For the last 10 years or so, New York State’s rules for taxing stock option income have been the subject of much dispute and litigation. In many cases, the New York State Department of Taxation and Finance has successfully defended its position, but its defeat in a recent case (E. Randall Stuckless, DTA No. 819319) promises to change significantly the way in which New York state can tax stock option income earned by nonresidents.

In the Stuckless case, New York’s Tax Appeals Tribunal—the highest administrative court in the tax appeals process—expressly rejected the Department’s “grant-to-exercise” methodology for the taxation of a nonresident’s stock option income. This decision represents a major shift in Tax Department policy on an issue where it was very active, and most certainly presents an opportunity for refunds of taxes, interest and penalties paid based on the old grant-to-exercise rules.

Background on the Grant-to-Exercise Rule

Mr. Stuckless argued, as have many taxpayers over the past decade, that the tax department’s methodology for taxing stock option income was incorrect. Under rules issued in 1995 through an interpretive memorandum, the department treated the “spread” between the grant and the exercise price of a stock option as compensation for services rendered (see TSB-M-95(3)I). More important, the department required that the income be allocated to New York based on the nonresident’s New York workdays during the entire grant-to-exercise period.

This created some very difficult situations. According to this 1995 memorandum, New York was entitled to tax a portion of the option income if an employee spent even a single workday in New York State during the grant-to-exercise period—a period of time that could extend several tax years. For instance, an employee who lived and worked in New Jersey for a New Jersey employer would have to pay New York tax on a portion of his stock option income if he occasionally traveled into New York for meetings, to entertain clients, to participate in seminars, etc., during the grant-to-exercise period.

This rule had an even more pronounced effect on ex-New Yorkers. If an employee who was granted stock options when he lived and worked in New York retired to Florida and waited five years before he exercised the options, New York believed it was entitled to tax on 100 percent of the option income. No credit is given for time spent in Florida, as the New York Department of Taxation would argue that there were no workdays in Florida after the taxpayer retired.

Even if the employee could claim that, during his New York employment, he spent a large percentage of time working out of the state, he would have the heavy burden of proving the existence of these out-of-state workdays in order to reduce the grant-to-exercise percentage.

Despite the difficulty of the grant-to-exercise rule in practice, New York has applied it consistently in audits since 1995 with almost complete success.

The Stuckless Decision and Its Aftermath

In the Stuckless case, after several appeals, a reargument and assistance from an amicus curiae (a “friend of the court”), the Tribunal finally held that New York’s Department of Taxation and Finance had no regulatory authority to impose a multiyear allocation rule on stock option income. Instead, the Tribunal determined that any allocation of stock option income by a nonresident of New York must be based on the taxpayer’s New York workdays during the year in which the option income was realized. No “look back” or other type of “grant-to-exercise” test was appropriate.

The decision significantly affects nonresidents with stock option income. In the example above, for instance, the New Jersey employee could eliminate the tax on all of his option income if he were able to avoid New York during the year he planned to exercise his options. And the retired Floridian would pay no tax to New York, as long as he exercised his options after he moved south.

More generally, taxpayers who paid taxes voluntarily or upon audit under the grant-to-exercise methodology could be in line for significant refunds. It is expected that there will be some guidance from Albany on the Department’s position concerning the administration of such refunds. In the meantime, New York law allows refund claims to be filed within certain time limitations (generally two or three years, depending on the circumstances), so taxpayers and practitioners should take immediate steps to do so.

Planning opportunities are also available.

Taxpayers who are thinking of exercising options in 2006 would be well advised to significantly limit their time in New York for the rest of the year. Recently proposed regulatory changes in the stock options area are supposed to be effective beginning in 2007. These rules will reportedly be based on workdays during the multiyear “grant-to-vesting” period. Thus, taxpayers looking to take advantage of the Stuckless decision should act quickly.

Mark S. Klein, Esq., is a partner in the tax department of Hodgson Russ LLP, where his practice is concentrated on New York state tax matters. He can be reached at mklein@hodgsonruss.com.

Timothy Noonan, Esq., concentrates in state and local tax law, with a focus on New York state and City tax issues at Hodgson Russ LLP. He is a frequent lecturer on New York state and multistate tax matters and is on the faculty of the Institute of Continuing Professional Education. He can be reached at tnoonan@hodgsonruss.com.