C’mon Already
New York has once again missed its April 1 budget deadline, in no small part because the Governor’s party, which controls both the State Senate and Assembly,[i] is once again at odds with the Governor over tax policy.
The Legislature is pushing for tax increases on businesses and on high earners, while the Governor opposes raising the personal income tax but is willing to extend the “temporary” increase in the top tax rate for corporations.[ii]
The negotiations between these two branches of New York’s one-party government are complicated by the fact that the Governor is up for re-election this November, as is every member of the State Legislature.[iii]
While our elected officials are duking it out, figuratively speaking, the State’s Department of Taxation and Finance (the “Department”) is trying to collect the revenue owing under New York’s current tax laws.
As we will see shortly, both the government and taxpayers will sometimes have to confront what are seemingly straightforward but often difficult-to-interpret provisions of the State’s tax law.
New York S Corp
For example, under current New York Tax Law (the “Tax Law”), a New York corporation[iv] that elects to be treated as an S corporation for federal tax purposes is not automatically treated as having also elected to be treated as an S corporation for New York tax purposes.[v] Rather, the corporation must make an affirmative election to be regarded as a New York S corporation.
That being said, there is an exception.
Among the amendments to the Tax Law that were enacted as part of the 2007-2008 New York State budget was the addition of a provision that, under specified circumstances, requires certain New York corporations that are federal S corporations[vi] to be treated as S corporations for purposes of the Tax Law.
Shutting Down An Abuse
This provision[vii] was enacted to close what the State’s Legislature described as a “tax loophole” that allowed some New York resident individuals to avoid the State’s personal income tax by placing assets into a federal S corporation that did not elect to be treated as an S corporation for purposes of the Tax Law.
According to the Memorandum in support of the provision,[viii] some New York residents were taking advantage of the favorable treatment of investment capital and investment income under the State’s franchise tax on general business corporations by placing their stocks, bonds, and other investment assets[ix] into a New York corporation that would elect to be a federal S corporation, but also chose not to make the New York S corporation election. The corporation’s investment income would pass through to the shareholders for federal tax purposes.[x] As a New York C corporation, however, this investment income was not passed through to the entity’s shareholders for purposes of the State’s personal income tax; instead, it was taxed at the corporation level at a more favorable rate.
In other cases, the Memorandum explained, individuals who anticipated moving out of the State sought to avoid New York tax on the gain from the upcoming sale of an asset by transferring it to a New York C corporation while they were a New York resident. The corporation, which had elected to be a federal S corporation, would then sell the asset, and the gain would be taxed by the State under the corporation’s presumably lower investment allocation percentage. The distribution of the gain to the shareholders was then delayed until the shareholders moved out of state. At that time, the distribution to the nonresidents would not be subject to tax by New York.[xi]
This type of behavior, the Legislature found, was concentrated among a small number of affluent taxpayers who could avail themselves of this type of arrangement.
Forced NY “S” Election
The Tax Law was amended to correct this loophole by mandating that a New York C corporation will be treated as a New York S corporation for a taxable year[xii] if it is a federal S corporation and more than 50% of the corporation’s federal gross income for such year[xiii] is derived from investment income.[xiv] As a result, the corporation’s shareholders would be subject to New York’s personal income tax with respect to the income and gain from the corporation’s investment assets.
For the purposes of the foregoing rule, the term “investment income” means the sum of an eligible S corporation’s gross income from interest, dividends, royalties, annuities, rents and gains derived from dealings in property, to the extent such items would be includable in federal gross income for the taxable year.[xv]
Notwithstanding the enactment of this loophole-closing provision, it appears that individuals taxpayers and the Department still disagree over the meaning of the term “investment assets” – the amount of gain from which may be pivotal in determining whether a federal S corporation that did not elect to be treated as a New York S corporation should, nonetheless, be treated as having made such an election for a particular tax year – as was illustrated by a recent decision that considered a sale by nonresident shareholders of their stock in a federal S corporation where the sellers and the corporate buyer jointly elected under Section 338(h)(10) of the Code[xvi] to treat the transaction as a purchase and sale of assets for federal tax purposes.[xvii]
Before considering this decision, however, it may be helpful to first review New York’s source rules for nonresidents and the State’s history with Section 338(h)(10) of the Code.
Source Rules
In general, nonresidents are subject to New York personal income tax on their New York source income, which is defined as the sum of income, gain, loss, and deduction derived from or connected with New York sources.[xviii] For example, where a nonresident sells New York real property[xix] or tangible personal property located in New York, the gain from such sale is taxable in the State.[xx]
If a nonresident individual carries on a trade or business party within and partly outside New York, the nonresident must determine the items of income, gain, loss, and deduction that are derived from or connected with New York sources.[xxi]
However, income derived from intangible personal property, including dividends and interest, as well as the gain from the disposition of intangible property (for example, shares of stock in a corporation), constitute income derived from New York sources only to the extent that the intangible property is employed in a business carried on in New York.[xxii]
If the intangible property is not “employed” in a New York business, the gain from its sale will be sourced to the nonresident seller’s state of domicile.
Goodwill
What about the gain from the sale of goodwill that is associated with a New York business, and which often represents the single-most valuable asset being sold? How is the gain from the sale of this intangible asset sourced for purposes of determining the New York income of a nonresident owner?[xxiii]
There is no point denying that the goodwill of a business is employed in that business; indeed, it is integral to the business.[xxiv] The question of its situs, however, may be something else entirely though, generally speaking, the gain from the sale of the goodwill should be apportioned according to the business’s apportionment factor.[xxv]
NY Tax Law and Section 338(h)(10)
In determining the New York source income or gain of a nonresident shareholder of a federal S corporation that has also elected to be treated as a New York S corporation,[xxvi] there is included in the nonresident’s income only their pro rata share of such S corporation items that are derived from or connected with New York sources and that enter into the nonresident’s federal adjusted gross income.[xxvii]
In 2009, New York’s Tax Appeals Tribunal considered a nonresident’s sale of stock in a New York S corporation.[xxviii] The Tribunal concluded that, even though the selling shareholders and the purchaser elected under Section 338(h)(10) of the Code to treat the stock transaction as an asset sale for purposes of the federal income tax, the transaction would still be treated as a stock sale with respect to the nonresident shareholders. Because the gain derived by a nonresident from the sale of intangible personal property, such as stock, does not constitute income derived from New York sources, except to the extent that the property was employed in a business carried on in the State, it was not subject to New York tax.
In the following year, however, the New York Legislature reversed this outcome[xxix] by amending the Tax Law to provide that a nonresident’s share of the New York-source portion of the gain realized by a target S corporation as a result of a Section 338(h)(10) election would be taxable to the nonresident shareholder.[xxx]
Now, let’s turn to the decision.
Deemed Sale of Assets
Target was a New York corporation that elected to be treated as an S corporation for federal income tax purposes effective as of its date of incorporation. It did not elect to be treated as an S corporation for purposes of the New York State income tax.[xxxi]
Stock Transaction
During the Tax Year, Corp[xxxii] purchased all the issued and outstanding shares of Target stock from Target’s shareholders for approximately $58 million. At least two of such shareholders (the “Taxpayers”) were not residents of New York.
Section 338(h)(10) Election
Following the stock transaction, Target’s shareholders and Corp made a valid joint election[xxxiii] to treat the transaction – for federal tax purposes – as though a newly formed, wholly owned corporate subsidiary of Corp (“New Sub”; actually, “post-sale” Target) had purchased all of Target’s assets in exchange for consideration of an amount equal to the sum of (i) the $58 million purchase price for the Target stock, plus (ii) the amount of Target’s liabilities, following which Target was deemed to have made a liquidating distribution of the $58 million to its shareholders.[xxxiv]
Significantly, but for Target’s having elected to be treated as an S corporation for federal tax purposes, the sale of Target’s stock by its individual shareholders to Corp would not have qualified for the above-described election to treat the transaction as a purchase and sale of Target’s assets.[xxxv]
Cost Recovery
As a result of the deemed purchase and sale of Target’s assets, New Sub obtained a cost basis for Target’s assets, with respect to which it was then able to claim cost recovery deductions[xxxvi] in the form of depreciation, bonus depreciation, and/or amortization[xxxvii] depending upon the asset, how the cost basis was allocated among the assets,[xxxviii] and the assets’ respective recovery periods.
According to the IRS Form 8883, Asset Allocation Statement Under Section 338, filed by Target,[xxxix] almost $49.5 million of the total sale price was attributable to Target’s “self-created” goodwill[xl] and other intangible assets.[xli]
When acquired through an actual or deemed purchase and sale of assets that make up a trade or business, goodwill is treated as an asset the nature of which is subject to allowance for amortization. Thus, New Sub was entitled to amortize the goodwill it purchased from Target over a period of 15 years.[xlii]
Target and Shareholder Tax Returns
Following the above transaction, Target filed a General Business Corporation Franchise Tax Return[xliii] as a New York C corporation for the period beginning January 1 and ending February 21 of the Tax Year (the “NY corporate return”).[xliv] On its return, Target reported a New York business income base of approximately $2.85 million based upon total business (operating) income of over $43 million and a New York business apportionment factor (“BAF”) for the tax period of 6.5898%.[xlv] Target calculated the New York tax due, which it paid in full.
Although Target was an eligible S corporation for the Tax Year – meaning, it had a valid federal S corporation election[xlvi] in effect – its shareholders did not elect S corporation status for that year.[xlvii]
The Audits
The Department subsequently audited Target. The initial scope of the audit was to determine whether the sale of Target to Corp through the elective federal Section 338(h)(10) deemed asset sale triggered the mandatory S corporation election provision under the Tax Law, described earlier.[xlviii]
The Tax Law provides that shareholders of a federal S corporation that have not elected S corporation status for New York tax purposes will be deemed to have made such an election for the current tax year if the eligible S corporation’s “investment income”[xlix] for such taxable year is more than 50% of its federal gross income for the tax year.
On Target’s U.S. Income Tax Return for an S Corporation[l] for the tax period beginning January 1 and ending February 21 of the Tax Year, Target reported total federal gross income of approximately $60.2 million, made up largely of long-term capital gain of almost $44.48 million, substantially all of which came from the deemed sale of the goodwill created by Target during the course of its business operations.
Investment Income?
At the conclusion of the audit, the auditor determined that the gain associated with Target’s self-created goodwill was “investment income” within the meaning of New York’s mandatory S corporation election provision.
Therefore, the auditor concluded that $44.48 million in income from the sale of Target to Corp should be considered investment income when determining whether Target’s investment income for the Tax Year was greater than 50% of its federal gross income for that year for purposes of New York’s mandatory S corporation election provision.[li]
Based upon the information Target reported on its federal tax return for the Tax Year, the auditor determined that Target’s investment income percentage[lii] was equal to 81.82%.
Thus, the auditor concluded that Target met the criteria that should have triggered a mandatory New York S corporation election by Target for the Tax Year.
Surprisingly, Target “accepted” the mandatory election.
Taxation of the Taxpayers
As a result of the mandatory S corporation election, the auditor adjusted Target’s New York corporate return for the Tax Year to reflect a change in its filing status from a C corporation to an S corporation, as a result of which Target was responsible only for the fixed dollar minimum tax.[liii]
In addition, as a result of the New York “S” election, additional taxable gain should have flowed through to Target’s shareholders, including the Taxpayers, based on their pro rata interest in Target.[liv]
The Department then audited the Taxpayers to determine their New York personal tax liability for the Tax Year based upon Target’s acceptance of the mandatory S corporation election and the Taxpayer’s ownership interest in Target.[lv]
The auditor determined that the Taxpayers received a total of $1.724 million in taxable New York source capital gain from the sale of Target, based upon the Taxpayers’ respective percentage stock interests, the flow-through items of income, gain, etc., that were reported on their federal schedules K-1, and Target’s’s BAF of 6.5898%.[lvi]
The Department then issued notices of deficiency to the Taxpayers, asserting additional New York income tax for the Tax Year, plus interest.
Classification of Target’s Goodwill
The Taxpayers petitioned the Division of Tax Appeals to protest the notices of deficiency and, specifically, to dispute the classification of the gain realized on the deemed sale of Target’s self-created goodwill as “investment income” for purposes of determining whether the forced New York “S” election was applicable.
According to the Taxpayers, the self-created goodwill was used in Target’s business and, when it was deemed to have been purchased as a result of the Section 338(h)(10) election, was subject to the allowance for amortization in the hands of the buyer (New Sub). Therefore, the Taxpayers’ argument went, the gain from the sale of such self-created goodwill should have been considered business, not investment, income for purposes of the mandatory S corporation rule.
The ALJ’s Opinion
The only issue before the ALJ was whether the 50% investment income threshold was met, which depended upon whether the gain from the deemed sale of Target’s self-created goodwill fell within the definition of “investment income” under the mandatory “S” election rule.[lvii]
According to the ALJ, the parties stipulated that if self-created goodwill was “investment income,” the 50% threshold was met, a mandatory S corporation election was required and the Taxpayers owed the additional tax asserted in the notices of deficiency; if not, then the threshold was not met, and the Taxpayers would not owe any income tax to New York for the Tax Year.[lviii]
The ALJ explained that, for eligible federal S corporations, the decision to elect New York S corporation status was generally voluntary;[lix] however, an S election was required under the following circumstances:
“Notwithstanding the provisions in [Tax Law Sec. 660(a)], in the case of an eligible S corporation for which the election under [Tax Law Sec. 660(a)] is not in effect for the current taxable year, the shareholders of an eligible S corporation are deemed to have made that election effective for the eligible S corporation’s entire current taxable year, if the eligible S corporation’s investment income for the current taxable year is more than 50% of its federal gross income for such year.”
The ALJ continued:
“[T]he term ‘investment income’ . . . means the sum of an eligible S corporation’s gross income from interest, dividends, royalties, annuities, rents and gains derived from dealings in property, including the corporation’s share of such items from a partnership, estate or trust, to the extent such items would be includable in federal gross income for the taxable year.”
The ALJ observed that all or substantially all of the reported long-term capital gain at issue came from the deemed sale of goodwill created by the Target during the course of its business operations.
Having said that, however, and having reminded the Taxpayers of the presumption of correctness that attaches to a properly issued notice of deficiency, and of their burden to prove by clear and convincing evidence that the deficiency was erroneous, the ALJ stated, without any discussion, that the Department had properly applied the mandatory “S” election rule when it determined that such goodwill should have been included in the Target’s investment income.
What’s more, the ALJ added, the Department’s determination was supported by a decision of the Tax Appeals Tribunal according to which the gain from the sale of self-created goodwill was investment income for purposes of this rule.[lx] As such, the 50% investment income threshold was met, and a mandatory S corporation election was required.
With that, the ALJ rejected the Taxpayers’ argument that the Tax Appeals Tribunal opinion on which it was relying had been wrongly decided, stating that the decision was binding precedent that must be followed.[lxi]
Thus, the ALJ denied the Taxpayers’ petitions and sustained the notices of deficiency.[lxii]
Did the ALJ Miss the Mark?
The ALJ decided that Target’s gain the deemed sale[lxiii] of its goodwill represented an item of investment income. In doing so, it failed to consider – as did the precedent[lxiv] on which the ALJ relied – the significance of whether the asset deemed to have been sold was held for investment by the corporation or for use in its trade or business.
As stated above, for purposes of New York’s mandatory “S” election rule, the term “investment income” means the sum of a federal S corporation’s gross income from various sources, including interest, dividends, royalties, annuities, rents and gains derived from dealings in property to the extent such items would be includable in the S corporation’s federal gross income for the taxable year in question.[lxv]
However, not all gains derived from “dealings in property” – i.e., sales or exchanges of property – represent investment income, and not all properties held by a corporation are held for the production of such income.
Indeed, most corporations hold their assets for use in the conduct of a trade or business. These assets are of the kind that generate business income, and not investment income.
In the context of a purchase and sale, a group of assets constitutes a trade or business if the use of such assets would constitute an active trade or business under Section 355 of the Code,[lxvi] or its character is such that goodwill or going concern value could under any circumstances attach to such group of assets.[lxvii]
A corporation is treated as engaged in a trade or business if a specific group of activities is being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income or profit.[lxviii]
The determination of whether a corporation’s trade or business is actively conducted is made from all of the facts and circumstances. Generally, the corporation is required itself to perform active and substantial management and operational functions. Significantly for purposes of this post, the active conduct of a trade or business does not include the holding of property for investment purposes.[lxix]
Assuming the group of assets in question constitutes a trade or business, the Code and the regulations prescribe the “residual method” for allocating among such assets the consideration treated as having been paid and received by the buyer and the seller, respectively, for purposes of determining the former’s cost bases for the assets and the latter’s gain realized from the sale of the assets. Under this method, the final group of assets to which such consideration is allocated consists of goodwill and going concern value.[lxx]
The self-created asset known as “goodwill” is treated as a capital asset,[lxxi] at least in the hands of the business that originated the goodwill. It represents the value of a trade or business that is attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of the trade or business or some other factor.[lxxii]
Goodwill is closely related to going concern value, which is the additional value that attaches to property because of its existence as an integral part of an ongoing business activity.[lxxiii]
An asset or group of assets constitutes a trade or business if goodwill or going concern value could, under any circumstances, attach to the assets.[lxxiv]
When the assets of the business are sold, the goodwill becomes, in the hands of the buyer, “property used in the trade or business” of a character which is subject to the allowance for depreciation or amortization.[lxxv]
Based on the foregoing, one may conclude that goodwill arises only in the context of a trade or business, and is inseparable from such trade or business.[lxxvi]
Form the same reason, it is difficult to see how the ALJ in the present case, or the TAT in the decision relied on by the ALJ as precedential, determined that goodwill could exist as an asset other than as part of a trade or business. In other words, the gain arising from the sale of goodwill in the context of the sale of a business should not have been treated as investment income for purposes of New York’s mandatory S corporation election rule.[lxxvii]
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] No longer veto-proof, but history has shown us that even a veto-proof Legislature lacks the political will to override the titular head of the majority’s political party. Witness many of the years during A. Cuomo’s tenure.
[ii] Much of New York’s Tax Law is a history of “temporary” tax increases which are almost always extended several times and eventually become permanent.
[iii] They are not necessarily appealing to the same base of support.
[iv] One that is subject to New York’s income tax jurisdiction.
[v] NY Tax Law Sec.660(a). Only a small number of states (including New York) do not provide for conforming “S” elections.
[vi] IRC Sec. 1361.
[vii] NY Tax Law Sec. 660(i), effective for taxable years beginning on or after January 1, 2007.
[viii] 2007-2008 New York State Executive Budget Revenue Article VII Legislation Memorandum In Support.
[ix] We’ll return to this soon enough.
[x] IRC Sec. 1366.
[xi] The gain from the “sale” of the intangible being sourced in the jurisdiction of which the seller is a resident. See below.
[xii] An eligible S corporation will be treated as a New York S corporation only for a tax year for which the 50% test described above is met. If the 50% test is not met for a tax year, the eligible S corporation will be treated as a New York C corporation for that year, even if the corporation was treated as a New York S corporation under the provisions of NY Tax Law Sec. 660(i) for the prior year. TSB-M-07(8)I; TSB-M-08(1)C.
[xiii] Determined from the actual federal S corporation return filed by the corporation, not from a pro forma federal C corporation return. See TSB-M-07(8)I; TSB-M-08(1)C.
[xiv] IRC Sec. 61(a)(3) provides that gross income includes “[g]ains derived from dealings in property.” The regulations under IRC Sec. 61 do not define the term “gains derived from dealings in property.” However, Reg. Sec. 1.61-6 provides that “[g]ain realized on the sale or exchange of property” – meaning, gain derived from dealings in property – including “tangible items, such as a building, and intangible items, such as goodwill” – is included in gross income. Reg. Sec. 1.61-6(c) then states that “certain gains derived from dealings in property” – i.e., sales or exchanges of property – “are treated specially.”
[xv] NY Tax Law Sec. 660(i)(3).
[xvi] Of course, there are only two Codes (initial cap “C”) in effect today: the Ten Commandments and the Internal Revenue Code. All others are lower case (the bankruptcy code, for example). Justinian’s Code also merits a capital “C”.
[xvii] In the Matter of the Petition of Petosa and In the Matter of the Petition of Wheeler, Division of Tax Appeals, DTA Nos. 831253 and 831264.
[xviii] NY Tax Law Sec. 631(a) and (b).
[xix] For purposes of this rule, the term “real property located in” New York was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in New York and has a fair market value that equals or exceeds 50% of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity. NY Tax Law Sec. 631(b)(1)(A)(1).
In accordance with an “anti-stuffing” rule, only those assets that the entity owned for at least two years before the date of the sale or exchange of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on such date.
[xx] A nonresident will be subject to N.Y. personal income tax with respect to their income from:
- real or tangible personal property located in the State, (including certain gains or losses from the sale or exchange of an interest in an entity that owns real property in N.Y.)
- services performed in N.Y.
- a business, trade, profession, or occupation carried on in N.Y.
- their distributive share of N.Y. partnership income or gain
- any income received related to a business, trade, profession, or occupation previously carried on in the State, including, but not limited to, covenants not to compete and termination agreements; and
- a N.Y. S corporation in which they are a shareholder, including, for example, any gain recognized on the deemed asset sale for federal income tax purposes where the S corporation’s shareholders have made an election under Sec. 338(h)(10) or Sec. 336(e) of the Code.
Although the foregoing list encompasses a great many items of income, there are limits to the State’s reach; for example, N.Y. income does not include a nonresident’s income:
- from interest, dividends, or gains from the sale or exchange of intangible personal property, unless they are part of the income they received from carrying on a business, trade, profession, or occupation in N.Y.; and
- as a shareholder of a corporation that is a N.Y. C corporation.
[xxi] NY Tax Law Sec. 631(c). New York provides special allocation and apportionment rules for this purpose.
[xxii] NY Tax Law Sec. 631(b)(2).
[xxiii] Let’s assume the entity through which the business is operated is a pass-through entity, such as an S corporation. The character of the gain realized by the corporation and which passes through to the shareholder is determined as if it were realized by the shareholder directly from the source from which realized by the corporation. IRC Sec. 1366(b).
[xxiv] For an interesting discussion of this issue – albeit from the State of California – see In re the Consolidated Appeals of The 2009 Metropoulos Family Trust; The Evan D. Metropoulos 2009 Trust, California Office of Tax Appeals, Case Nos. 18010012, 18010013, Nov. 7, 2019. The OTA considered the sale of goodwill by an S corporation that had nonresident shareholders. According to the OTA, the S corporation’s sale of goodwill generated business income; thus, the source of the gain to be allocated to the nonresident shareholders was determined using the S corporation’s California apportionment percentage – it was not based on the nonresidents’ state of domicile.
[xxv] NY Tax Law Sec. 210-A(10); 20 NYCRR Sec. 4-4.3(e).
[xxvi] NY Tax Law Sec. 660.
[xxvii] NY Tax Law Sec. 632(a)(2).
[xxviii] In the Matter of the Petition of Baum, Decision DTA No. 820837.
[xxix] The 2010 amendments to NY Tax Law Sec. 632(a)(2) (L 2010, ch 57, Part C).
[xxx] That amended section provides, in relevant part: “[I]f the shareholders of the S corporation have made an election under section 338(h)(10) of the Internal Revenue Code, then any gain recognized on the deemed asset sale for federal income tax purposes will be treated as New York source income allocated in a manner consistent with the applicable methods and rules for allocation under article nine-A of this chapter in the year that the shareholder made the section 338(h)(10) election.”
[xxxi] There is no comparable election for purposes of the New York City income tax; meaning, a N.Y. S corporation is taxed as a C corporation by the City.
[xxxii] Corp was actually organized as a limited liability company under state law. Because it was able to make an election under IRC Sec. 338(h)(10), as we’ll soon see, it must have “checked the box” under Reg. Sec. 301.7701-3 to be treated as an association taxable as a corporation for tax purposes, or it filed a Form 2553 to be treated as an S corporation, in which case, it was treated as having made a check the box election to be classified as an association. Reg. Sec. 301.7701-3(c)(1)(v)(C).
[xxxiii] Under IRC Sec. 338(h)(10). The election is made jointly by the purchasing corporation and the shareholders of the target S corporation on IRS Form 8023. The section 338(h)(10) election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.
S corporation shareholders who do not sell their stock must also consent to the election – this highlights the importance of providing for a drag-along in the S corporation shareholders’ agreement, together with a mechanism for compelling a shareholder’s consent to certain tax-related elections.
[xxxiv] Reg. Sec. 1.338(h)(10)-1(d).
[xxxv] Interestingly, IRC Sec. 338(h)(10) does not actually mention S corporations; it refers only to a consolidated group or an affiliated group of corporations. The regulations under that section make it applicable to S corporations.
[xxxvi] The quicker a buyer is able to recover their cost for the acquired assets – by offsetting the buyer’s income – the less expensive the deal becomes for the buyer.
[xxxvii] IRC Sec. 168, Sec. 168(k), and Sec. 197, respectively.
[xxxviii] Reg. Sec. 1.338-6 and 1.338-7.
[xxxix] Both Target and New Sub are required to file this form. The first is filed by Target as an S Corp; the second by Target as the subsidiary of a C corporation. In general, the form is attached to the returns on which the effects of the deemed sale and purchase of Target’s assets are required to be reported.
[xl] Not acquired by Target in the context of having purchased another business.
[xli] Class VI and Class VII assets; the former covers all section 197 intangibles except goodwill and going concern value; the latter covers goodwill and going concern value.
[xlii] Pursuant to IRC Sec. 197.
[xliii] On form CT-3.
[xliv] If no Sec. 338(h)(10) had been made, the federal S corporation’s tax year would have ended the day before the transaction date; with the election, the S corporation’s tax year ends at the end of the transaction date.
In the case of a C corporation all the stock of which is acquired by another C corporation, its current tax year closes at the end of the transaction date.
[xlv] All corporations must apportion within and without New York their total business income and business capital by a business apportionment factor (BAF) that is expressed as a fraction. The numerator and denominator of the BAF includes only those receipts, net income, net gains, and other items that are included in the computation of entire net income for the taxable year. The numerator of the BAF is the sum of all New York receipts and the denominator is the sum of all receipts. NY Tax Law Sec. 210-A.
[xlvi] IRC Sec. 1362.
[xlvii] If the shareholders of an S corporation make an S election for federal tax purposes, New York does not automatically treat the corporation as a New York S corporation, subject to one exception.
It wasn’t long ago that New York’s Legislature considered but rejected an automatic election. According to the FY 2024 Executive Budget Briefing Book, New York’s Governor proposed an amendment to the Tax Law that would have required all federal S Corporations be treated as such for New York State tax purposes unless the corporation was a qualified New York manufacturer and chose New York C corporation status.
[xlviii] NY Tax Law Sec. 660(i).
[xlix] Recall the Memorandum in Support discussed earlier, and its description of the abuse targeted by the mandated S corporation election.
[l] IRS Form 1120-S.
[li] NY Tax Law Sec. 660(i).
[lii] Total investment income (almost entirely gain from the deemed sale of goodwill) over total federal gross income.
[liii] According to the ALJ, the resulting reduction in the corporate-level tax was refunded to “the corporation.” Query what the purchase and sale agreement provided with respect to any such refund.
[liv] IRC Sec. 1366. Significantly, the character of any item of income or gain included in a shareholder’s pro rata share is determined as if such item were realized directly from the source from which realized by the corporation.
[lv] The Taxpayers did not file New York State personal income tax returns for the Tax Year because they were nonresidents of New York for that year and did not have a New York filing requirement prior to the audit of Target. Therefore, the auditor used their federal income tax returns as a starting point to determine their New York tax liability.
[lvi] The parties agreed that the BAF percentages used by the Department to calculate the New York source income of Target and Taxpayers were correct.
[lvii] NY Tax Law Sec. 660(i)(3).
[lviii] Because the Target would continue to be treated as a C corporation for purposes of the New York income tax, and the Taxpayers’ gain from the sale of their Target stock would have been treated as the sale of an intangible that was situated outside the State.
[lix] NY Tax Law Sec. 660(a).
[lx] Matter of Lepage (Tax Appeals Tribunal, May 17, 2021). The taxpayer in that decision reported the gain from a deemed sale of assets (under a Sec. 338(h)(10) election) as gain from the “sale of intangibles and goodwill” and other business property. According to the TAT, this income fell within the parameters of the gains derived from “dealings in property” and were properly classified as “investment income.”
[lxi] I agreed with the Taxpayers’ contention, and still do.
[lxii] It remains to be seen whether the Taxpayer’s will appeal the ALJ’s determination by filing an exception with the Tax Appeals Tribunal. The exception must be filed with the Secretary to the Tribunal within 30 days of notification of the ALJ’s determination.
[lxiii] As a result of the IRC Sec. 338(h)(10) election.
[lxiv] Matter of Lepage (Tax Appeals Tribunal, May 17, 2021).
[lxv] NY Tax Law Sec. 660(i)(3).
[lxvi] A divisive reorganization.
[lxvii] Reg. Sec. 1.1060-1(b)(2).
[lxviii] Reg. Sec. 1.355-3(b). Such group of activities ordinarily must include the collection of income and the payment of expenses.
[lxix] Reg. Sec. 1.355-3(b)(2)(iv)(A).
[lxx] Class VII. Reg. Sec. 1.338-6(b)(2)(vii); Reg. Sec. 1.1060-1(a).
[lxxi] IRC Sec. 1221.
[lxxii] Reg. Sec. 1.197-2(b)(1). Think of it as the total of all those indefinable qualities that bring customers to a business, such as the right to have the business at a particular location under a trade name or trademark, any special knowledge or know-how, the number and quality of customers, or any other similar elements of value in the business as a going concern.
[lxxiii] Reg. Sec. 1.197-2(b)(2). Going concern value includes the value attributable to the ability of a trade to continue functioning or generating income without interruption notwithstanding a change in ownership. It also includes the value that is attributable to the immediate use or availability of an acquired trade or business, such as, for example, the use of the revenues or net earnings that otherwise would not be received during any period if the acquired trade or business were not available or operational.
[lxxiv] Reg. 1.197-2(e)(1); Reg. Sec. 1.1060-1(b)(2). For this purpose, all the facts and circumstances, including any employee relationships that continue (or covenants not to compete that are entered into) as part of the transfer of the assets, are taken into account in determining whether goodwill or going concern value could attach to the assets.
[lxxv] IRC Sec. 1231(b).
[lxxvi] See IRC Sec. 163(d)(4), which defines “investment income” (for purposes of the limitation on the deduction of investment interest expenses) as to include gain from the disposition of property held for investment.
See also IRC Sec. 1362(d), which addresses the loss of a corporation’s “S” election where the corporation has Subchapter C earnings and profits and excess passive investment income.
[lxxvii] Think back on the genesis of the mandatory election rule, discussed earlier. It’s difficult to see how the goodwill associated with a trade or business may be contributed to a corporation independently of such business. In other words, can the abuse targeted by the Legislature have encompassed the transfer of goodwill? Unlikely.