The Mid-Terms
With 50 seats in the Senate, the Dems still control that Chamber. A win in the Georgia runoff, however, may lessen the burden for Majority Leader Schumer by, perhaps, neutralizing the significance of a certain member of his own party.[i]
Meanwhile, the GOP has claimed “control” of the House by a very thin margin,[ii] but the party’s leadership is already being challenged by its more conservative members.[iii]
On the other side of the aisle, moderate Dems in the House are certainly taking notice of how well the elections went for the “progressive” wing of their party.[iv]
Politics being what it is, would it surprise you if nothing happened in Congress for the next two years? Probably not.
New York
Closer to home, New York’s Gov. Hochul was elected to her first full term[v] and the Dems continued to control the Assembly and Senate.
Unfortunately, the prognosis for New York’s economic future is not bright, at least in the short term.[vi] How is Albany likely to respond to these fiscal pressures? Would it surprise you if we hear more about taxing the “rich” and about business paying its “fair” share? Probably not.
Speaking of which, how will business owners respond if Albany delivers such a message?
Facing the possibility of being further squeezed by the state, some New York business owners and investors may consider moving to a jurisdiction with a friendlier tax environment.[vii]
One such state may be Florida, which has “gained nine congressional seats (increasing from 19 to 28) since the mid-1980s, while New York has lost eight seats during that same period (falling from 34 to 26).”[viii]
The GOP did very well in Florida, with Gov. DeSantis winning easily; indeed, it appears the Sunshine State experienced the “red wave” that so many expected but failed to materialize nationally.[ix]
Consider Before You Go
Under the circumstances, it’s likely we will continue to see business owners, and perhaps their businesses, departing New York for Florida and other lower-tax jurisdictions.
Hopefully, most of these folks will consult their tax advisers before making any significant moves toward leaving the state.[x]
They will be told that a taxpayer who has been historically domiciled[xi] in New York, and who is claiming to have changed their domicile, must be able to support this change with unequivocal acts. All the relevant facts and circumstances must be considered before a determination may be reached – especially certain “primary” factors – but the evidence to support the change must be “clear and convincing.”
Specifically, each primary factor must be analyzed to determine if it points toward proving a New York or other domicile. In conducting this analysis, the taxpayer’s New York ties must be explored in relationship to the taxpayer’s connection to the new domicile claimed. Each factor is weighed individually, and then collectively.
The five primary factors are as follows:
- the individual’s use and maintenance of a New York residence,
- their active business involvement,
- where they spend time during the year,
- the location of items which they hold near and dear, and
- the location of family connections.
It is often the case that the residence, time, dear items, and family factors are not determinative of domicile, either because the presence of a factor in one state does not outweigh its presence in the other, or because a factor is not applicable.[xii]
It is also often the case that the question of domicile is determined by reference to the taxpayer’s business activity.[xiii]
New York Business
A taxpayer’s continued and active participation in a New York business, or their substantial investment in or management of such a business, is a primary factor in determining the taxpayer’s domicile – as suggested above, it is often the deciding factor.
If a taxpayer continues active involvement or participation in the day-to-day operation or management of New York business entities, without comparable or greater business activities outside New York, then the business factor will support continued New York domicile.
The extent of an individual’s control and supervision over a New York business can be such that their active involvement continues even when they are not physically present in New York.
On the other hand, a taxpayer’s passive investment in a New York business is not, by itself, indicative or supportive of domicile.[xiv]
The Federal Tax Return
Let’s assume an individual business owner (the taxpayer) who claims to have abandoned their New York domicile and to have established a new domicile elsewhere. At the time they “leave” New York, they still own all or a significant amount of the equity in a New York business.
In determining the nature and extent of the taxpayer’s involvement with the New York business, it is imperative that one consider the taxpayer’s federal income tax returns, as well as those of the business.
A taxpayer may not fully appreciate that items reported on their federal return constitute admissions by the taxpayer. Unfortunately, these “admissions” are often inconsistent with the taxpayer’s assertion that they have changed their domicile and are not actively engaged in a New York business.
As a result, the taxpayer and whoever is representing them in a New York residency audit will be burdened with the unenviable task of trying to reconcile the two positions.
Form 1040
Consider the taxpayer’s federal individual income tax return, on IRS Form 1040. Is the information reported consistent with the taxpayer’s claim of having abandoned their New York domicile?
Did the taxpayer report compensation income on their Form 1040 (Line 1)? If so, what business employed the taxpayer? Stated differently, for whom did the taxpayer render services? Their New York business? If so, what were these services, how often were they provided, from where were they provided, and what was the total number of hours worked? Was an IRS Form W-2 issued to the taxpayer by a New York employer? How significant was the compensation? Did it approximate what the taxpayer was paid prior to the purported change of domicile? Does this point to continued active participation in the New York business?
Does the 1040 (Line 7) reflect a gain from the sale of assets? Was Form 4797 filed to report the sale of business property related to a New York business? What is the taxpayer’s involvement with that business?
How about “other income” (on Line 8)? Does Schedule 1 to the Form 1040 include business income? If so, was Schedule C, Profit or Loss from Business, filed with the taxpayer’s return? What about Schedule E, Supplemental Income or Loss? If so, was any income or loss from a New York business reported for a partnership[xv] or S corporation on Part II of Schedule E? Was this income or loss described as “nonpassive,” meaning that the taxpayer materially participated in the business in which the entity was engaged? Can this designation be used by a taxing authority to demonstrate that the taxpayer (self-described as a former New Yorker) has significant New York business connections?
Form 8960
Did the taxpayer attach Form 8960, Net Investment Income Tax,[xvi] to their return? Did the taxpayer make any adjustments (Part I, Line 4, and especially Line 4b) to their “net investment income” for income that was derived from a trade or business that is not a passive activity as to the taxpayer? Specifically, did the taxpayer exclude their share of S corporation or partnership income because of the taxpayer’s having materially participated in the business?
Form 1120-S
In the case of an S corporation, the Form 1120-S should be reviewed for “Compensation of officers” (Line 7), which indicates the amount paid to officers in the trade or business activities of the corporation.[xvii] In turn, we are referred to Form 1125-E, Compensation of Officers. Is the taxpayer identified as an officer? If so, what does the form say about the amount of time the taxpayer devotes to the business? How much are they paid for their services? How much of the corporation’s stock does the taxpayer own?
What does the Sch. K-1 issued by the S corporation tell us about the taxpayer’s relationship to the corporation? What is the taxpayer’s pro rata share of the corporation’s income? Is the corporation indebted to the taxpayer? Did the corporation make significant distributions to the taxpayer, at least as compared to the taxpayer’s compensation? If so, is it likely the taxpayer – who claims to be a former New Yorker – would remain engaged in the corporation’s affairs to protect their economic interest in the continued well-being of its business? Does the nature of their involvement go beyond that of an investor?
Form 1065
In the case of a partnership (including an LLC treated as such[xviii]), the Form 1065, U.S. Return of Partnership Income, asks that the partners be classified as active or passive.[xix] For example, according to the instructions to the form, if the partnership’s principal activity is a trade or business, a general partner should be classified as “active” if they materially participated in all partnership trade or business activities; otherwise, they are “passive.” All limited partners in a partnership whose principal activity is a trade or business are to be classified as passive. How is the taxpayer classified? Is their classification consistent with one who is no longer active in a New York business?
Does the Schedule K-1 (Part II, Line G, of the 1065) issued to the taxpayer identify the taxpayer as a general partner or as a managing member? Does the K-1 indicate (Part III, Line 4a) that the taxpayer received “guaranteed payments” for services[xx] rendered by the taxpayer to the partnership?
In Short
The foregoing addresses only some of the federal tax filings that the “former” New Yorker should review with their adviser to assess the strength of the taxpayer’s claim of having abandoned their New York domicile.
The inquiries raised by the information on such returns are directed toward resolving one issue: is the level of involvement in a New York business, as reflected on the taxpayer’s and related parties’ federal tax returns, consistent with the taxpayer’s assertion that the taxpayer has abandoned their New York domicile? Can the taxpayer reconcile their purported status as a non-New York domiciliary with the federal returns reflecting their continued active participation in a New York business, especially where the taxpayer either founded the business or was its chief executive and principal owner?
Unfortunately, the answer in too many situations is “no,” notwithstanding the taxpayer’s protestations to the contrary. New York will use the taxpayer’s personal and business federal tax filings against the taxpayer, either to reject entirely the taxpayer’s claim of non-New York domicile, or in extracting an expensive settlement from the taxpayer.
If the taxpayer’s adviser had their druthers, would they convince the taxpayer to make a clean break from the New York business? Maybe not if that causes inclusion of the gain from the sale of the taxpayer’s equity in the business in their New York income.[xxi]
Alternatively, and probably the better course, the adviser would settle for the taxpayer’s stepping away from the business and transitioning the day-to-day operation and management to their children or to a key and trusted employee. They would also adjust the taxpayer’s compensation accordingly. Such an approach would strengthen their hand in defending a residency audit.
Why, then, would the taxpayer reject these suggestions?
In the case of our taxpayer, corporate dividends and/or partnership distributions, plus an element of “compensation,” may provide the cash flow required by the taxpayer to maintain their lifestyle – the taxpayer is understandably reluctant to turn off that spigot. It is also possible that the taxpayer may not have found the appropriate successor. Or the taxpayer simply can’t let go – not an uncommon condition, especially among self-made business owners.
In the end, however, the taxpayer needs to decide whether they can afford to present the strongest set of facts possible to support the abandonment of their New York domicile. With appropriate planning, the decision need not be an all-or-nothing proposition, and the federal returns would be consistent with the taxpayer’s having ceased to be a New Yorker.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] “Almost heaven, West Virginia.”
[ii] 218 seats are required for a majority. https://thehill.com/homenews/house/3723506-republicans-win-control-of-the-house/?email=0d71c9a83f2a42d0587d55fbaef0736bce831a76&emaila=caf543e567c3083ca16e5b043fe9e5f2&emailb=e2ffb77866e41a8fc10591e1664194be58201f012112ead442fcc623609f6293&utm_source=Sailthru&utm_medium=email&utm_campaign=11.16.22%20JB%20GOP%20House.
[iii] The selection of the Speaker of the House requires a majority of the entire Chamber. Will Kevin McCarthy reach out to middle of the road Dems for support?
[iv] https://thehill.com/homenews/campaign/3731453-progressives-ranks-and-plans-expand-after-midterms/. According to The Hill, of the 18 candidates the Progressive caucus endorsed this election cycle, 15 won their races.
[v] Though the race was closer than Dems would have liked.
[vi] For example, according to a report recently released by Comptroller DiNapoli, New York’s share of security industry jobs nationally has dropped from one in three to less than one in five.[vi] Still, the industry accounts for at least 22% of the State’s tax revenue – that’s why the more than 50% nationwide decline in the industry’s profits portends some financial hurt for the Empire State.
The Comptroller also warned that quality of life issues in NYC, as well as the continued shift to remote work, may further impair the state’s finances.
[vii] Assuming they’re not ready to expatriate, which is what 750 of our fellow citizens did last quarter. Indeed, this figure may be the quarterly average over the last few years.
[viii] https://siepr.stanford.edu/publications/policy-brief/apples-and-oranges-contrasting-economic-policy-new-york-and-florida#:~:text=These%20different%20population%20trends%20continued,New%20York’s%20declined%20by%20319%2C000.
This is an excellent report prepared by the Stanford Institute for Economic Policy Research.
[ix] https://www.npr.org/2022/11/10/1135856131/how-florida-a-one-time-swing-state-turned-red.
[x] They should adopt a record-keeping system that will enable them to refute any claim by the state that they were taxable as a New York resident for a particular tax year because they satisfied the statutory residence test for that year. In addition, they should put together a plan – based upon the five principal factors that New York considers in determining an individual’s domicile – for the purpose of maximizing the individual’s chances of withstanding a challenge by New York to their claim of having changed their domicile.
[xi] Domicile is defined as the place an individual intends to be their permanent home. Intention is a decisive factor in the determination of whether a particular residence is one’s domicile. Thus, this is a subjective inquiry—it goes to one’s state of mind.
Once a taxpayer’s domicile has been established, it continues until he abandons his old domicile and moves to a new one with the bona fide intention of making his permanent home there.
[xii] Often family, as where the taxpayer’s children are grown and living apart from them.
[xiii] The income from which often remains important to the taxpayer.
[xiv] It is not uncommon for the “retired” taxpayer to retain a board seat and to continue to hold the title of CEO. This is not necessarily fatal, provided the positions are merely honorific and provided the taxpayer does not, in fact, materially participate in the business.
[xv] Including an LLC treated as a partnership for tax purposes.
[xvi] IRC Sec. 1411.
[xvii] Comparable inquiries are made in the case of a C corporation. See Forms 1120, and 1125-E.
[xviii] Reg. Sec. 301.7701-3; an eligible entity with at least two members that has not elected to be treated as an association for tax purposes.
[xix] See the Analysis of Net Income which follows Schedule K on Form 1065.
[xx] Treated as self-employment income.
[xxi] A sale of equity while the taxpayer is still domiciled in New York would be taxable in New York. A sale in exchange for an installment note would not fare any better – the taxpayer would have to accelerate recognition of the gain if they depart the state while the note remans outstanding.
