliminate profits interests; enact an annual mark-to-market tax on the rich; revoke the basis step-up for property passing from a decedent; impose a gains tax on a decedent’s assets as if they had been sold at the time of death; eliminate the enhanced basic exclusion for gift and estate tax purposes; make the grantor trust rules consistent with the gift and estate taxes (thereby doing away with a host of gift and estate tax planning vehicles); impose a tax on a deemed sale of property by so-called “dynasty trusts” after a prescribed period; prohibit discounted valuations for investment assets; limit the use of like kind exchanges; apply the 3.8 percent surtax on net investment income to an individual taxpayer’s share of partnership and S corporation income, without regard to how active the taxpayer is in the business, provided the individual has more than $500,000 of AGI; impose a new 5 percent surcharge on individuals with AGI for the year in excess of $10 million, plus an additional 3 percent (8 percent in total) for those with income for the year beyond $25 million; cut the amount of gain that may be excluded from income on the sale of Section 1202 stock by an individual with $400,000 or more of AGI from 100 percent to 50 percent; make permanent the limitation on the use of excess business losses by individuals; impose a minimum tax on certain mega-sized, mega-profitable C corporations; increase the IRS’s enforcement budget.

I wonder how many former owners will experience so-called “hindsight bias” (yes, it’s “a thing”) a few months from now, assuming the President’s tax and spending agenda continues on its present “course.”

[xiii] The highest personal rate was previously 8.82 percent.

The increases could have been much worse if the veto-proof Legislature had refused to compromise: https://www.rivkinradler.com/publications/new-york-is-poised-for-some-significant-tax-increases/ .

And don’t forget NYC, with a corporate tax rate of 8.85 percent (the City does not recognize the election to be treated as an “S” corporation) and an individual rate of 3.876 percent.

California, please step aside. There’s a new kid in town. (Apologies to The Eagles.)

[xiv] Especially when they were also being demonized by the governments of each jurisdiction, which somehow forgot which taxpayers funded a disproportionately large share of their budgets.

[xv] Beginning late last year and continuing into the current year.

[xvi] For example, earlier this month, California announced a plan to double the taxes it collects in order to fund a single-payer health-care system. “Go West Young. . ..” is no more.

[xvii] I’m surprised this nickname hasn’t been abandoned yet.

[xviii] The do-it-yourselfer has no one else to blame. They choose to listen to “knowledgeable” friends who have shared with them how to “successfully” charter a course out of New York. As the old idiom goes, “if I had a dollar for every. . .”

For shits and giggles: I once had a guy who worked in pharma, retired, “moved” to Florida, received a “Residency Questionnaire” that he completed himself, and in which he described his plan to become a gentleman farmer. If dislodging a chunk of turf with every swing of one’s club on a golf course counts as tilling the soil, then I suppose he answered truthfully. It’s an evil game played by those with idle hands.

[xix] New York Tax Law provides two bases for state tax residency: (a) individuals “domiciled” in New York – the subject of this post – and (b) individuals not domiciled in the State but who (i) are present therein for more than 183 days, and (ii) maintain a “permanent place of abode” (one in which they had a “residential interest”) in the State for “substantially all of the taxable year” (“statutory residence”). For our purposes, we will assume the owner of the New York business (who maintains a permanent place of abode in the state) will be able to demonstrate they were not present in the state for more than 183 days during the taxable year.

[xx] We’ll consider these in a future post.

[xxi] This is certainly an evolving issue as the boundaries of working remotely are tested and developed.

[xxii] The land of milk, honey and Covid.

[xxiii] I see this way too often: the federal returns must be consistent with the taxpayer’s position as to their domicile – one cannot be “active” for federal purposes (for example, for purposes of the passive loss rules or the surtax on net investment income) while claiming to be “passive” for purposes of supporting the abandonment of their New York domicile.

[xxiv] See, e.g., Matter of Herbert L. Kartiganer et al., 194 AD2d 879, where the extent of an individual’s control and supervision over a New York business was such that his active involvement continued even during times when he was not physically present in New York.

[xxv] Think “anticipatory assignment of income” analysis.

[xxvi] N.Y. Tax Law Sec. 639(a).

[xxvii] I’ve had so many cases in which New York has inexplicably pursued domicile for folks who are clearly domiciled elsewhere but who have significant real estate business interests in the state from which they receive the bulk of their income, which is already taxable in New York.

[xxviii] NY Tax Law Sec. 631(a) and (b).

[xxix] For purposes of this rule, the term “real property located in” New York was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in New York and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity. NY Tax Law Sec. 631(b)(1)(A)(1).

In accordance with an “anti-stuffing” rule, only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on such date.

[xxx] A nonresident will be subject to N.Y. 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 N.Y.)
• services performed in N.Y.
• a business, trade, profession, or occupation carried on in N.Y.
• their distributive share of N.Y. 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 N.Y. 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’s shareholders have made an election under Sec. 338(h)(10) or Sec. 336(e) of the Code.

Although the foregoing list encompasses a great many items of income, there are limits to the State’s reach; for example, N.Y. 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 N.Y.; and
• as a shareholder of a corporation that is a N.Y. C corporation.

[xxxi] NY Tax Law Sec. 631(c). New York provides special allocation and apportionment rules for this purpose.

[xxxii] NY Tax Law Sec. 631(b)(2).

[xxxiii] Let’s assume the entity through which the business is operated is a pass-through entity, such as an S corporation. The character of the gain realized by the corporation and which passes through to the shareholder is determined as if it were realized by the shareholder directly from the source from which realized by the corporation. IRC Sec. 1366(b).

[xxxiv] https://www.tax.ny.gov/bus/ct/pending/apportionment-with-nov-2019-update-for-pshp-discretionary.pdf .

[xxxv] NY Tax Law Sec. 210-A(10).

[xxxvi] NY Tax Law Sec. 210-A(11). Though the taxpayer may also request that the fraction be adjusted.

For an interesting discussion of this issue – albeit from the State of California – see In re the Consolidated Appeals of The 2009 Metropoulos Family Trust; The Evan D. Metropoulos 2009 Trust, California Office of Tax Appeals, Case Nos. 18010012, 18010013, Nov. 7, 2019. The OTA considered the sale of goodwill by an S corporation that had nonresident shareholders. According to the OTA, the S corporation’s sale of goodwill generated business income; thus, the source of the gain to be allocated to the nonresident shareholders was determined using the S corporation’s California apportionment percentage – it was not based on the nonresidents’ state of domicile.

[xxxvii] “Cause the house always wins. Play long enough, you never change the stakes. The house takes you. Unless, when that perfect hand comes along, you bet big, then you take the house.” From Ocean’s Eleven.