Welcome back. This article is Part Two in the three-part “After the Move” series, outlining the potential New York State tax savings (and, more specifically, unexpected tax exposure) following a move away from the state.

Part One of the series focused on employment compensation, including New York’s nonresident income sourcing rules for telecommuting and the proper sourcing methodologies for various types of deferred compensation. Part Three, which is forthcoming, will look at what happens when a taxpayer who has left New York decides they want to return—either temporarily or permanently—with a focus on the post-move burden of proof issues related to changes of domicile. In Part Two, we discuss how nonresidents must source the gains on sales of interests in multistate businesses, including flow-through entities such as partnerships and S corporations.

One of the most common (and potentially lucrative) financial triggers for a change of residency are substantial one-off transactions, such as the complete or partial sale of a business. The timing and focus of these moves is understandable. As we outlined in Part One, New York State residents are taxed on one thing: everything. New York State nonresidents, however, are taxed only on income that is derived from or connected with New York sources. The comparison between New York City residents and nonresidents is even starker, because New York City does not impose any type of nonresident tax; this means that New York City personal income tax is all or nothing based on residency. When a taxpayer is expecting a once in a lifetime gain associated with the sale of a business, there is, therefore, no shortage of financial incentive for considering a change of residency. But Part Two of this After the Move series is meant to help taxpayers and practitioners avoid the incorrect assumption that simply changing your residency in advance of the sale of a business will automatically avoid all New York State tax exposure. Unfortunately, that is not always the case. Instead, there are several important rules that must be considered in order to properly quantify the value of any change of residency that centers on the sale of a business.

This article outlines several potential pitfalls that can lead to unexpected New York source income, including New York State’s accrual rule; rules for sourcing gains on sales of S corporation stock with an IRC § 338(h)(10) election; and nonresident partners’ treatment of gain on transfers of certain partnership or membership interests. As we mentioned in Part One, there are many valid reasons why individuals decide to either remain in or leave a particular location. But if you are motivated to leave New York because of tax considerations, this series highlights what awaits on the other side of a potentially bumpy exodus from New York. In other words, this series is meant to ensure the juice is worth the squeeze when leaving New York State. And when we’re discussing the potentially significant amounts of gain associated with sales of businesses, there is plenty of juice to consider!  

New York’s Accrual Rule

Generally speaking, New York source income does not include gains from the sale or exchange of intangible personal property, unless the property is employed in a business, trade, profession, or occupation carried on in New York State. This general rule is outlined in section 631(b)(2) of New York State’s Tax Law; section 132.5(a) of the state’s personal income tax regulations; and various New York State Tax Bulletins. Not to mention section 3 of article XVI of New York State’s Constitution. It can be very tempting to therefore assume that changing your residency away from New York State prior to receiving the proceeds from the sale of an intangible ownership interest in a business (e.g., stock or membership interests) will be enough to avoid recognizing any New York State source income. There are, however, both timing and structuring issues to consider before jumping to this conclusion.

On the timing front, section 639 of New York’s Tax Law lays out a provision, known as the “accrual rule.” This rule essentially transforms all cash-basis taxpayers into accrual-basis taxpayers for the year in which a residency change occurs. In other words, under the accrual rule, taxpayers are forced to attribute items of income, gain, loss, or deduction to their former state of residence if they had the right to receive those items before their move.

Take, for example, this fairly typical hypothetical:

William is the sole shareholder of a New York C corporation that owns a chain of hardware stores. William enters into a contract to sell his stock in the corporation on June 1, 2023. The contract stipulates that the purchase price for the stock is $1,000,000. William moves to Florida on July 1, 2023 and receives payment on August 1, 2023.

Under section 154.10 of New York’s personal income tax regulations, which provide additional guidance on the accrual rule, the state makes clear that taxpayers must include in their income “all items required to be included if a Federal income tax return were being filed for the same period on an accrual basis.” Because the Tax Department’s regulations refer specifically to the federal rules, guidance surrounding the accrual rule relies heavily on federal tax principles. Specifically, New York has consistently applied the federal all events test to determine whether income is accruable to the prior state of residence. (The accrual can apply in cases of both taxpayers moving out of New York and taxpayers moving into New York.)

On the federal level, accruals are determined using the “all-events test.” Under this test, expenses (or, in the case of New York’s accrual rule, income) are accruable to a prior period when:

1. All the events that bear on the fact of income have occurred, and
2. The amount of income can be determined with reasonable accuracy.

So how does this rule impact our hypothetical taxpayer, William, when selling his entire stake in a New York C corporation?

Under New York’s general rules, the intangible gain from the sale of stock would not be taxed to William as a nonresident. But under the accrual rule, William must also consider whether the two requirements of the all-events test have been satisfied. First, have all the events that bear on the fact of income occurred? Here, if there are no contingencies contained in the stock sale contract, this requirement is likely satisfied. But if, instead, the contract is expressly contingent on the completion of a due diligence process and/or subject to pending regulatory approvals, and these conditions are not satisfied by the time of William’s move out of New York, William should be able to argue that the gain from the stock sale should not be included in their New York state taxable income, because not all events that fix their right to receive the income have occurred.

The second prong of the all-events test requires that the amount of the income be determined with reasonable accuracy. In our example, that prong is most likely satisfied. The contract stipulates that William will receive $1,000,000 in exchange for his stock in the corporation. The income can therefore be determined with reasonable accuracy. But what if the corporation were engaged in active litigation, and the contract stipulated that the purchase price would be reduced by any eventual liability? If the litigation was not resolved before William’s move out of New York, William would have a strong argument that this income should not accrue to New York because the purchase price could not be determined with reasonable accuracy during the prior resident period.

Of course, the smart tax practitioner could avoid this situation altogether by advising taxpayers not to enter into a contract of sale before a move out of New York. This point reemphasizes a theme from Part One of this series—which is the value of planning ahead when considering a change of residency.

But even when taxpayers are able to complete their moves well in advance of a business sale, there are still several specific types of transactions involving the sale or transfer of intangible ownership interests that can produce unexpected amounts of New York source income.

Deemed Asset Sales under IRC § 338(h)(10)

As outlined above, New York State nonresidents are typically able to exclude gains recognized from the sale of stock under the state’s general income sourcing rules. But, as with most rules, there are important exceptions. 

Once such exception involves what is known as the 338(h)(10) election or “deemed asset sale.” Under this election, which can be made under section 338(h)(10) of the Internal Revenue Code (“IRC” or “Code”), a one‐step stock sale is essentially divided into two separate fictional transactions: (1) a deemed asset sale, and (2) a deemed liquidation in which the proceeds of the deemed asset sale are distributed to the selling shareholders in exchange for their stock. The target corporation reports (and flows through to the selling shareholders) the gain on the deemed asset sale. That gain, however, increases the shareholders’ bases in their stock, such that the shareholders recognize a loss from the deemed liquidation. For federal tax purposes, that loss offsets the gain recognized from the deemed asset sale. Under this structure, the purchaser also receives a stepped‐up basis in the acquired assets equal to the stock purchase price. For federal tax purposes, the structure can be a win-win for sellers and purchasers. In New York State, however, unsuspecting sellers may end up with unwanted New York source income when completing transactions with a 338(h)(10) election in place.

The problematic rules in New York State stem from litigation that dates back to 2009, where it was determined that, under the deemed asset sale structure, the shareholders had really just sold stock in their S corporation—which qualifies as an intangible not taxable to a nonresident. This was a win for the taxpayers. But, not surprisingly, the Tax Department was unhappy with this result and convinced the legislature to pass section 632(a)(2) of the Tax Law, which now states that “if the shareholders of [an] 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.” The gain is specifically sourced to New York based on the S corporation’s business allocation percentage (BAP) in the year that the shareholders make the 338(h)(10) election.

If we return to our hypothetical taxpayer William, we can see how this plays out in practice. If instead of owning 100% of a New York C corporation, William was the sole shareholder of a New York S corporation with a 2023 BAP of 100%, William is likely to end up with unwanted New York source income if the sale is completed as a deemed asset sale. This is because if William makes a 338(h)(10) election, then the gain is treated as New York source income, based on the S corporation’s BAP in the year of the election, which in this case is 100%. So while William may avoid New York City tax as a result of his timely change of residency, his expected New York State tax savings may be nonexistent.

For purchasers, 338(h)(10) elections can provide favorable basis adjustments. Because of this benefit, purchasers of S corporations are often eager to structure transactions using a 338(h)(10) election. But for the reasons outlined above, any taxpayers leaving New York in connection with the sale of S corporation stock must carefully consider whether this structure will negate any of the expected benefits of leaving the state before completing the sale of their business.

Sales of Entities Owning Real Property in New York State

Other groups of transactions that can produce unexpected New York source income are sales or exchanges of interests in partnerships, limited liability companies (LLCs), S corporations, or small, non-publicly traded C corporations if the entity owns significant amounts of real property in New York State.   

This rule, which was added as section 631(b)(1)(A)(1) to the Tax Law in 2009, expanded the definition of New York source income to include gains from the sales of these types of entities, if the entity owns real property in New York State that has a fair market value that equals or exceeds 50% of the fair market value of the assets the entity has owned for at least two years as of the date of the sale or exchange. Returning to our hypothetical taxpayer William, the following example shows how this provision can work.

On June 1, 2023, William, a recent nonresident individual of New York State, sold his entire interest in Partnership ABC. For federal income tax purposes, William will recognize a gain of $12,000 from the sale.

At the time of sale, Partnership ABC owns real property in New York State valued at $950,000. On that same date, the fair market value of all the assets that Partnership ABC owns is $2,375,000; and the fair market value of all the assets that the partnership has owned for at least two years, including any real property located in New York State, is determined to be $1,532,258.

 Accordingly, on June 1, 2023, the fair market value of Partnership ABC’s real property located in New York State exceeds 50% of the fair market value of all the assets Partnership ABC owned for at least two years ($950,000/$1,532,258 = .62 or 62%). Therefore, all or a portion of William’s gain from the sale of his partnership interest is considered to be derived from New York sources.

 To determine the portion of the gain from the sale of their partnership interest in Partnership ABC that must be included in New York source income, the gain reported for federal income tax purposes ($12,000) is multiplied by a fraction whose numerator is the fair market value of Partnership ABC’s real property located in New York State ($950,000), and whose denominator is the fair market value of all the assets that the entity owned on the date of the sale ($2,375,000). Therefore, William determines that $4,800 ($12,000 X .40) is the portion of the gain from the sale of his partnership interest in Partnership ABC that must be included in New York source income.

The laws two-year holding period is intended to prevent asset “stuffing,” whereby taxpayers could otherwise sidestep the rule entirely by having the entity acquire additional assets immediately before the sale or transfer of the owners’ interests. Notably, however, even under New York’s current rules for the sourcing of gains on sales of interests in entities holding New York real property, the effect of recently acquired assets should not be overlooked entirely. This is because these assets may still have an impact on the percentage of gain sourced to New York.

Take the example above, where the fair market value of Partnership ABC’s real property located in New York State exceeded 50% of the fair market value of all the assets Partnership ABC owned for at least two years ($950,000/$1,532,258 = .62 or 62%). But, as shown in the example, the recently acquired assets are still included in the relevant BAP—i.e., $950,000/$2,375,000 = .40 or 40%. This means that newly acquired assets may still affect a nonresident’s ability to limit unwanted or unsuspected New York source income when selling their interests in an entity owning New York real property.

Nonresident Partners Allocation of Gain from Sales or Transfers of Partnership Interests Subject to IRC § 1060

Although New York’s 338(h)(10) rules, along with the state’s guidance for sales of certain entities owning real property, have been on the books for several years, there is also a more recent, and in our experience, lesser-known New York provision that continues to give taxpayers headaches when planning for a change of residency in connection with the sale of a business. This provision, section 632(a)(1) of the Tax Law, which was added in 2017, provides that gains on transfers of certain intangible partnership interests must be sourced to New York State even when the gain is recognized by a nonresident. Specifically, any gain or loss recognized for federal income tax purposes by a nonresident partner on the sale or transfer of a partnership interest must be allocated to New York using the partnership’s three-factor BAP if the sale or transfer is subject to the provisions of IRC § 1060. This relatively new section of New York’s Tax Law can frustrate and disappoint recent New York State nonresidents looking to dispose of certain partnership or membership interests after establishing residency outside of New York.

According to New York State’s Technical Memorandum on section 632(a)(1), a sale or transfer of a partnership interest is considered a transaction subject to the provisions of IRC § 1060 (the gain of which is therefore fully or partially sourced to New York State) when:

1. The transferor recognizes a gain or loss on the sale of the partnership interest for federal income tax purposes;
2. The transferee treats the purchase of the partnership interest as a purchase of partnership assets;
3. The assets acquired by the transferee constitute a trade or business; and
4. The transferee’s basis in the transferred assets is determined wholly by reference to the transferee’s consideration.

The federal treatment is therefore similar to a deemed asset sale under IRC § 338(h)(10), where the purchaser receives a basis step up in the acquired assets. There is, however, one unique scenario in which section 632(a)(1) of New York’s Tax Law may apply even without the specific objective of achieving a basis step up in the partnership’s assets. New York’s Technical Memorandum notes that “[a] sale or transfer of a partnership interest that causes the partnership’s status as a partnership to terminate under IRC § 708(b)(1)(A), or that causes the LLC’s status as a partnership to terminate under IRC § 708(b)(1)(A) (when, after the sale or transfer, the LLC is treated as a single-member disregarded entity for federal tax purposes) is considered a transaction subject to the provisions of IRC § 1060.” This scenario, which stems from Revenue Ruling 99-6, and whereby a partnership ceases to exist after the transaction, tends to cause the most shock for unsuspecting taxpayers. Take, for example, the following example involving our hypothetical taxpayer, William, and his business partner, June:

William, a nonresident of New York State, and June, a resident of New York State, were the only two partners in Partnership AB, a calendar-year filer. On May 15, 2023, Partnership AB terminated under IRC § 708(b) when William and June (the transferors) sold their entire respective partnership interests in Partnership AB to a third party, Marian (the transferee). William recognized a $50,000 gain for federal income tax purposes on the sale of their partnership interest. June recognized a $60,000 gain for federal income tax purposes on the sale of their partnership interest. Partnership AB’s BAP for the taxable year in which the partnership interests were sold (i.e., 2023) was 30%. The total amount of William’s gain on the sale of their partnership interest that is derived from New York Sources is therefore $15,000 (i.e., $50,000 x 30% = $15,000).

Similar to the nonresident seller of S corporation stock under a 338(h)(10) transaction or the nonresident seller of an entity holding significant amounts of New York real property, this provision has the effect of turning gain on the sale of an intangible into New York source income even when recognized by a nonresident. There is, however, an important carve-out in the Tax Department’s Technical Memorandum, which notes that a sale or transfer of a partnership interest to which IRC § 1060(d) applies is not considered a transaction subject to the provisions of IRC § 1060 for purposes of applying section 632(a)(1) of the Tax Law.

Section 1060(d) of the Internal Revenue Code can apply in situations when a purchaser acquires less than 100% of the partnership or membership interests, but the purchaser still seeks a basis adjustment. In this instance, an IRC Section § 754 election allows a partnership to adjust the basis of the property within the partnership. Once the amount of the basis adjustment is determined, it must then be allocated among the partnership’s individual assets pursuant to section 755 of the Code. And as part of this allocation, the rules of section 1060(d) may apply in order to value certain intangibles held by the partnership. New York’s Technical Memorandum suggests that if this is the only reason section 1060 comes into play, then the selling partners may avoid being subject to the gain allocation rules under section 632(a)(1) of the Tax Law.

This carve-out means that nonresident partners must consider whether there may be advantages to selling less than their entire partnership interest. If, for example, we change the hypothetical above to a situation where less than 100% of the partners’ interests are sold, it is possible to end up with a very different outcome. In this new hypothetical:

William, a nonresident of New York State, and June, a resident of New York State, are again the only two partners in Partnership AB. On May 15, 2023, William and June (the transferors) sell only 80% of their combined partnership interests to the third party, Marian (the transferee). William therefore recognizes a $40,000 gain for federal income tax purposes on the sale of their partnership interest. June recognizes a $48,000 gain for federal income tax purposes on the sale of their partnership interest.

Here, however, even if Partnership AB makes a 754 election, which results in a section 1060(d) gain allocation, the Tax Department’s Technical Memorandum suggests that this is not considered a transaction subject to the provisions of IRC § 1060 for purposes of applying section 632(a)(1) of the Tax Law. This means that William recognizes gain only on the sale of an intangible (the sale of their partnership interest), none of which would be derived from New York sources, regardless of Partnership AB’s 2023 BAP.

This distinction highlights the importance of carefully planning, understanding, and structuring transactions involving the sale or transfer of partnership or membership interests, in order to avoid any unexpected results.

Conclusion

As we highlighted above, one of the most common (and potentially lucrative) financial triggers for a change of residency can be the sale of a business in which a departing taxpayer holds an interest. Although New York’s general rule is that New York source income does not include gains from the sale or exchange of intangible personal property, there are both timing and structuring issues to consider in order to avoid triggering any of the significant exceptions to this general rule.

Part One of this series notes that anyone considering a move out of New York State must first properly consider and apply New York’s strict residency rules; this advice holds true for taxpayers considering the sale of a business. But as the articles in this series show, winning the difficult residency battle doesn’t necessarily mean total victory if the taxpayer leaving New York is left with significant amounts of New York source income. Understanding New York State’s sourcing rules for sales of businesses is therefore essential for understanding what comes After the Move.

 K. Craig Reilly, Esq., is a partner at Hodgson Russ. Craig counsels businesses and individuals in a range of state and local tax issues, with a focus on New York State, New York City, New Jersey, and multistate tax issues. Craig advises clients on all aspects of state and local tax from planning and compliance to controversy and litigation. He represents clients in disputes with the New York State Department of Taxation and Finance, New York City Department of Finance, and New Jersey Division of Taxation and is experienced in handling sales tax, corporate franchise tax, personal income tax, and residency audits. Craig works closely with remote retailers and cloud-based software vendors on a variety of multistate tax compliance issues, including filing requirements, sales and use tax collection obligations, income allocation and apportionment, tax registrations, and applications for voluntary disclosure and other amnesty programs. Craig also spends significant time counseling businesses and individuals in the financial services sector on various multistate tax planning topics, including residency planning, income apportionment and allocation, state and city entity level taxes, and entity restructuring.