Much has been written over the last few weeks about the unprecedented financial cushion that many states have accumulated thanks to federal support prompted by the pandemic and larger-than-expected tax revenue.[i]
However, in the last few days we have started to hear warnings from various sources that state economic forecasts for the remainder of 2022 and for 2023 are likely to be revised downward; for example: “The current global geopolitical crisis, continued uncertainties related to the ongoing pandemic, high inflation, and evolving federal monetary policy could all muddle the revenue outlook for the states.”[ii] Add to that the expiration of federal aid programs, the volatility of the stock markets, and talk of recession.[iii]
In the event states do encounter financial headwinds, many of them – most certainly New York – will probably seek to bolster their revenues by increasing their audit activity of taxpayers, not only in the realm of taxes that are traditionally imposed and administered at the state or local level (for example, sales and use taxes) but also income taxes that are based upon a taxpayer’s income as determined for purposes of the federal income tax.[iv]
A state’s foray into this territory will likely not be limited to the adjustments to federal taxable income that are required under state law. Instead, it may include the examination of those items of taxpayer income, gain, deduction, and loss that are reported on the taxpayer’s federal tax return; in other words, the base to which any unique state adjustments are then made.
The fact that many states, including New York, have by and large conformed to the federal tax law should facilitate their efforts to assess more state income tax.
Many years ago, New York revised its personal income tax law to achieve close conformity with the federal system of income taxation. The stated purpose for the revision was to simplify tax return preparation, improve compliance and enforcement, and aid in the interpretation of tax law provisions.[v] In furtherance of this policy of conformity, as the Code is amended by Congress, New York, generally speaking, “automatically” adopts the federal changes.[vi]
However, New York’s Tax Law does not conform to the Code in all respects. Indeed, there are a number of instances in which New York has chosen to decouple from specific provisions or amendments of the Code.[vii]
Adjusted Gross Income
By far, the most significant example of New York’s conformity to the Code is found in the State’s computation of a New York taxpayer’s State income tax liability; this begins with the taxpayer’s federal adjusted gross income,[viii] which is then modified by certain New York “additions” and subtractions”[ix] – basically, items for which New York has decided a different tax treatment is appropriate for its own purposes.
In general, a taxpayer’s adjusted gross income is determined by reducing their gross income by certain deductions attributable to the taxpayer’s trade or business, deductions attributable to the production of rental income, and losses from the sale or exchange of certain property.[x]
A corollary to the conformity principle requires that any changes to the taxpayer’s federal income tax liability[xi] be accounted for in re-determining the taxpayer’s New York income tax liability.
For example, if the IRS successfully challenges a taxpayer’s treatment of an item of business income or deduction on their tax return, it generally follows that the taxpayer’s New York income tax liability will also have to be redetermined. How will New York learn of the change to the taxpayer’s adjusted gross income and the possible increase in the taxpayer’s New York income tax liability?
According to New York’s Tax Law, if the amount of a taxpayer’s federal taxable income is changed by the IRS, the taxpayer must report such change within ninety days after the “final determination” of such change, and must concede the accuracy of such determination.[xii] If the taxpayer fails to comply with this reporting requirement, then any resulting New York income tax liability may be assessed by the State at any time – the applicable statute of limitations on the assessment of a deficiency is tolled.[xiii]
Based on the foregoing, one might think it would behoove New York to wait for the IRS to examine a taxpayer’s federal income tax return, and then assess any resulting deficiency in New York income tax.
After all, most of the substantive tax issues presented in a New York income tax return arise under the Code (i.e., federal tax law); this necessarily follows from New York’s application of the conformity principle.
Moreover, the IRS is necessarily much more familiar with the Code, as well as with the judicial and administrative interpretations thereof, whereas New York is not.
Such an approach would also allow the State to dedicate its resources to compliance efforts that are specific to New York including, for example, the examination of uniquely New York income tax issues, such as questions of residency and the allocation of income within and without the State.
Why Wait for the Feds?
There are occasions, however, in which the State (as opposed to the IRS), for whatever reason, may have initiated the examination of a taxpayer’s New York income tax return; in those cases, the State may have to interpret the application of federal tax law to a taxpayer’s circumstances in order to determine the taxpayer’s correct income tax liability to New York.
According to New York’s Constitution,[xiv] the legislature,
“in any law imposing a tax or taxes on, in respect to or measured by income, may define the income on, in respect to or by which such tax or taxes are imposed or measured, by reference to any provision of the laws of the United States as the same may be or become effective at any time or from time to time, and may prescribe exceptions or modifications to any such provision.”
Thus, the State may define the income it intends to tax by reference to the Code, but the State’s Tax Law is not required to be identical to the Code. That said, the New York courts have stated:[xv]
“It has long been the policy of our courts to adopt, whenever reasonable and practical, the Federal construction of substantially similar tax provisions. . . The doctrine is in furtherance of the legislative policy of maintaining uniformity in the administration of the two tax laws. As this court observed . . ., we give great weight to the Federal decisions ‘for the purpose of maintaining uniformity of administration of the Tax Law which the Legislature has sought to achieve.’”
In other words, the personal income tax provisions of New York Tax Law that incorporate provisions of the Code should generally be interpreted as such Code provisions are interpreted for federal income tax purposes.[xvi] However, the Code does not control the interpretation of the New York statutory adjustments made to federal taxable income.
Implicit in the foregoing is the acknowledgement that the State may examine a taxpayer’s federal tax items for purposes of determining the taxpayer’s New York income tax liability.
Historically, when this has occurred, some taxpayers have invoked Federalist principles[xvii] in an attempt to block the State from interpreting the applicable federal tax law for the purpose of determining a New York income tax liability.
A recent example of one such taxpayer’s unsuccessful attempt is discussed below.[xviii]
LLC was organized as a New York limited liability company and was engaged in the Business. During the taxable years in question, Individual (who was a New York resident) held a 33 percent interest in LLC. The other 67 percent was held by Foreign Company, which was disregarded[xix] for tax purposes. Taxpayer, who was a nonresident alien,[xx] owned 100 percent of Foreign Company.[xxi]
For each of the two audit years, LLC filed federal and New York State partnership returns reporting ordinary income and interest income. LLC issued a federal Sch. K-1 to Foreign Company reporting the latter’s distributive share of such income items. A statement attached to LLC’s federal partnership return provided, in relevant part, as follows:
“Effectively connected U.S. source taxable income (IRC Sec. 864) allocated to foreign partner and subject to U.S. tax: . . . / foreign source income not effectively connected and not subject to U.S. tax: . . .”
In the New York partnership returns[xxii] filed for the first audit year, LLC reported that all of its gross receipts were New York source gross income and that its metropolitan commuter transportation district allocation percentage was 100 percent.[xxiii]
In contrast, LLC indicated[xxiv] that its books and records did not reflect income earned in New York; moreover, LLC neither provided an allocation schedule nor listed all places, both in and out of New York, where LLC carried on business.
In New York partnership return for the second audit year, LLC reported that approximately one-half of its total gross receipts was New York source gross income.
As in the preceding year, LLC indicated that its books and records did not reflect income earned in New York and did not provide a list of all places, both in and out of New York, where the partnership carried on business.
Taxpayer filed federal nonresident alien tax returns and New York nonresident income tax returns[xxv] for the audit years reporting federal adjusted gross income consistent with the statements attached to LLC’s federal partnership returns that 50 percent of the distributive share of such income during those years was not effectively connected income and not subject to federal (or state) taxation.
The Division of Taxation (Division) audited Taxpayer and LLC for the audit period.
During the exam, the Division sought to determine where LLC conducted business, both inside and outside NYS; thus, it requested information regarding the activities of LLC, of its employees and owners, and of its affiliates, where these activities were conducted, and a description of each business activity inside and outside of New York. It also requested information to support the computation of the allocation percentages used on the New York State return.[xxvi]
In addition, the Division inquired about Taxpayer’s federal audit history, including whether any federal changes arising from such audits were reported to New York.
When Taxpayer and their representatives failed to provide the information requested, the auditor utilized prior audit information relating to Taxpayer, as well as publicly available information, to complete the audit of LLC.
Specifically, the auditor’s research determined that LLC and Individual were licensed to conduct the Business in New York, whereas Taxpayer was not. A prior audit of Taxpayer revealed that Taxpayer was an employee of Corp, a corporation that Taxpayer and Individual owned in the same proportion as their ownership interest in LLC. The auditor explained that the prior audit determined that LLC leased employees from Corp and deducted such expenses as an “administrative expense” on its partnership returns.
During the audit years, Corp had several employees including Taxpayer and Individual. These employees, other than Taxpayer, were based in New York. The auditor also determined that Corp’s primary source of revenue was providing services to LLC.
Based on the foregoing, the auditor determined that Taxpayer’s distributive share of income from LLC was effectively connected and was also from New York sources based upon LLC’s office location, its failure to provide information during the audit, and Taxpayer’s prior audit history.
The Division issued a notice of deficiency to Taxpayer asserting New York income tax for each of the audit years.[xxvii]
In arriving at the asserted tax, the auditor first increased Taxpayer’s reported federal adjusted gross income by the total amount of Schedule K-1 income from LLC that LLC treated as not being effectively connected income. The auditor then computed the New York source fraction based upon the finding that the full amount of LLC income allocated to Taxpayer, as adjusted, was New York income.
The revised State income tax liability was computed accordingly.
Taxpayer decided to challenge the imposition of tax on Taxpayer’s full distributive share of partnership income from LLC and brought its case to the Division of Tax Appeals.[xxviii]
Division of Tax Appeals
At the hearing before the administrative law judge (ALJ), Taxpayer claimed that all items of LLC income were derived from foreign sources. Taxpayer also claimed that LLC’s income was largely attributable to the work performed by Taxpayer on behalf of LLC in Foreign Country.[xxix] However, the ALJ noted that Taxpayer did not present any witnesses or submit any evidence establishing the source of LLC’s income.
The ALJ began its discussion of the case by explaining that a notice of deficiency issued by the Division was presumed to be correct until the contrary was established, and the burden of showing that such a notice was incorrect rested upon the taxpayer.[xxx]
Taxpayer asserted that: the Division had no authority to adjust Taxpayer’s federal adjusted gross income, as reported to, and “accepted” by, the Internal Revenue Service[xxxi]; and 50 percent of Taxpayer’s distributive share of income from LLC was not effectively connected income and, thus, was not subject to either federal or New York income taxation.
The ALJ rejected Taxpayer’s assertion that the Division had no authority to change Taxpayer’s federal adjusted gross income as reported to the IRS.
The Tax Law,[xxxii] the ALJ stated, imposes tax on the income from New York sources of a nonresident individual. The tax imposed upon the nonresident is equal to the tax that would have been imposed upon a New York resident, reduced by certain credits, and then multiplied by the New York source fraction.[xxxiii] The tax computed as if the taxpayer were a resident is determined by applying the appropriate graduated rate[xxxiv] to the taxpayer’s total income from all sources (less any statutory deductions, exemptions, or credits).[xxxv]
The taxpayer’s total income is derived from “New York adjusted gross income,”[xxxvi] which is determined by reference to the taxpayer’s “federal adjusted gross income as defined in the laws of the United States for the taxable year . . .”[xxxvii]
In turn, the New York source fraction, is equal to the individual’s New York source income divided by the individual’s New York adjusted gross income from all sources for the entire year.[xxxviii] A nonresident individual’s New York source income is defined as “the net amount of items of income, gain, loss, and deduction entering into his federal adjusted gross income, as defined in the laws of the United States for the taxable year, derived from or connected with New York sources, including: (A) his distributive share of partnership income, gain, loss and deduction, determined under section six hundred thirty-two…”[xxxix]
The New York source income of a nonresident partner, the ALJ continued, includes their distributive share of all items of partnership income, gain, loss, and deduction entering into their federal adjusted gross income to the extent such items are derived from or connected with New York sources.[xl] The New York source partnership income is determined by calculating the percentage of partnership business activity both within and without New York, looking at partnership property, partnership payroll and partnership gross income.[xli]
In short, a nonresident having income from non-New York sources should receive a reduction in the amount of tax owed because the tax calculated on a nonresident’s New York taxable income will be multiplied by a fraction in which the numerator is the taxpayer’s New York source income and the denominator is the taxpayer’s federal adjusted gross income. Thus, if the New York source income is 50 percent of a nonresident taxpayer’s total federal adjusted gross income, the nonresident taxpayer should pay a tax of one-half of what a similarly situated New York taxpayer would pay.
The Division Determines AGI
The ALJ observed that the references in the New York Tax Law[xlii] to “federal adjusted gross income, as defined in the laws of the United States” undermined Taxpayer’s claim that the Division was bound to accept Taxpayer’s federal adjusted gross income as reported.
According to the ALJ, the Division was not required to accept Taxpayer’s federal adjusted gross income as reported. “To suggest otherwise,” the ALJ stated, “would permit all state taxpayers who, whether consciously or unconsciously, underreported their federal adjusted gross income to benefit from a misapplication of the law. Such is a result the legislature surely could not have intended.”
Moreover, the ALJ explained, Taxpayer’s argument was also in conflict with the plain language of the Tax Law,[xliii] which provides that, if upon examination of a return, the Division determines an underpayment of tax, it may issue a notice of deficiency to the taxpayer. The statute does not limit the Division’s examination to New York additions and subtractions or to issues concerning residency or domicile, the ALJ stated. “To suggest otherwise is absurd.”[xliv]
Prepare to be Harried
Over the last few years, much has been written about the IRS’s audit record. The percentage of returns examined has dropped, while the average time spent on an audit has increased. The IRS lacks the resources, we are told, to enforce the tax laws, especially in an environment in which changes to the Code occur frequently. Congress has been reluctant/unable to fund the tax agency.
At the same time, as discussed above, the states that impose income taxes based upon federal taxable income will probably become more proactive in examining the federal returns of their own taxpayers.
The confluence of these developments may spell trouble for the taxpayer if the federal and state taxing authorities decide to cooperate more closely with one another, including perhaps the “delegation” of certain examination functions from the federal to the state level.
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[i] See, e.g., https://www.pewtrusts.org/en/research-and-analysis/articles/2022/05/10/budget-surpluses-push-states-financial-reserves-to-all-time-highs.
[ii] See, e.g., https://www.taxpolicycenter.org/taxvox/states-forecast-weaker-revenue-growth-ahead-growing-uncertainties#:~:text=According%20to%20preliminary%20data%20for,shifting%20income%20tax%20revenues%20between.
[iii] In the case of New York, I would also add the continued loss of taxpayers as individuals and businesses move to friendlier tax climates.
[iv] Indeed, this trend began in New York before the pandemic.
[v] Thus, New York’s Tax Law provides that: “Any term used in this article shall have the same meaning as when used in a comparable context in the laws of the United States relating to federal income taxes, unless a different meaning is clearly required but such meaning shall be subject to the exceptions or modifications prescribed in this article or by statute.” N.Y. Tax Law Sec. 607(a). Consistent with the foregoing, a taxpayer’s taxable year and accounting method for purposes of the Tax Law are the same as for federal income tax purposes. N.Y. Tax Law Sec. 605.
[vi] So-called “rolling conformity.”
[vii] For example, New York elected not to conform to parts of the 2017 Tax Cuts and Jobs Act (P.L. 115-97). By decoupling, New York effectively became a “fixed date” conformity jurisdiction: it applies the federal law as it was prior to the federal changes.
[viii] IRC Sec. 62.
[ix] Start with N.Y. Tax Law Sec. 612(a), (b) and (c).
[x] IRC Sec. 62(a). Yes, there are also a few other, very targeted items.
[xi] For whatever reason.
[xii] N.Y. Tax Law Sec. 659.
[xiii] N.Y. Tax Law Sec. 683(c)(1)(C). The regular three-year statute of limitations on assessment, which begins to run with the filing of the tax return, will not apply. N.Y. Tax Law Sec. 683(a).
[xiv] Article 3, Sec. 22.
[xv] Marx v. Bragalini, 6 N.Y.2d 322 (1959).
[xvi] Therefore, the decisions of federal courts interpreting the Code may be precedential insofar as they interpret a Code provision that has been incorporated into the Tax Law.
[xvii] There is also the principle of comity under Section 2 of Article IV of the Constitution.
[xviii] In the Matter of the Petition of Yacov Harel for Redetermination of a Deficiency or for Refund of New York State Personal Income Tax under Article 22, Division of Tax Appeals, Determination DTA NO. 829515.
[xix] Reg. Sec. 301.7701-3; a single member LLC.
[xx] IRC Sec. 7701(b)(1)(B). Taxpayer was a citizen and resident of Foreign Country.
[xxi] Thus, Taxpayer was deemed to own 67% of LLC.
[xxii] Form IT-204.
[xxiii] Section 9 of the form. Partnerships doing business within the MCTD must pay a Metropolitan Commuter Transportation Mobility tax.
[xxiv] Section 10 of the form.
[xxv] IRS Form 1040-NR and New York Form IT-203, respectively.
[xxvi] Among the items requested for this purpose were the following: workpapers supporting the computation of the allocation percentages used on the NYS return; a breakdown for receipts by location; a breakdown of total receipts by various revenue streams; a description of how each revenue stream was earned; a description of how each revenue stream was allocated to New York; copies of any written procedures used to record receipts or revenue; a written description of the typical step-by-step process for allocating receipts from the source document to the financial statements.
[xxvii] The notice also asserted negligence penalties and interest plus a penalty for failing to provide information during the audit.
[xxviii] It is unclear whether Taxpayer skipped the Bureau of Conciliation and Mediation Services (BCMS).
[xxix] Taxpayer provided a list of services and duties that he claimed to have performed in Foreign Country.
[xxx] N.Y. Tax Law Sec. 689(e).
[xxxi] How many times has a client or accountant told you that a return position has been accepted by the IRS when, in fact, the return was never examined by the IRS? Talk about faulty reasoning: “it was never examined; thus, it must have been accepted as filed.” Ugh.
[xxxii] N.Y. Tax Law Sec. 601(e)(1).
[xxxiii] N.Y. Tax Law Sec. 601(e)(2), (3).
[xxxiv] N.Y. Tax Law Sec. 601(a) through (c).
[xxxv] N.Y. Tax Law Sec. 606, 611(a).
[xxxvi] N.Y. Tax Law Sec. 611(a)
[xxxvii] N.Y. Tax Law Sec. 612 (a).
[xxxviii] N.Y. Tax Law Sec. 601(e)(3).
[xxxix] N.Y. Tax Law Sec. 631(a)(1) and (2).
[xl] N.Y. Tax Law Sec. 632(a) (1).
[xli] 20 NYCRR 132.15(d), (e), and (f).
[xlii] N.Y. Tax Law Sec. 601, 612 and 631.
[xliii] N.Y. Tax Law Sec. 681.
[xliv] Next, the ALJ rejected Taxpayer’s claim that only 50 percent of their distributive share of income from LLC was effectively connected income.
Pursuant to IRC Sec. 871(b)(1), a non-resident alien individual engaged in a trade or business within the U.S. is taxable on the income effectively connected with the conduct of that trade or business.
In turn, IRC Sec. 875(1) provides that if a partnership is engaged in business in the U.S., each of its members who are nonresident aliens or foreign corporations will be considered to be so engaged. Furthermore, income from any sources, including sources outside the U.S., derived by the foreign partner may be treated as effectively connected to the conduct of that business.
In this case it was clear that LLC was, during the years in issue, a domestic LLC (taxed as a partnership) engaged in the Business in New York.
While Taxpayer contended that they did much of the partnership work outside the U.S., Taxpayer “has not offered a scintilla of evidence to support these factual assertions.” It is the portion of the distributive share attributable to New York sources which is subject to taxation. If one-half of LLC’s income was not effectively connected income (as defined by IRC Sec. 864), Taxpayer failed to prove it.