In August, the State of New York enacted legislation that will result in higher income taxes for many. Except as otherwise noted, the changes are retroactive to January 1, 2010. The most important changes are summarized below:

New York City Personal Income Tax. The City of New York imposes its own income tax on individual residents of New York City (“NYC”), in addition to the New York State income tax. Until this year, the top NYC rate was 3.648% for NYC taxable income in excess of $90,000. The legislation adds a new rate of 3.876% for individuals with NYC taxable income over $500,000.

New Source Rule for Income Received by a Nonresident Related to a Business Previously Carried on in New York. New York has made a significant change to its rules for determining the income of a non-resident individual who is subject to the New York income tax. For tax years beginning on or after January 1, 2010, income of a nonresident related to a business, trade, profession or occupation previously carried on in New York, whether or not as an employee, is considered New York source income and subject to the New York income tax. The provision covers income such as payments under a covenant not to compete and employment termination payments. Income from a business previously carried on in New York includes a non-resident individual’s share of income from a partnership, (including a limited liability company taxed as a partnership) or S corporation that conducted business in New York.

Previously, such income was sourced to the nonresident’s state of residence. For example, assume a New Jersey resident works in New York as an employee of a New York business. Upon the termination of his employment he enters into an agreement which for two years prohibits him from working for any business within 100 miles of his former employer that is a competitor of the former employer. Prior to 2010, any payments he received under this agreement would have been sourced in New Jersey and not subject to New York State income taxes. Beginning in 2010, such payments are sourced in New York for New York income tax purposes, where he previously worked, and therefore are subject to New York income tax. This is the case even if the agreement pursuant to which the payments are being made was entered into before 2010.

New Source Rule for S Corporation Deemed Asset Sales. When the shareholders of an S corporation sell their stock to a corporate buyer, the sellers and the buyer can make a joint election under IRC Section 338(h)(10) to treat the transaction as though the S corporation sold its assets and then liquidated. This allows the buyer to get a stepped-up basis in the assets, even though it purchased stock.

New York recognizes this provision for New York S Corporations but, as a result of the 2009 Tax Appeal Tribunal decision in Baum, was forced to source such income for a non-resident seller, as though it was a stock sale. A non-resident of New York who sells stock of a corporation engaged in business in New York does not have to pay New York income tax because New York treats the gain on the sale as having its source in the taxpayer’s state of residence. That meant that even when a stock sale was accompanied by a Section 338(h)(10) election, the non-New York resident did not have to pay any New York income tax on his gain.

The new legislation overturns Baum, so that now when such an election is made in connection with the sale of stock of a New York S corporation, the deemed asset sale portion of the transaction is treated as though it was an actual asset sale for New York sourcing purposes. As a result, a non-resident shareholder must pay New York income tax on the New York business allocation percentage of any gain arising upon the sale of those assets. Note, this change is retroactive to January 1, 2007, and could affect sales you have already made. The deemed liquidation portion of the transaction, however, is not affected. Any loss on that portion is not New York source income for a non-resident shareholder and therefore cannot offset any portion of the deemed asset sale gain in New York.

Deferral of certain tax credits. For 2010 through 2012, business tax credits can only be used to reduce New York State income tax by $2,000,000. The excess over $2,000,000 in any year is deferred without interest. Taxpayers must take the deferral into account when computing their estimated tax payments (including treating the provision as if it were in effect for 2009).

Itemized deductions further limited for some taxpayers. New York severely limits itemized deductions for high income individuals. For an individual with New York adjusted gross income in excess of $1,000,000, the only itemized deduction permitted is 50% of the amount of the individual’s federal charitable contribution deduction. Under the new law, for tax years 2010 through 2012, for an individual with more than $10,000,000 of New York adjusted gross income, the amount allowed is halved again, to 25% of the amount of the individual’s federal charitable contribution deduction. Estimated payments for 2010 must be adjusted as though the provision was in effect in 2009 although no penalty will be applied to the April and June payments if any underpayment is made up by the September payment. This is clearly a revenue raising and budget balancing measure.

Sales tax on clothing. New York State revised its $110 exemption on the sale of clothing and footwear as follows:

Click here to view the table.

Out-of-state sellers. The new legislation retroactively narrowed the definition of a vendor, that is, a person required to collect New York sales tax. For sales on or after June 1, 2009, an in-state affiliate that only provides accounting or legal services or advice to an out-of-state seller, or directs the activities of an out-of-state seller (including but not limited to making decisions about strategic planning, marketing, inventory, staffing, distribution or cash management), will not cause an out-of-state seller to be a vendor for New York sales tax purposes.