An Administrative Law Judge has held that the Department of Taxation and Finance correctly applied retroactively a 2006 regulation regarding the computation of New York source income from stock options, which superseded an earlier (and contrary) Tax Appeals Tribunal decision. Matter of Lawrence Gleason, DTA No. 823829 (N.Y.S. Div. of Tax App., Oct. 25, 2012).

Facts. Lawrence Gleason, a Connecticut resident, was employed by American Airlines until he retired in April 2005. During his employment, he performed services both within and outside New York State. For several years beginning in 1996, American Airlines granted him incentive nonstatutory stock options. Mr. Gleason exercised the stock options in 2006, after he had retired, generating approximately $350,000 in compensation that year. Mr. Gleason filed a 2006 New York nonresident return but did not source any of his stock option income to New York.

Following an audit of Mr. Gleason’s 2006 return, the Department sourced his stock option income to New York using a New York workday allocation ratio for the 2004 tax year, the last full year that Mr. Gleason worked. After the case proceeded to the Division of Tax Appeals, the Department modified its methodology, applying an allocation ratio using a date-of-grant to date-ofretirement allocation period. For options granted to Mr. Gleason between 1996 and 2001, the Department computed the fraction based on the ratio of the taxpayer’s New York workdays from year of grant through 2001 (more on this later) to total workdays from year of grant until he retired in April 2005. For stock options granted in 2003 (none were granted in 2002), the Department applied the ratio of New York workdays from 2003 (the year of grant) through Mr. Gleason’s retirement, to total workdays from 2003 until his retirement. At issue was the correctness of the Department’s allocation period calculation and the applicability of a regulation pertaining to stock option sourcing.

Background on Stock Option Sourcing. Effective December 27, 2006, and applicable to taxable years commencing on or after January 1, 2006, the Department amended its personal income tax regulations to set forth an allocation period for sourcing a nonresident’s income from stock options. A nonresident’s stock option compensation is multiplied by a New York workday fraction for the individual’s “allocation period” to determine the portion of that income derived from New York sources. For most types of stock options, the regulations provide for a New York workday fraction based on an allocation period from the date the option was granted to the date of vesting. In light of the confusion at the time over the proper method of sourcing stock option income, the regulations permitted, at the taxpayer’s election, and for the 2006 tax year only, use of an allocation period from the date of grant to the earliest of the date of exercise, date of termination of employment, or the date the compensation is recognized for federal income tax purposes. 20 NYCRR 132.24(c)(3).

These regulation amendments were promulgated after to the Tax Appeals Tribunal decisions in Matter of Stuckless, referred to by the ALJ as Stuckless I and Stuckless II. Those cases involved income from stock options granted when the taxpayer was a New York resident but exercised when he was no longer a resident. (In contrast, Mr. Gleason was always a Connecticut resident.) In Stuckless I, the Tribunal held that a 1995 Technical Services Bureau memorandum for sourcing stock option income (which applied a grant-to-exercise allocation method) was inapplicable, and moreover was not “legal authority.” The Tribunal instead measured the New York source income from the taxpayer’s stock options based on the appreciation in value of the underlying stock until the time he moved out of New York. Matter of E. Randall Stuckless, DTA No. 819319 (N.Y.S. Tax App. Trib., May 12, 2005). In December 2005, the Tribunal granted the Department’s motion for reargument. Nine months later, in Stuckless II, the Tribunal withdrew its earlier decision and held that a single yearof- exercise allocation period should apply instead. Matter of E. Randall Stuckless, DTA No. 819319 (N.Y.S. Tax App. Trib., August 17, 2006). The Tribunal stated in Stuckless II that “[i]f the Division wishes to . . .create a separate set of new rules for identified special circumstances, we think such a change should be effected through legislation or adopted in regulations.”

In the meantime, the Tax Law was amended in April 2006, specifically to address Stuckless I, to provide that “a nonresident taxpayer who has been granted statutory stock options . . . shall compute his or her New York source income as determined under rules and regulations prescribed by the commissioner.” Tax Law § 631(g). The above-described regulation, effective December 27, 2006, was promulgated in response to this legislative directive.

ALJ Decision. The ALJ held that the Department reasonably and correctly concluded that Mr. Gleason’s 2006 stock option income was allocable to New York in accordance with the stock option regulation amended in December 2006. Although the method used by the Department’s auditor in assessing the tax (based on an allocation period for 2004 only) was not specifically authorized under the regulation, it was nonetheless found to be reasonable under the circumstances, based on the limited information the auditor had been given by the taxpayer. The ALJ held that the methodology for the revised deficiency, based in part on an allocation period through 2001, was also reasonable, noting that it was an “approximation” of the date-of-grant to date-oftermination method provided for in the regulations for 2006 only. The ALJ noted that the Department’s inclusion in the numerator of the allocation fraction of New York workdays from date of grant to 2001 was an error (since Mr. Gleason retired in 2005), but an error that worked in Mr. Gleason’s favor.

The taxpayer’s position appeared to be that the application of the Department’s regulation retroactive to the 2006 tax year violated Mr. Gleason’s due process rights. Although not entirely clear from the decision, Mr. Gleason seemed to be arguing that either Stuckless I (sourcing stock option income based on actual appreciation of value) or Stuckless II (using a year-of-exercise allocation period) should have been applied. The ALJ disagreed.

The ALJ first noted that the Division of Tax Appeals does have the authority to determine whether a Departmental regulation is constitutionally valid, whether facially or as applied. However, the ALJ went on to conclude that the history of New York’s treatment of nonresident stock option income — and particularly the Tribunal’s granting in December 2005 of the Department’s motion to reargue Stuckless I — should have put Mr. Gleason on notice in 2006 that he could not rely on Stuckless I or on Stuckless II, holding that any reliance on the “tenuous precedent of either Stuckless I or II at any time during 2006 was unreasonable.” The ALJ also found that the retroactive applicability of the regulation amendments, from December 27, 2006 to the beginning of the year, fell within a constitutionally permissible range of retroactivity. The ALJ also rejected Mr. Gleason’s argument that by amending the Tax Law in April 2006, the Legislature had “improperly usurped the Tribunal’s authority,” noting that it was the “Legislature’s prerogative” to amend the Tax Law as it sees fit.

Additional Insights. The regulations now generally provide for a date-of-grant to date-of-vesting allocation period for sourcing most stock option income. The correctness of that regulation for years after 2006 does not appear to be impacted by the Gleason decision, whatever its eventual outcome. The ALJ’s statement that it was “unreasonable” for the taxpayer to have relied on the Tribunal decision Stuckless II at any time during 2006 is questionable. However, its impact appears to be limited to whether the 2006 regulation could undo retroactively the yearof- exercise methodology decided in Stuckless II, and not to the viability of that regulation.