The New York State Tax Appeals Tribunal and Division of Tax Appeals recently issued two opinions upholding planning techniques that had the effect of exempting from New York State personal income tax gains from the sale of New York businesses conducted by S corporations owned by nonresidents of New York (See Matter of Baum, Tax Appeals Tribunal, February 12, 2009; Matter of Mintz, Division of Tax Appeals, June 4, 2009).
Generally a nonresident shareholder of a New York S corporation is subject to personal income tax on the income of the corporation to the extent it is from New York sources. Gain on the sale of shares of the corporation, however, is not taxable since it represents income from intangible property which has a situs at the residence of the owner. When the business is to be sold, purchasers will generally prefer to purchase assets rather than stock for both tax and non-tax reasons—principally, stepping up the tax basis of the assets to the purchase price and avoiding unknown liabilities of the corporate entity. If a New York S corporation sells its New York business at a gain, the gain will flow through to nonresident shareholders in the same fashion as operating income and will be subject to New York tax. This gain will result in a step up in the shareholders’ tax basis in the shares, but this will provide no New York tax benefit for the nonresident holder on disposition of the shares since the shares have a situs outside New York.
Under section 338(h)(10) of the Internal Revenue Code, the parties to the sale of the stock of an S corporation can elect to have the transaction treated as if it involved a sale of the corporation’s assets followed by a complete liquidation of the corporation in which the sales proceeds were distributed to the shareholders. If this treatment applied for New York State tax purposes, gain on the deemed sale of New York assets would be taxable to the nonresident shareholders as described above. In the Baum case, the New York State Tax Appeals Tribunal held that the federal treatment does not apply for New York tax purposes and that the nonresident shareholder’s sale of shares is exempt from tax. This appears to give the parties a double benefit—a step up in tax basis for the purchaser and a tax-free sale for the seller. It is conceivable that the Department of Taxation and Finance will challenge the purchaser’s step up, but it would face an obstacle in the New York Tax Law’s provision that the purchaser’s tax calculation under both the personal income tax (NY Tax Law §§ 612(a), 631(a), 632(a)(2)) and the corporate franchise tax (NY Tax Law § 208.9) begins with federal taxable income which reflects the step up.
The second case, Matter of Mintz, involved an actual sale of substantially all the assets of a New York S corporation followed by its complete liquidation. If the sale had been for cash, the corporate gain on the New York assets would have subjected the nonresident shareholders to New York personal income tax. By the simple expedient of issuing a promissory note in the amount of the $22 million purchase price and paying the note in the month after the closing, a New York tax exceeding $650,000 was eliminated. In this case, the interplay of federal rules for corporate acquisitions and the New York Tax Law was again involved. Under the Internal Revenue Code, if a corporation receives an installment obligation on a sale of assets during a 12-month period beginning on the date of the adoption of a plan of liquidation and ending on the completion of the liquidation and distributes the obligation to its shareholders in the liquidation, the receipt of payments on the installment obligation will be treated as received by the shareholders in exchange for their stock (IRC § 453(h)). In the case of an S corporation, no gain or loss is recognized by the liquidating corporation with respect to the installment obligation and the character of the gain or loss to the shareholder will be determined “in accordance with the principles of section 1366(b)” (IRC § 453B(h)). Section 1366(b) states that “the character of any item included in a shareholder’s pro rata share [of the corporation’s income] shall be determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation.” Under the Internal Revenue Service’s interpretation of these provisions, it appears that if the only consideration received by the corporation consists of installment obligations, the corporation’s gain on the sale of its assets is not recognized and the only gain taken into account is the shareholder’s gain on the stock, if any, measured by the difference between the payments on the installment obligation and his or her basis in the stock. The basis is not adjusted upward for the unrecognized gain of the corporation (See Treas. Reg. § 1.338(h)(10)-1, Example (10)). Presumably, the shareholder level gain is to be characterized on some sort of allocated basis by reference to the character of the unrecognized gain at the corporate level “under the principles of section 1366(b)” (See also NY Tax Law §§ 617(b), 632(a)(2), 660(a)).
The Mintz case concluded that since the shareholder’s gain is measured by the difference between the amount realized on the disposition of the shareholder’s stock and the shareholder’s tax basis in the stock, the transaction should be viewed as a sale of an intangible asset by a nonresident of New York and therefore not subject to the personal income tax. There is accordingly no need to reach the question of the character of the gain. The administrative law judge’s determination reads in part as follows:
. . .IRC § 1366(b) impacts and determines the character of income or gain received, but only to the extent the income or gain itself is includible in a taxpayer’s income in the first instance (i.e., for federal purposes and for New York State resident taxpayer purposes). In short, IRC § 1366(b) would apply if the gain in question were included in petitioners’ New York source income. However, since the gain petitioners received (via periodic installment payments) in exchange for their stock in [the corporation] was gain from the sale of stock held by a nonresident, the same is not includible as New York source income, is not subject to taxation by New York State, and IRC § 1366(b) simply does not apply or have any impact under these circumstances.
In effect, the determination seems to say that the test of taxability under the New York Tax Law should be applied after the application of sections 453(h) and 453B(h) of the Internal Revenue Code but before the application of section 1366(b).
It is not known whether the Department of Taxation and Finance will appeal the Mintz determination to the Tax Appeals Tribunal. It cannot appeal the Baum decision. In any event, the principal lesson of these cases is that small changes in structure can produce dramatically different results.