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Nonresident Allocation Rules

New York’s Nonresident Allocation Rules are some of the most frequently referenced issues in audits and tax questions. They are also some of the most active practice areas in New York taxation -- and one of the issues most likely to lead to an audit in the state. Even if a taxpayer is able to establish residency in another state, he or she might still have issues in New York because under New York’s rules, nonresidents also have to pay New York state taxes in some situations.

Overview of Nonresident Taxation

The tax computation for New York residents is simple. Residents are taxable on one thing: Everything. Nonresidents, however, can be taxed only on income that is derived from or connected to New York sources. That isn’t just because New York likes to treat nonresidents more favorably. Under the U.S. Constitution, a state may not tax a nonresident’s income unless it has some connection with the state. So the focus in nonresident allocation cases is usually on one thing — whether the taxpayer’s income was derived from or connected to New York sources. Generally, under Tax Law section 631, the New York-source income of a nonresident individual includes all items of income, gain, loss, and deduction entering into the taxpayer’s federal adjusted gross income that are attributed to the ownership of any interest in real or tangible property located in New York or a business, trade, profession, or occupation carried on in New York.

Employee Wages

Employees’ wages likely constitute the most common form of income in allocation audits. And for the most part, the rules are straightforward. If all the employee’s services are performed in New York, all compensation is allocated to New York. When a nonresident performs services within and outside New York State, the nonresident’s income must be allocated to New York according to a fraction, the numerator of which is the number of days worked in New York and denominator of which is the total number of days worked everywhere.

According to New York’s Allocation guidelines, a taxpayer doesn’t have to work an entire day for it to count as a “workday” in New York. Although, in many cases our firm takes the position that taxpayers can work half-days. Taxpayers should also keep in mind the convenience of the employer rule, which basically says if a taxpayer employed by a New York employer works outside of New York for his or her own convenience, the nonresident taxpayer must count it as a New York workday.

Bonuses

Bonuses are generally allocated in the same way as regular compensation. If a bonus is received during the tax year in which it was earned, the allocation fraction is simply based on the same wage allocation fraction used for regular salary. However, if a bonus is paid for work performed in a different year, the workday allocation fraction applicable for the year in which the bonus was earned is used. Thus, a bonus paid in February 2010 for work performed in 2009 would be allocated based on the workday allocation fraction applicable to the 2009 year.

Pensions and Retirement Income

The general rule: Compensation for services rendered in New York State is subject to tax even if it is received in a year when no services are performed in the state. So a former New Yorker who receives some form of a deferred compensation generally — and emphasis on the word ‘‘generally’’ — will be required to pay New York taxes on that compensation. The allocation formula for that type of income is based on a fraction, the numerator of which is New York compensation for the year of retirement plus the preceding three years, and the denominator of which is total compensation for the same period.

But there are several exclusions in New York and federal law that can apply to exclude some forms of compensation paid after termination of employment. There are also special federal rules applicable in this area that are not covered or addressed in New York’s laws or regulations. For example, Public Law section 104-95 prohibits the states from taxing a nonresident’s retirement income, regardless of its source.

Other Postemployment Compensation

Other forms of deferred compensation receive special treatment. For instance, under prior law, some forms of termination pay escaped  New York taxation, such as payments under a covenant not to compete contract.  But the tax law was changed in 2009 to make sure that all forms of post-employment compensation could be taxed by New York to the extent the taxpayer worked in New York in prior years.

Stock options are another form of deferred compensation that has received a lot of coverage in practitioner circles and publications. The rules for income from stock options exercised in 2006 and later years are straightforward. Stock option income must be allocated based on the taxpayer’s workday allocation factors between the date on which the options were granted and the date on which the options vested.

Director’s Fees

According to the allocation guidelines, a nonresident board member who works in New York for a corporation doing business in New York has to allocate board compensation based on the location of board meetings. For those purposes, a board meeting obviously counts as a workday. The guidelines also seem to permit allocation of other board-related work, but they do reference application of the convenience rule in making that determination.

Gains or Losses From Real Property

In the past, the rules in this area were clear. Under current legislation, the phrase “real property located in this state” as defined in Tax Law section 631 is redefined to include interests in a partnership, limited liability company, S corporation, or closely held C corporation (that is, with 100 or fewer shareholders) owning real property located in New York State if the value of the real property exceeds 50% of the value of all of the assets in the entity. There is a two-year lookback rule to avoid taxpayers’ “stuffing” assets into an existing entity before a sale. For sales of entity interests occurring on an after May 7, 2009, any gain recognized on the sale of an interest in that entity will be allocated among the assets in the entity, and the amount allocated to New York real property will be treated as New York-source income.

Business Income

The taxation of business income necessarily varies based on the vehicles through which it is earned. For sole proprietors and partners, the regulations provide that items of income, gain, loss, and deduction attributable to that business, trade, profession, or occupation must be apportioned and allocated to New York State on a fair and equitable basis in accordance with approved methods of accounting. According to the regulations, that “fair and equitable” allocation must be done using one of two methods. First is an “actual” method, if the book and records disclose the in-state and out-of-state income “to the satisfaction of the Tax Commission.” Absent that, the regulations set for what basically is a three-factor formula comprising of property, payroll, and receipts of the business or partnership from in-state and out-of-state sources. That same allocation would apply for nonresident members of LLCs.

Shareholders of S corporations, however, allocate differently. Under the tax law, S corporation shareholders determine the New York-source portion of their pro rata share of the corporation’s income or loss based on the rules applicable to regular business corporations under article 9-A of the Tax Law. The article 9-A allocation rules call for a single-factor allocation, based on receipts only. So that rule creates somewhat of an uneven playing field for taxpayers involved in flow-through entities.

Be on the lookout for these types of issues, because they arise in almost every residency audit the tax department undertakes. Unlike issues about domicile and day count, these questions may not be at the forefront of the auditors’ minds, and they are often overlooked in residency planning situations. But given New York’s high tax rates, even for nonresidents, these questions are often hugely important in day-to-day residency audits.

In today's world, many taxpayers lead complex lives and may travel to multiple states as part of business, family obligations and other experiences. If you are subject to a New York State nonresident audit or have questions about residency or nonresidency issues, contact the attorneys at Hodgson Russ LLP for a consultation.