New York Advisory Opinion TSB-A-85 (5)I: If a New York corporation elects New York S corporation status and its only income is interest, dividends, and capital gains, is that investment income taxable to a nonresident shareholder even though the same income wouldn't be taxable if the nonresident earned it directly?

Plain-English summary

A New York public accounting firm asked the Department about a structure some of its clients were considering: organizing New York S corporations solely to hold investments in securities and commodities, generating only interest, dividends, and capital gains/losses, with some shareholders being nonresidents. The question was whether that investment income would be subject to New York personal income tax when it passed through to a nonresident shareholder.

The Department walked through the S corporation election mechanics. Tax Law § 660 lets the shareholders of a federal S corporation elect New York S corporation status, which exempts the corporation itself from the Article 9-A franchise tax. In exchange, § 632(a)(1)(B) requires shareholders to include their pro rata share of the corporation's income, loss, and deduction in their own New York adjusted gross income. For a nonresident shareholder specifically, § 637 limits that inclusion to the portion of the pro rata share connected with New York sources, computed under rules consistent with Article 9-A's corporate allocation methods.

Ordinarily, a nonresident earning interest, dividends, or capital gains directly as an individual investor wouldn't have New York-source income at all - investment income isn't tied to New York the way wages or business income earned here would be. But the Department held that doesn't matter once the S corporation election is in place: because the shareholders freely chose S corporation status specifically to get the corporate-level tax exemption, they take on the S corporation's own inclusion rules as the price of that choice. So the investment income passes through and is taxed to the nonresident shareholders even though the identical income, earned directly, would escape New York tax entirely.

What this means for you

Nonresidents considering investing through a New York S corporation

Don't assume a New York S corporation shelters investment income from New York tax for a nonresident shareholder just because that income wouldn't be New York-source if earned directly. Electing New York S corporation status pulls your pro rata share of the corporation's interest, dividends, and capital gains into your New York adjusted gross income regardless.

Accountants structuring investment vehicles for out-of-state clients

If a client is weighing a New York S corporation purely to shelter a group of investors' portfolio income from the Article 9-A franchise tax, flag that the trade-off includes exposing nonresident shareholders' pro rata share of that same investment income to New York personal income tax - a result they wouldn't face investing individually.

Multi-state investment groups choosing between an S corporation and a partnership

A partnership generally passes character through to partners without creating New York-source income for a nonresident on portfolio investment gains; an electing New York S corporation, by contrast, subjects a nonresident shareholder's pro rata share of that same investment income to New York tax as the cost of the corporation's own franchise tax exemption.

Common questions

Q: I'm a nonresident considering investing through a New York S corporation that only holds securities - will I owe New York tax on my share of the interest and dividends?
A: Yes. Once the corporation elects New York S corporation status, your pro rata share of its investment income is included in your New York adjusted gross income, even though that same income wouldn't be New York-source if you earned it directly.

Q: Why does electing S corporation status change the outcome for a nonresident's investment income?
A: The election exempts the corporation from the Article 9-A franchise tax. In return, all shareholders - including nonresidents - take on the statutory obligation under § 632(a)(1)(B) and § 637 to include their pro rata share of the corporation's income in New York adjusted gross income, regardless of whether that income would otherwise be New York-source.

Q: Does this apply to all types of S corporation income, or just investment income?
A: The opinion specifically addresses investment income (interest, dividends, capital gains) because that was the fact pattern presented - a corporation with no other business activity. The underlying statutory pass-through rule isn't limited to investment income, but this opinion's holding is grounded in those facts.

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1985.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a85_5i.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-85 (5) I
Income Tax
October 22, 1985

STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

PETITION NO. I821201A

On December 1, 1982, a Petition for Advisory Opinion was received from David L. Lieb &
Co., 200 Park Avenue, New York, New York 10166.
The issue raised is whether the S corporation investment income of a nonresident shareholder
of an electing New York S corporation is subject to the Personal Income Tax imposed under Article
22 of the Tax Law.
Petitioner is a New York public accounting firm. A number of Petitioner's clients are
considering organizing New York S corporations for investing in securities and commodities. The
only income of these corporations would be from interest, dividends and capital gains and losses.
Some of the shareholders may be nonresidents.
Section 660 of the Tax Law allows the shareholders of a federal S corporation subject to
Article 9-A of the Tax Law to make an election to be treated as a New York S corporation. If all of
the shareholders make this election, the New York S corporation will be exempt from the Franchise
Tax imposed under Article 9-A.
However, section 632(a)(1)(B) provides that if the shareholders make such an election, they
must include in their New York adjusted gross income their pro rata share of the S corporation's
income, loss and deduction, increased by deductions for taxes described in sections 1366(f)(2) and
(3) of the Internal Revenue Code, as determined under section 637 of the Tax Law.
Section 637 of the Tax Law provides that in determining New York adjusted gross income
of a nonresident shareholder of an S corporation, only the portion of the shareholder's pro rata share
of items of income, loss and deduction which are connected with New York sources shall be
included. The portion connected with New York sources is to be computed pursuant to regulations
of the Tax Commission consistent with the applicable methods and rules for allocation under Article
9-A of the Tax Law.
In return for corporate franchise tax exemption, S corporation shareholders assume an
obligation to individually pay tax on S corporation income. By freely electing S corporation status,
nonresidents choose to subject themselves to New York S corporation rules and procedures.
Nonresident shareholders, therefore, must include in their New York adjusted gross income their pro
rata share of New York S corporation income, loss and deduction even if such income, loss and
deduction would not be included in such nonresidents' New York adjusted gross income if earned
or incurred by such nonresidents as individuals.

RODERICK G. W. CHU, COMMISSIONER
TP-8 (3/83)

GABRIEL B. DiCERBO, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR

-2­
TSB-A-85 (5) I
Income Tax
October 22, 1985

Accordingly, the S corporation investment income of a nonresident shareholder of an electing
New York S corporation is subject to the Personal Income Tax imposed under Article 22 of the Tax
Law since the freely made S corporation election creates such an obligation.

DATED: August 21, 1985

NOTE:

s/FRANK J. PUCCIA
Director
Technical Services Bureau

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