MoFo New York Tax Insights, Volume 4, Issue 9, September 2013

Gain on Sale of Non-New York Leaseholds Held Properly Sourced to New York Based on Business Allocation Percentage

By Kara M. Kraman

A New York State Administrative Law Judge held that a nonresident shareholder in a corporation that elected New York S corporation status should have included his pro rata share of the gain from the S corporation's sale of four Pennsylvania leasehold interests in his New York source income, based on the S corporation's business allocation percentage. Matter of Steven E. Breitman, DTA No. 824268 (N.Y.S. Div. of Tax App., Aug. 1, 2013).

The taxpayer, Steven Breitman, a New Jersey resident, was the owner and president of SEBCO Laundry Systems, Inc. ("SEBCO"). SEBCO provided laundry facilities in apartment buildings by entering into lease agreements with building owners allowing it to occupy space in which it installed its coin-operated laundry equipment. SEBCO operated at approximately 3,000 locations in several states, including New York, New Jersey and Pennsylvania. The owners of four properties located in Pennsylvania notified SEBCO that they were selling the properties. As a result, in 2005, the property owners agreed to purchase SEBCO's leasehold interests in the four properties, resulting in a $500,000 gain to SEBCO, all of which was passed through to Breitman as the S corporation's shareholder.

SEBCO had elected New York State S corporation status. In order to make a New York S corporation election, all nonresident shareholders must agree to pay New York State income tax on their distributive share of S corporation income earned in the State. In this case, Mr. Breitman filed a 2005 New York nonresident income tax return, but did not include any portion of his distributive share of the S corporation's gain in his New York source income or, for that matter, his share of the S corporation's losses in the years 2002 through 2004.

Following an audit of Mr. Breitman's New York State returns, the Department of Taxation and Finance increased his New York source income for 2005 by the $500,000 gain from the leasehold sales apportioned by SEBCO's business allocation percentage ("BAP") of roughly 40%. The Department similarly apportioned his distributive share of SEBCO's losses in 2002-2004.

Mr. Breitman claimed that none of the gain was subject to New York tax, arguing that application of the tax was unconstitutional because the tax burden resulting from formulary apportionment of the gain was out of all appropriate proportion to SEBCO's business in New York. He also contended that the leaseholds had no connection to New York State to justify subjecting the resulting gain to New York tax. ALJ Decision. The ALJ rejected Mr. Breitman's arguments, holding that the Department properly sourced a portion of the gain to New York for personal income tax purposes based on SEBCO's BAP. Applying the Article 9-A apportionment rules to a personal income tax case, because the income was derived from an S corporation, the ALJ first noted that the gain from the sale of the leaseholds was not investment income, but rather was business income, and thus apportionable.

The ALJ explained that in order to avoid application of the S corporation's BAP to income from its unitary business enterprise, Mr. Breitman needed to show that the gain from the sales resulted in the sourcing of income to New York that was "grossly disproportionate to SEBCO's business activities in New York." The ALJ held that Breitman failed to prove it was "grossly disproportionate," noting, among other things, that the leasehold interests were an integral and necessary part of SEBCO's unitary business enterprise, and that the sale of those assets did not rise to the level of a discrete and unrelated business activity. Moreover, the ALJ presumed that SEBCO had taken business deductions for the four leaseholds, and had also included the value of those leaseholds in the denominator of SEBCO's property factor.

The ALJ cited to the Court of Appeals decision in Matter of British Land (Maryland), Inc. v. Tax Appeals Tribunal, 85 NY2d 139 (1995), where the Court held that the inclusion of gain from the sale of the taxpayer's Maryland property resulted in the unconstitutional taxation of extraterritorial value. However, the Court of Appeals did not reach its conclusion based solely on the fact that the property was located in Maryland, and where, as here, the leaseholds sold were an integral part of a unitary business, their sale was not a discrete and unrelated activity, and the resulting gain could properly be subject to formulary apportionment.

Additional Insights

It is unusual to come across a decision involving the personal income tax that applies Article 9-A sourcing rules and case law. This approach is required by Tax Law § 632(a), which provides that the portion of a nonresident individual's income from an S corporation deemed connected with New York sources is determined under the Article 9-A apportionment rules. Under the Article 9-A precedent, where a corporation's gain is part of the business income of a unitary business, a portion of that gain can properly be sourced to New York − and treated as the New York source income of a nonresident individual shareholder of a New York S corporation - unless the taxpayer can show that such treatment is grossly disproportionate to the corporation's business activities conducted in New York State. The fact that the gain resulted from the sale of non-New York property is not alone enough to exclude it from New York source income under the personal income tax.

Tribunal Reverses Dismissal and Allows Case to Proceed Before ALJ

By Hollis L. Hyans

In Matter of Medical Capital Corp., DTA No. 824837 (N.Y.S. Tax App. Trib., July 25, 2013), the New York State Tax Appeals Tribunal reversed the decision of an Administrative Law Judge, which had dismissed a taxpayer's petition for failing to state a cause of action, and sent the case back for a hearing on the merits.

In the proceeding below, Medical Capital had filed a petition seeking review of a Notice of Deficiency asserting tax due of nearly $48,000. In its petition, it described the appointment of a receiver and the activities that the...