Outmigration
The Office of the New York State Comptroller just released a new report that examines taxpayer migration trends during the pandemic.[i] The report, which builds on an earlier analysis of pre-pandemic taxpayer migration trends, reveals there was much more movement out of the State than was thought initially.
During that period, on a net basis, out-migration from New York skyrocketed, due largely to those leaving New York City; over one in every 100 resident filers left the State. By the end of the period, out-migration rates for families remained much higher than pre-pandemic levels, with married filers leaving at substantially higher rates. The total number of New York’s personal income tax filers declined for the first time since the Great Recession.
Moreover, as net departures and out-migration rates remained elevated, the total number of nonresident taxpayers grew. With nonresidents comprising over half of full-year filers at the highest income levels, and with high-income earners comprising a large share of personal income tax collections, the report warns policy makers to carefully consider the effect of the movement of taxpayers on State tax and budget matters.[ii]
If someone were to ask the individual taxpayer in the decision discussed below[iii] about the likelihood of anyone in Albany listening to the Comptroller’s advice, I’m fairly certain she would characterize it as a forlorn hope.
Taxpayer and Holding LLC
Taxpayer was domiciled in New York State and City during the two tax years in question (the “Tax Years”). Taxpayer filed a New York State resident income tax return, form IT-201, for each Tax Year as a resident of both the State and the City.
Taxpayer served as the marketing director of Capital LLC during the Tax Years. She was also a member of Holding LLC.
Holding LLC’s operating agreement indicated that LLC’s principal place of business was located in New York City. The operating agreement further stated that the LLC’s business “shall be to serve as a holding company, and that [Holding LLC] shall not engage in any direct business activities.”
Capital LLC was the investment manager for Holding LLC. According to Capital LLC’s website, “the company is a New York-based asset management firm with HQs in NY and CT.”
Capital LLC invested on behalf of two private hedge funds (the Funds) in which Holding LLC had an interest and which were managed by Holding LLC’s wholly owned Advisors LLC.[iv]
The Carried Interest
On account of her services rendered to Capital LLC, Taxpayer was awarded a carried interest in Holding LLC as compensation,[v] which entitled Taxpayer to a share of the profits to be derived by Holding LLC through its subsidiaries. As a result of such membership interest, Taxpayer received a share of Holding LLC’s flow-through investment income consisting of interest income, dividends, capital gains, plus a share of its ordinary business income or loss.[vi]
Taxpayer received a schedule K-1 as a member of Holding LLC[vii] for each Tax Year. The schedule K-1s (which listed a Connecticut address[viii]) reported Taxpayer’s share of Holding LLC’s ordinary business income for the first Tax Year and Taxpayer’s share of LLC’s business loss for the second Tax Year. They also reported Taxpayer’s share of Holding LLC’s interest income, dividends, and capital gains for such years.
Tax Returns
As a New York resident, Taxpayer correctly reported all of her schedule K-1 income (or loss) from Holding LLC on her New York income tax returns.
Taxpayer filed a New York State Resident Credit form[ix] with the New York returns to claim a resident tax credit (“RTC”) for taxes paid to Connecticut with respect to the income reported.
Taxpayer also filed a Connecticut nonresident return for each of the Tax Years, reporting and paying tax to Connecticut on the schedule K-1 income from Holding LLC that was sourced to Connecticut under Connecticut law. This return reported and paid tax on all of the income reported by Taxpayer as Connecticut sourced on the resident credit form[x] filed with New York.
According to Taxpayer, the Connecticut source income included the interest income, dividends, and capital gains reflected on the schedule K-1, in addition to Taxpayer’s share of Holding LLC’s ordinary business income (or loss).
The Audit
The Division of Taxation (the “Division”) audited Taxpayer New York returns for the Tax Years and accepted her income, deductions, and residency status as filed.
The Division also accepted the sourcing of Holding LLC’s ordinary business income to Connecticut and accepted the RTC claimed for the taxes paid to Connecticut on such Connecticut-source ordinary business income as filed.
However, the Division disagreed with Taxpayer’s treatment of the Connecticut sourced investment income reported on the return.
The Deficiency
The Division adjusted Taxpayer’s returns to disallow the RTCs to the extent they were claimed for taxes paid to Connecticut on Taxpayer’s share of Holding LLC’s investment income.[xi]
As a result of the Division’s adjustments disallowing the RTCs, the Division issued Taxpayer a notice of deficiency assessing additional income tax due for the Tax Years, plus interest.
The Division explained that because New York did not consider Taxpayer’s carried interest (her membership interest in Holding LLC) as intangible property that Taxpayer employed in a trade or business in Connecticut, one had to look at the source and character of Holding LLC’s capital gain, interest, and dividend income to determine whether and how they would be taxed by New York and, consequently, whether the RTC would be available.
Taxpayer’s share of Holding LLC’s income, the Division stated, retained its source and character as it passed from the LLC to Taxpayer.[xii] Since the capital gains, interest, and dividends of the kind allocated to Taxpayer from Holding LLC were not considered as income from intangible property used in a trade or business, New York would not currently tax this income if it had been received by a nonresident.
The Division explained that because New York does not tax nonresidents on their investment (nonbusiness) income from intangible assets, the Division would not allow the RTC on taxes paid by a resident to other states in respect of such income.
Conciliation Conference
Taxpayer filed a request for conciliation conference with the Division’s Bureau of Conciliation and Mediation Services (BCMS).
A conciliation conference was held at which Taxpayer tried to convince the conferee that the Division’s position was without merit.
Unfortunately for Taxpayer, BCMS issued a conciliation order sustaining the Division’s notice of deficiency.
Division of Tax Appeals
Taxpayer then timely filed a petition with the Division of Tax Appeals requesting an administrative hearing before an administrative law judge (the “ALJ”). The only issue before the ALJ was whether the Division properly denied the RTC claimed by Taxpayer for the Tax Years. Stated differently, the ALJ was asked to determine whether the taxes paid by Taxpayer to Connecticut on her share of Holding LLC’s interest income, dividends, and capital gains were eligible for a RTC based on the source and character of the income.[xiii]
According to the ALJ, this income was correctly categorized by Holding LLC as capital gains, interest and dividends[xiv] and properly reported to each member on a schedule K-1 under those categories. Under federal law, the ALJ explained, this type of income is treated as a “special allocation”[xv] that retains its source and character in the hands of the partner or member.
Taxpayer paid tax to both Connecticut and New York during the Tax Years on all the dividends, interest and capital gains income reported to Taxpayer by Holding LLC.
ALJ’s Determination
The Administrative Law Judge (“ALJ”) first considered the factual question of whether Taxpayer proved that Holding LLC’s business operations were conducted exclusively in Connecticut. The ALJ concluded that Taxpayer did not meet the burden of proof on this point and that this failure “fatally undermined” Taxpayer’s claim to the RTC during the Tax Years.
The ALJ also addressed Taxpayer’s legal argument for the RTC, for purposes of which the ALJ assumed that Holding LLC operated exclusively in Connecticut.
The ALJ observed that, as the income at issue was derived from intangible personal property – the carried interest – qualification for the credit depended on whether the intangible property was employed in a trade or business carried on in Connecticut.
The ALJ determined that Taxpayer’s membership interest in Holding LLC was not employed in a business. Rather, the ALJ found that Holding LLC owned the Funds and traded intangible property for its own account. According to the ALJ, this kind of activity was not considered a business under the Tax Law. Accordingly, as the income at issue was derived from intangible personal property not used in a business, the ALJ found that it did not qualify for the RTC.
Not Compensation
Next, the ALJ rejected Taxpayer’s contention that the income at issue should be characterized as compensation for services and thus properly sourced to Connecticut. Because the partnership income at issue retained its character when passed through to its partners (as nonbusiness investment income), the ALJ concluded that any characterization of such income as compensation for services was properly given no effect.
Finally, the ALJ rejected Taxpayer’s contention that the double taxation of intangible income in the present case as a result of the denial of the RTC was unconstitutional.[xvi]
Tax Appeals Tribunal
Following the ALJ’s adverse determination, Taxpayer filed a timely appeal with the Tax Appeals Tribunal (the “Tribunal”).[xvii]
Taxpayer’s Position
Taxpayer argued the evidence showed that Holding LLC was a business that operated in Connecticut during the Tax Years.
Taxpayer also contended the ALJ wrongly concluded that Holding LLC traded on its own account. According to Taxpayer, Holding LLC was an active investment manager for third party investors.
Taxpayer asserted that her membership interest in Holding LLC was an asset employed in a business conducted in Connecticut. That business generated the intangible income at issue. Thus, Taxpayer argued that the income derived from the conduct of the business was also derived from an asset employed in that business.
Taxpayer further contended that the Division’s position denying her the RTC unlawfully imposed double taxation (by New York and Connecticut) upon the income in question.
In addition, Taxpayer asserted that the income in respect of the carried interest was compensatory.[xviii] On the basis of that assertion, Taxpayer questioned how the Division could allow the RTC for the tax on the ordinary business income allocated to Taxpayer from Holding LLC during the Tax Years yet disallow the RTC with respect to Taxpayer’s other income from Holding LLC. Taxpayer asserted that such different treatment was illogical as both forms of income were compensatory in nature.
Division’s Position
The Division agreed with the ALJ’s finding that Taxpayer’s entitlement to the RTC turned on whether the income at issue was derived from Connecticut sources.
The Division further agreed with the ALJ’s finding that, as the income at issue was from intangibles, it was necessarily New York income unless Taxpayer showed that the property was employed in a business carried on in Connecticut. The Division contended that the ALJ properly determined that the intangible income at issue was not employed in a business and, therefore, was not derived from Connecticut sources. Thus, according to the Division, Taxpayer was not entitled to the RTC as claimed.[xix]
The Division also asserted that relevant case law made clear, contrary to Taxpayer’s contention, that double taxation of income that resulted from a taxpayer’s residency status was not unconstitutional.
Tribunal’s Opinion
The Tribunal first addressed, and disagreed with, the ALJ’s denial of Taxpayer’s credit claim based on the ALJ’s finding that Taxpayer failed to prove that Holding LLC’s operations were conducted exclusively in Connecticut.
It pointed out that the affidavit of the Division’s auditor stated that “[Holding LLC] operated solely in Connecticut at all times.” Consistent with this statement, the Division allowed a resident credit with respect to 100 percent of the ordinary income portion of Taxpayer’s share of partnership income. The Division’s audit thus necessarily concluded that such income was derived from or connected to Connecticut sources.[xx]
Further, given the 100 percent allocation, the Division found that Holding LLC conducted its business exclusively in Connecticut with respect to the ordinary income portion of the partnership’s income. The partnership’s intangible income was derived from the same investment management activity as the ordinary income portion. The Division’s audit and the affidavit of its auditor thus showed that Holding LLC operated exclusively in Connecticut during the years at issue.
Also supportive of a finding that Holding LLC operated in Connecticut, were Holding LLC’s schedule K-1 forms, listing a Connecticut address, and the affidavit of a Senior Advisor at Capital LLC, stating that Capital LLC was an asset management firm based in Connecticut.
In contrast, the Tribunal found that evidence in the record suggesting that Holding LLC may have operated in New York during the Tax Years was flawed.
Having determined that Holding LLC conducted its operations exclusively in Connecticut during the period at issue, the Tribunal then addressed whether Taxpayer may receive the RTC on her share of the LLC’s income allocable to the carried interest.
Taxpayer, the Tribunal explained, was a New York resident and, therefore, subject to New York personal income tax on her income from all sources.[xxi]
On the other hand, the Tribunal continued, a partnership is not subject to New York personal income tax. Rather, each partner in a partnership pays tax on such partner’s distributive share of the partnership’s items of income, gain, loss, and deduction.[xxii] Thus, Taxpayer’s distributive share of partnership income as reported on Taxpayer’s schedule K-1 forms was included in her federal adjusted gross income and, therefore, was included in Taxpayer’s New York adjusted gross income, subject to any applicable New York modifications.[xxiii]
Each item of partnership income, gain, loss, or deduction must have the same character for a partner under New York’s personal income tax law as for federal income tax purposes.[xxiv] In addition, each such item retains its character even where the item flows through tiers of partnerships to the resident partner.[xxv]Accordingly, amounts allocated to Taxpayer by Holding LLC during the years at issue as ordinary income, capital gain, interest, and dividends retained their character and were properly reported as such on Taxpayer’s returns.
New York’s Tax Law allows for a tax credit to a New York resident against the income tax otherwise due for “any income tax imposed for the taxable year by another state” on income “both derived therefrom and subject to tax” in New York.[xxvi] Thus, the income in question had to be subject to income tax in both states and must be “derived from” the other state.
The parties agreed that the income at issue was subject to income tax in both New York and Connecticut. However, they contested whether such income was “derived from” Connecticut.[xxvii]
The Tribunal indicated that, for purposes of the RTC, the Division’s regulation provides that “[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 sources, as set forth in [the Tax Law[xxviii]] in relation to the New York source income of a nonresident individual.”[xxix] New York source income for a nonresident individual, the Tribunal continued, is generally defined as income “derived from or connected with New York sources.”[xxx] According to the Tribunal, parallel language indicates that the RTC[xxxi] is generally allowable only to the extent that similar income would be taxable to a nonresident as income derived from or connected with New York sources, including the nonresident’s share of any partnership income, gain, loss, and deduction.[xxxii]
The same further provides:
[T]he resident credit against ordinary tax is allowable for income tax imposed by another jurisdiction upon compensation for personal services performed in the other jurisdiction, income from a business, trade or profession carried on in the other jurisdiction, and income from real or tangible personal property situated in the other jurisdiction. Conversely, the resident credit is not allowed for tax imposed by another jurisdiction upon income from intangibles, except where such income is from property employed in a business, trade or profession carried on in the other jurisdiction. Thus, for example, no resident credit is allowable for an income tax of another jurisdiction on dividend income not derived from property employed in a business, trade or profession carried on in such jurisdiction”.[xxxiii]
With respect to a nonresident individual’s income from intangible personal property, Tax Law § 631 (b) (2) is consistent with the resident credit regulation, stating, in relevant part, that “[i]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].”
The assets of the Funds that generated the interest income, dividends, and capital gains at issue were intangible personal property.[xxxiv]
As to the “property” which must be “employed in a business, trade, or profession carried on in the other jurisdiction” in order for intangible income to qualify for the RTC, “the property which the statute requires to be [so] employed . . . is the very same intangible property . . . from which the income is derived.”
The intangible personal property which must be employed in a business in Connecticut in order for Taxpayer’s intangible income to qualify for the RTC is the property that generated the income at issue; that is, the assets of the Funds from which Taxpayer’s interest income, dividends, and capital gains during the Tax Years were derived.
Thus, the Tribunal rejected Taxpayer’s contention that, for purposes of the RTC, her partnership interest in Holding LLC was the intangible personal property employed in a business in Connecticut which generated the intangible income at issue.
Under the regulation, “employed in a business” in 20 NYCRR 120.4 (d) simply means used in the conduct of a business.[xxxv]
According to the Tribiunal, Taxpayer failed to show that the intangible assets of the Funds were employed in the conduct of Holding LLC’s business. In fact, Taxpayer did not even argue that the assets of the Funds were employed in the conduct of its business. Thus, the Tribunal concluded that Taxpayer failed to meet her burden to establish a clear entitlement to the resident credit.
The Tribunal also found that Taxpayer failed to show, contrary to the ALJ’s finding, that Holding LLC was not trading on its own account.
Taxpayer also complained about the difference in treatment accorded her share of Holding LLC’s ordinary business income, which qualified for the RTC, versus her share of the investment income at issue, which did not. According to Taxpayer, both were compensatory in nature and should have received like treatment.
The Tribunal responded that different treatment of such different kinds of income is required by the RTC statute and regulations. In support of its position, the Tribunal quoted the rationale provided by the Court of Appeals’ for the RTC’s treatment of income from intangibles:
“The credit is not generally available for intangible income because that income has no identifiable situs. Intangible income generally is not derived, at least directly, from the taxpayer’s efforts in any jurisdiction outside of New York, and cannot be traced to any jurisdiction outside New York. It is simply investment income, and under the long-recognized doctrine of mobilia sequuntur personam ([“(m)ovables follow the * * * person”] . . . , it is subject to taxation by New York as the State of residence. However, where the taxpayer can show that intangible income is in fact derived from the taxpayer’s activities in a State other than New York, the taxpayer is entitled to the credit.[xxxvi]
Double Taxation
It seems that no matter where one looks, one will find support for the conclusion that New York is tough on taxpayers. The State has among the highest personal income tax rates in the country, it runs down with a vengeance those who claim to have become former residents, and it is ranked near the bottom of the Tax Foundation’s “State Business Tax Climate Index.”[xxxvii]
The foregoing decision does nothing to change this conclusion. It affirms the State’s position that for a resident taxpayer to qualify for the New York RTC, the tax imposed by the other state must be on compensation for personal services performed in the other jurisdiction, income from a trade or business carried on in the other jurisdiction, or income from real or tangible personal property situated in the other jurisdiction.
Investment income from an intangible asset that is taxed by the other state will not qualify for the RTC because it is not out-of-state income. Instead, it is “intangible income,” which does not have an identifiable situs in either New York or the other state for tax purposes, is not derived from a taxpayer’s efforts in a jurisdiction outside of New York, and cannot be traced to any jurisdiction outside of New York.
Thus, such income is subject to double taxation.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] https://www.osc.ny.gov/files/reports/pdf/taxpayer-movement-during-the-pandemic.pdf .
[ii] A voice in the wilderness? I wouldn’t be surprised.
[iii] In the Matter of the Petition of Allison Greenberg, Decision DTA NO. 829737.
[iv] In exchange for its investment management services, Capital LLC was paid a performance-based fee and a percentage of assets fee.
[v] It was unclear whether Taxpayer was claiming that she received an incentive fee and profit allocation from Capital LLC in addition to the “profit allocation” and “incentive compensation” she received from Holding LLC, or if Taxpayer was conflating the two LLCs. Taxpayer’s schedules K-1 reporting the income at issue were from Holding LLC.
As an aside, note how Taxpayer described the grant of the membership interest in Holding LLC as compensatory.
[vi] “4. Compensation. (a) As full consideration to the Member for the services to be rendered pursuant to this Agreement and the Operating Agreement, the Member shall be granted a profit allocation (“Profit Allocation”) equal to a six and one-half percent (6.5%) Economic Interest in the Company. The foregoing percentage applies to the Member’s Economic Interest in Net Profits other than in connection with Incentive Compensation. Net Profits attributable to Incentive Compensation shall be allocated to the Member in accordance with Section 4.1(b) of the Operating Agreement.
[vii] Holding was treated as a partnership for tax purposes.
[viii] According to the auditor, Holding LLC operated solely in Connecticut.
[ix] Form IT-112-R.
[x] Form IT-112-R.
[xi] Reported on form IT-112-R as interest income, dividends, and capital gains.
As for the second tax year, the Division accepted the sourcing of the flow-through ordinary loss to Connecticut but, because no tax was paid on the loss, the Division disallowed the claimed RTC in its entirety.
[xii] New York State Tax Law Sec. 617(b) and New York State Regulation Sec. 137.6. The federal rule is that “[t]he character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share . . . shall be determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.” IRC Sec. 702[b].
[xiii] Tax Law Sec. 620.
[xiv] Presumably as opposed to business income.
[xv] Under IRC Sec. 702(b). These items are stated separately because they may be taxed differently to different partners, depending on each partner’s tax situation.
[xvi] In reaching this conclusion, the Administrative Law Judge relied primarily on Matter of Tamagni v Tax Appeals Trib. of State of N.Y. (91 NY2d 530 [1998], cert denied 525 US 931 [1998]).
[xvii] Also part of the Division of Tax Appeals.
[xviii] Although Taxpayer contended that the Division’s interpretation of the RTC wrongly imposed double taxation upon her, Taxpayer expressly stated in her reply brief that she was not raising an issue of constitutionality. Rather, she contended that the Division’s interpretation misconstrued the statute, and that the relevant regulation distorted the meaning of the statue.
[xix] The Division asserted that Taxpayer cited no relevant legal authority in support of her position.
[xx] Tax Law Sec. 620[a].
[xxi] Tax Law Sec. 612 [New York adjusted gross income of a resident individual equals federal adjusted gross income, plus or minus specific modifications] and Sec. 611 [New York taxable income equals New York adjusted gross income less New York deductions and exemptions].
[xxii] Tax Law Sec. 617; 20 NYCRR 117.1
[xxiii] Under Tax Law Sec. 612; 20 NYCRR 117.2.
[xxiv] Tax Law Sec. 617[b]; 20 NYCRR 117.4[a].
[xxv] 20 NYCRR 117.4[b].
[xxvi] Tax Law Sec. 620(a).
[xxvii] The Tribunal noted that because Tax Law Sec. 620 (a) is a credit statute, the Tribunal was compelled to construe its language against Taxpayer. Taxpayer had to show a clear entitlement to the credit and had to demonstrate that her interpretation of the statute was the only reasonable interpretation.
[xxviii] Tax Law Sec. 631(a).
[xxix] 20 NYCRR 120.4[d]
[xxx] Tax Law Sec. 631(a).
[xxxi] Under Tax Law Sec. 620(a).
[xxxii] Under Tax Law Sec. 631(a).
[xxxiii] 20 NYCRR 120.4[d].
[xxxiv] Tax Law Sec. 631(b)(2) [defining income from intangible personal property as “including annuities, dividends, interest, and gains from the disposition of intangible personal property”]; NY Const, art XVI, Sec. 3 [providing that “[m]oneys [sic], credits, securities and other intangible personal property” within New York not employed in carrying on of any business are deemed located at the owner’s domicile].
[xxxv] The Tribunal pointed to TSB-M-92[3]I [“New York’s Tax Policy Relating to the Taxation of Intangible Personal Property of Nonresidents”] [October 9, 1992] [equates “employed in a business” with “used in the conduct of a business”].
[xxxvi] Matter of Tamagni v Tax Appeals Trib. of the State of N.Y., 91 NY2d at 536 [1998].
[xxxvii] https://taxfoundation.org/research/all/state/2024-state-business-tax-climate-index/ .
