When a New York S corporation shareholder moves out of state partway through the year, must her pro rata share of the corporation's capital gain be prorated between the resident and nonresident periods?

Plain-English summary

Eileen O'Reilly owned a one-third interest in MEA Inc., a New York S corporation whose only other significant asset was closely held shares in RMS Corporation, a Canadian company that never paid dividends. In February 1999, O'Reilly moved from New York to Connecticut, becoming a part-year New York resident for that tax year. In August 1999 - after her move - MEA sold its RMS shares and realized a capital gain, which MEA reported on its New York franchise tax return. Because MEA's investment allocation percentage for New York franchise tax purposes was zero, O'Reilly did not report her pro rata share of the gain as New York source income, reasoning that she was a Connecticut resident by the time the gain was realized.

The Department disagreed with treating the entire gain as belonging to whichever period contained the sale's closing date. Citing Matter of McNulty v. New York State Tax Commission, Matter of Wertheimer, and Matter of Greig, the Department explained that a shareholder's pro rata share of pass-through income (whether from a partnership or, as extended by Greig, an S corporation) for the year residency changes cannot simply be assigned to the period in which the entity's own tax year ends or a transaction happens to close. Instead, consistent with TSB-M-00(1)I, the pro rata share must be prorated between the resident and nonresident periods based on the number of days in each period.

Applying that rule to O'Reilly's facts, the Department held that the pro rata share of MEA's capital gain allocated to her resident period (before her February move) is New York source income under Tax Law § 638(a)(1), because a resident's income for the residency period is taxed from all sources. The pro rata share allocated to her nonresident period, however, is not New York source income, because Tax Law §§ 632(a)(2) and 638(a)(2) look to whether the S corporation's own income is derived from or connected with New York sources - and here MEA's investment allocation percentage was zero, so the capital gain itself had no New York source character.

What this means for you

S corporation shareholders who change residency mid-year

If you own an interest in a New York S corporation and move into or out of New York State during the tax year, you cannot report (or omit) your entire pro rata share of the corporation's income, gain, loss, or deduction based on whichever period contains the date the corporation recognized the item. Under McNulty, Wertheimer, and Greig, that share must instead be prorated between your resident and nonresident periods according to the number of days you spent in each, per TSB-M-00(1)I.

Whether the nonresident-period share is actually taxable depends on the entity's own New York allocation

Proration is only step one. Once the resident-period and nonresident-period shares are determined, the nonresident-period share is New York source income only if the S corporation's underlying income is itself derived from or connected with New York sources. Where, as with MEA here, the corporation's investment allocation percentage is zero, the nonresident-period share of that income escapes New York tax entirely, while the resident-period share remains fully taxable because residents are taxed on income from all sources during the period of residence.

Common questions

Q: Does a New York S corporation shareholder who changes residency during the year get to choose which period a pass-through gain belongs to?
A: No. Following McNulty, Wertheimer, and Greig, the shareholder's pro rata share must be prorated between the resident and nonresident periods based on the number of days in each period, not assigned entirely to the period in which the underlying transaction closed.

Q: Why wasn't the entire capital gain treated as nonresident-period income, since MEA's sale happened after Petitioner moved to Connecticut?
A: Because the timing of the corporation's own sale isn't controlling. The gain is prorated by days of residency in the year regardless of when MEA actually sold its RMS shares.

Q: Why was the nonresident-period share of the gain not taxed at all?
A: Because MEA's investment allocation percentage for New York franchise tax purposes was zero, meaning the capital gain was not derived from or connected with New York sources under Tax Law §§ 632(a)(2) and 638(a)(2).

Q: Was the resident-period share of the gain taxed the same way?
A: No - for a different reason. Tax Law § 638(a)(1) makes a part-year resident's New York adjusted gross income for the resident period taxable regardless of source, since residents are taxed on income from all sources during that period.

Q: What authority sets the day-count method used to prorate the income?
A: TSB-M-00(1)I, "New York Tax Treatment of Partnership and New York S Corporation Income of Part-Year Residents" (February 23, 2000), which applies proration based on the number of days in each period for tax years beginning in 1999 and later.

Citations and references

• Tax Law § 601(e) - imposes tax on nonresidents and part-year residents computed via the New York source fraction
• Tax Law § 632(a)(2) - New York source income of a nonresident S corporation shareholder
• Tax Law § 638(a) - New York source income of a part-year resident individual
• Matter of McNulty v. New York State Tax Commission, 70 NY2d 788, 522 NYS2d 103 - partner's distributive share of partnership income must be prorated, not assigned to the partnership's year-end
• Matter of Wertheimer, TSB-D-95-(2)I - proration of partnership losses between resident and nonresident periods is mandatory, not elective
• Matter of Greig, TSB-D-99-(21)I - invalidated a regulation assigning pass-through income by residency status at the entity's year-end; extended McNulty's proration rule to S corporation income
• TSB-M-00(1)I (February 23, 2000) - proration based on number of days in each period, for tax years beginning in 1999 and after

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_2003.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a03_1i.pdf

Original ruling text

New York State Department of Taxation and Finance

Office of Tax Policy Analysis
Technical Services Division

TSB-A-03(1)I
Income Tax
March 4, 2003

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I021009A

On October 9, 2002, a Petition for Advisory Opinion was received from Eileen O’ Reilly,
c/o Joseph W. Bencivenga, CPA, 60 East 42nd Street, New York, NY 10165.
The issue raised by Petitioner, Eileen O’ Reilly, is whether the amount of her pro rata share
of income from a New York S corporation for the year in which a change of residence occurred must
be prorated between the resident and nonresident periods.
Petitioner submits the following facts as the basis for this Advisory Opinion.
In February 1999, Petitioner moved from New York State to Connecticut. At that time,
Petitioner owned a one-third interest in MEA Inc. (MEA), a New York State S corporation.
MEA held cash and shares in RMS Corporation (RMS), a closely held Canadian corporation.
RMS did not pay any dividends. Prior to 1999, MEA’s only taxable income was a small amount
of interest income. In August 1999, MEA sold its interest in RMS and realized a capital gain. MEA
filed a New York franchise tax return for 1999 reporting this gain. Under New York State business
corporation franchise tax, MEA’s investment allocation percentage was zero. Petitioner states that
she did not report her pro rata share of the capital gain as New York source income since she was
a resident of Connecticut when the gain was realized by MEA.
Applicable Law
Section 601(e) of the Tax Law imposes a personal income tax for a part-year resident of
New York State, and provides, in part:
Nonresidents and part-year residents. (1) General. There is hereby imposed
for each taxable year on the taxable income which is derived from sources in this
state of every nonresident and part-year resident individual . . . a tax which shall be
equal to the tax base multiplied by the New York source fraction.
(2) Tax base. The tax base is the tax computed under subsections (a) through
(d) of this section, as the case may be, reduced by the credits permitted under
subsections (b), (c), (d) and (m) of section six hundred six, as if such nonresident or
part-year resident individual . . . were a resident subject to the provisions of part II
of this article.

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(3) New York source fraction. The New York source fraction is a fraction the
numerator of which is such individual's . . . New York source income determined in
accordance with part III of this article and the denominator of which is such
individual's New York adjusted gross income determined in accordance with part II
of this article . . . .
Section 632(a)(2) of the Tax Law describes New York source income of electing
shareholders of S corporations, and provides:
In determining New York source income of a nonresident shareholder of an
S corporation where the election provided for in subsection (a) of section six hundred
sixty of this article is in effect, there shall be included only the portion derived from
or connected with New York sources of such shareholder’s pro rata share of items
of S corporation income, loss and deduction entering into his federal adjusted gross
income, increased by reductions for taxes described in paragraphs two and three of
subsection (f) of section thirteen hundred sixty-six of the internal revenue code, as
such portion shall be determined under regulations of the commissioner consistent
with the applicable methods and rules for allocation under article nine-A or
thirty-two of this chapter.
Section 638(a) of the Tax Law describes New York source income of a part-year resident
individual, and provides:
Individuals. The New York source income of a part-year resident individual
shall be the sum of the following:
(1) New York adjusted gross income for the period of residence, determined
in accordance with part II of this article as if the taxpayer's taxable year for federal
income tax purposes were limited to the period of residence.
(2) New York source income for the period of nonresidence, determined in
accordance with section six hundred thirty-one as if the taxpayer's taxable year for
federal income tax purposes were limited to the period of nonresidence.
Opinion
For taxable years beginning prior to 1988, a nonresident individual computed his or her
New York State personal income tax based on the amount of income derived from or connected with
New York sources, and a resident individual computed his or her tax based on income from all
sources and received a credit for taxes paid to other states. When a taxpayer changed residence, he
or she computed a tax for the nonresident period based on the amount of income derived from or

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connected with New York sources and computed a tax for the resident period on income from all
sources.
Under this statutory scheme, in Matter of McNulty v New York State Tax Commission,
70 NY2d 788, 522 NYS2d 103, the Court of Appeals held former section 148.6 of the Personal
Income Tax Regulations (the Regulations) invalid and required that a partner’s distributive share
of partnership income, gain, loss, and deduction for tax year 1979, the year in which the change of
residence occurred, be prorated between the resident and nonresident periods. Former section 148.6
required taxpayers who moved in or out of New York State during the tax year to treat partnership
gains or losses as having all accrued in the portion of the taxable year in which the partnership’s own
tax year ended.
In McNulty, recognizing that the taxpayer’s distributive share of partnership income did not
indicate actual receipt of the income, the Court of Appeals found harm in requiring taxpayers who
move into or out of New York State during the tax year to treat partnership gains and losses as
having all accrued in the taxable period in which the partnership’s own tax year ends, regardless of
when the income was actually received. The court concluded that this was inconsistent with the
change of residence status rules which required an allocation that reflects either actual date of receipt
and expenditure or encompasses an annual amount distributed on a proportionate basis.
In Matter of Wertheimer, Dec St Tax Trib, January 12, 1995, TSB-D-95-(2)I, the issue
addressed was whether the petitioners were required to prorate their partnership losses between their
nonresident period and resident period for the 1986 tax year. In that case, the petitioners maintained
they could properly report all partnership losses in the resident period of their part-year income tax
return rather than prorating the losses between their resident and nonresident periods based on the
number of months that they resided in New York State, as held in the McNulty decision. The
petitioners asserted that the McNulty decision did not mandate proration, but permitted it. As such,
the petitioners maintained that they had a choice of prorating their distributive share of partnership
losses between their resident and nonresident periods, or allocating all of their share of partnership
losses to either the resident or nonresident period depending upon when the loss was deemed to have
accrued. The Tribunal disagreed with the petitioners’ position. The Tribunal noted that the basic
principles of taxation of income earned by a partnership under section 706(a) of the Internal
Revenue Code requires that each partner’s distributive share of the income, gain, loss, and deduction
be included in that partner’s taxable income for the taxable year of the partnership ending within or
with the partner’s tax year. A partner is required to report and pay tax on his distributive share of
the net income of the partnership in this manner without regard to whether this amount was actually
distributed or distributable to him in that year. In the Tribunal’s view, the holding of McNulty,
supra, is that where a partner’s distributive share of income is reported without regard to actual
receipt, the only possible method of allocation when there is a change of residency is on a
proportionate basis throughout the year. In McNulty, the accrual date method of allocating the
distributive share of partnership income was rejected because this method did not reflect the actual
date of receipt of the income.

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The New York Tax Reform Act of 1987, Chapter 28 of the Laws of 1987, changed the
manner in which nonresidents and part-year residents compute their tax for a taxable year beginning
on or after January 1, 1988. Now, under section 601(e) of the Tax Law, the tax imposed on a
nonresident or part-year resident individual’s taxable income derived from sources in New York
State is computed as if the individual were a resident, reduced by certain credits, and apportioned
to New York by the New York source fraction, the numerator of which is the individual’s New York
source income and the denominator of which is the individual’s New York adjusted gross income.
As a result, when a resident individual changes residence during the taxable year, the New York
source income is the sum of (1) the individual’s New York adjusted gross income from all sources
for the period of residence, determined as if the individual’s taxable year for federal income tax
purposes were limited to the resident period, plus (2) the individual’s New York adjusted gross
income derived from New York sources for the nonresident period, determined as if the individual’s
tax year for federal income tax purposes were limited to the period of nonresidence. The
denominator of the New York source fraction used to compute the tax is the individual’s New York
adjusted gross income from all sources for the entire year.
In 1990, section 148.6 of the Regulations was amended to reflect the Department’s view of
how the McNulty, supra, and Werthheimer, supra, cases apply under the current law. These
regulations provided that where there is a change of residence, the taxpayer’s distributive share of
partnership income, gain, loss and deduction to be included in the numerator of the New York
source fraction should be determined according to the status of the taxpayer as a resident or
nonresident at the time the taxable year of the partnership ends.
The Tax Appeals Tribunal found this regulation invalid in Matter of Greig, Dec St Tax Trib,
September 16, 1999, TSB-D-99-(21)I. The Tribunal, relying on the Court of Appeals decision in
McNulty, supra, stated that the taxpayer’s distributive share of partnership income, gain, loss and
deduction or pro rata share of New York S corporation income, gain, loss and deduction for the year
in which the change of residence occurs must be prorated between the resident and nonresident
periods. The decision is reflected in Technical Services Bureau Memorandum entitled New York
Tax Treatment of Partnership and New York S Corporation Income of Part-Year Residents,
February 23, 2000, TSB-M-00(1)I, which states that, for tax years beginning in 1999 and thereafter,
the rules for prorating between resident and nonresident periods is based on the number of days in
each period.
Accordingly, following McNulty, supra, Wertheimer, supra, and Grieg, supra, in this case,
Petitioner must prorate the amount of her pro rata share of the capital gain realized by MEA from
the sale of its interest in RMS between Petitioner’s resident and nonresident periods of the year.
Pursuant to TSB-M-00(1)I, supra, the amounts prorated are based on the number of days resided in
New York State. The pro rata share of the capital gain allocated to the resident period of the year
is New York source income pursuant to section 638(a)(1) of the Tax Law. The pro rata share of the
capital gain allocated to the nonresident period of the year is not New York source income pursuant
to sections 632(a)(2) and 638(a)(2) of the Tax Law since MEA’s capital gain is not derived from or

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connected with New York sources. MEA’s capital gain is not derived from or connected with
New York sources because, for New York franchise tax purposes, MEA’s investment allocation was
zero.

DATED: March 4, 2003

NOTE:

/s/
Jonathan Pessen
Tax Regulations Specialist IV
Technical Services Division

The opinions expressed in Advisory Opinions are
limited to the facts set forth therein.