When nonresident shareholders liquidate a New York S corporation whose only asset is a partnership interest in New York rental real estate, what are the New York personal income tax consequences under Article 22 of the Tax Law - and can a loss on the deemed sale of their S-corporation stock offset the gain on the deemed sale of the corporation's underlying asset?

Subject

Issue raised by Petitioner, Christopher L. Doyle, is what are the personal income tax ramifications of the liquidation of a New York S corporation owned by nonresident shareholders pursuant to Article 22 of the Tax Law under the fact pattern presented.

Plain-English summary

Christopher L. Doyle, Esq., of the Buffalo firm Hodgson, Russ, Andrews, Woods & Goodyear, petitioned the Department on behalf of unnamed nonresident taxpayers who wanted to know the New York personal income tax consequences of liquidating a New York S corporation. The facts: in Year 1, the nonresident taxpayers bought all the stock of a New York corporation for $100x. The prior shareholder had made a valid, timely New York S-corporation election under Tax Law § 660(a), and the taxpayers filed the paperwork needed to keep that election in effect after they took over. They were not in the business of trading stock. This corporation ("NYS-Corp") owned exactly one asset - a general partnership interest in a partnership that owned rental real estate in New York. NYS-Corp had no employees; its only revenue was distributions from that partnership, and the partnership's only revenue was New York rents. For franchise tax purposes, NYS-Corp allocated 100% of its income to New York.

For valid business reasons, the taxpayers wanted to liquidate NYS-Corp and hold the rental real estate business directly as a partnership instead. At the time of liquidation, the partnership interest would be worth $100x, NYS-Corp's basis in it would be $5x, and the taxpayers' combined basis in their NYS-Corp stock would be $100x. Under federal tax law, this liquidation triggers a cascade of deemed transactions. First, under IRC § 336, NYS-Corp is treated as if it sold the partnership interest for its $100x fair market value, realizing a $95x gain (the $100x value minus its $5x basis). Under IRC § 1366(a), that $95x gain passes through to the taxpayers' federal adjusted gross income. Under IRC § 1367(a), the taxpayers then get to increase their stock basis in NYS-Corp by that same $95x, bringing their combined stock basis from $100x up to $195x. Finally, under IRC § 331, the liquidation is also treated as the taxpayers selling their NYS-Corp stock for the fair market value of what they receive in the liquidation (the $100x partnership interest) - and since their stock basis is now $195x, they realize a $95x loss on that deemed stock sale. For federal purposes, the $95x gain and $95x loss roughly cancel each other out (though they remain separate items with their own character and timing).

New York does not follow suit. Tax Law § 601(e)(1) taxes nonresidents on an allocated share of their income based on their New York source income. Under § 631(a), a nonresident's New York source income includes - where a valid § 660(a) New York S-election is in effect - the shareholder's pro rata share of S-corporation income, loss, and deduction. Under § 632(a)(2), that pro rata share is sourced to New York using the same allocation rules that apply to the corporation itself under the Article 9-A franchise tax. Since NYS-Corp allocated 100% of its income to New York, the Department concluded that 100% of the taxpayers' pro rata share of the $95x gain on the deemed sale of the partnership interest is New York source income - fully taxable to the nonresident taxpayers.

But the $95x loss is sourced differently. Under § 631(b)(2) and the corresponding regulation (then numbered § 131.5(a), now § 132.5(a)), income or loss from intangible personal property - including gains and losses from disposing of intangibles like corporate stock - is not New York source income unless the intangible property was itself employed in a business carried on in New York. The taxpayers' NYS-Corp stock, in their own hands, was not property used in a New York trade or business - they simply held it as an investment. So their $95x loss on the deemed sale of that stock is not New York source income and gets no New York offset. The net result: the taxpayers must report the full $95x gain as New York taxable income, with no corresponding New York deduction for the loss that offsets it federally - an asymmetric result driven entirely by the different sourcing rules that apply to S-corporation pass-through income versus losses on intangible personal property. The Department noted it has no authority under Article 22 to allow any alternative computation method, and pointed out that this whole result flows from the taxpayers' choice to keep the New York S-election in effect - had they not done so, the $95x gain would not have been New York source income at all. The Department also noted, as it routinely does, that it presumes New York's tax statutes are constitutional and has no authority to rule otherwise.

What this means for you

Nonresidents considering buying into (or keeping) a New York S corporation

If you are a nonresident who owns, or is considering buying, stock in a corporation with a valid New York S-corporation election under Tax Law § 660(a), understand that the election is a package deal: it lets S-corporation income pass through to you for New York purposes, but it also means that any gain the corporation itself realizes and passes through to you - such as the gain on a deemed asset sale at liquidation - becomes New York source income to the extent the corporation allocates income to New York. This is true even if you personally have no other connection to New York business activity. If the corporation allocates all or most of its income to New York (as is common for entities holding New York real property or a New York-source partnership interest), that gain will likely be fully taxable to you as a nonresident.

Anyone liquidating an S corporation that holds appreciated property

Before liquidating an S corporation, model out the New York consequences separately from the federal consequences. On the federal side, a gain passed through from the corporation's deemed asset sale and an offsetting loss on your deemed stock sale can wash out. On the New York side, they may not, because New York sources S-corporation pass-through gain based on the corporation's own business allocation percentage, while it sources your personal stock-disposition loss based on whether you personally used that stock in a New York business - a test nonresident investors will typically fail. Do not assume federal netting will carry over to your New York nonresident return.

Accountants and tax advisors structuring exits from real-estate-holding S corporations

When a client's sole asset in an S corporation is a partnership interest in New York real estate (or any other asset generating a 100%-New York allocation), flag that a liquidation will likely trigger a fully-taxable New York gain on the deemed asset sale, unmatched by any New York-recognized loss on the shareholder's own stock. Consider whether alternative exit structures avoid triggering both the deemed asset sale under IRC § 336 and the deemed stock sale under IRC § 331 in the same transaction, since it is the interaction of those two federal mechanisms with New York's differing sourcing rules for S-corp income versus intangible property losses that produces the mismatch.

Common questions

Q: Why does the New York gain not get offset by the New York loss, when they cancel out for federal purposes?
A: Because New York sources these two items under completely different rules. The $95x gain is the taxpayers' pro rata share of NYS-Corp's own gain, passed through under the S-corporation rules of Tax Law § 631(a) and § 632(a)(2) - and it is sourced to New York based on NYS-Corp's own franchise tax allocation percentage, which here was 100%. The $95x loss, by contrast, belongs to the taxpayers personally - it is their loss on the deemed sale of their own NYS-Corp stock, an intangible asset - and Tax Law § 631(b)(2) sources losses on intangible property based on whether the taxpayer personally used that intangible in a New York business. Since the taxpayers did not use their stock in a New York business (they were not stock traders and held it only as an investment), the loss simply is not New York source income, so there is nothing to offset the gain against on the New York return.

Q: Would the result have been different if the taxpayers had not kept the New York S-election in effect?
A: Yes, according to the opinion. If the taxpayers had not made or continued the § 660(a) New York S-election, the S-corporation pass-through rules of §§ 631(a) and 632(a)(2) would not have applied, and the $95x gain from the deemed sale of the partnership interest would not have been New York source income at all. The Department was explicit that by making and maintaining the S-election, the taxpayers subjected themselves to this outcome and are bound by the consequences of that choice.

Q: Does this mean nonresident S-corporation shareholders are always taxed twice on the same economic gain?
A: Not exactly twice - the loss is real for federal purposes and does reduce their federal tax liability by offsetting the pass-through gain there. What this opinion shows is that New York simply does not recognize the offsetting loss as New York source income, so nonresidents can end up owing New York tax on the full gain even though, from a purely economic standpoint, the transaction was closer to a wash. It is less a double tax and more an asymmetric sourcing result baked into the differing statutory tests for S-corp pass-through income versus intangible property dispositions.

Q: Could the taxpayers have asked the Department to use some other method to compute their New York income to avoid this mismatch?
A: No. The opinion states plainly that Article 22 of the Tax Law gives the Commissioner no authority to accept alternative methods for determining New York source income. The statutory sourcing rules for S-corporation pass-through items and for intangible personal property losses apply as written, with no discretionary override available.

Q: Is the underlying real estate itself taxed differently because it is New York property?
A: The real estate is owned by the partnership, not directly by NYS-Corp or the taxpayers, and the opinion does not separately analyze a sale of the real estate itself. What matters here is that the partnership interest (NYS-Corp's asset) and the NYS-Corp stock (the taxpayers' asset) are two different pieces of property with two different New York sourcing rules - the fact that the underlying business is New York rental real estate is what drives NYS-Corp's 100% New York allocation percentage, which in turn is what makes the shareholders' entire pro rata share of the gain New York source income.

Citations and references

• IRC § 336 - treats a liquidating corporation as having sold its assets at fair market value, triggering NYS-Corp's deemed $95x gain on the partnership interest
• IRC § 1366(a) - passes an S corporation's income through to the shareholders' federal adjusted gross income
• IRC § 1367(a) - increases a shareholder's stock basis by pass-through income, raising the taxpayers' NYS-Corp stock basis from $100x to $195x
• IRC § 331 - treats a liquidating corporation's shareholders as having sold their stock for the fair market value of what they receive, producing the taxpayers' deemed $95x stock loss
• Tax Law § 601(e)(1) - imposes New York personal income tax on nonresidents based on their New York source income
• Tax Law § 631(a) - defines a nonresident's New York source income to include, where a § 660(a) election is in effect, the shareholder's pro rata share of S corporation income, loss, and deduction
• Tax Law § 632(a)(2) - sources a nonresident S corporation shareholder's pro rata share of items using the corporation's own Article 9-A franchise tax allocation methods
• Tax Law § 631(b)(2) - excludes income and loss from intangible personal property (including gains/losses on its disposition) from New York source income unless the property was employed in a New York business
• Tax Law § 660(a) - the New York S corporation election that made the S-corp pass-through rules applicable to the taxpayers
• Personal Income Tax Regulations § 132.5(a) (formerly § 131.5(a)) - the regulatory counterpart to § 631(b)(2) governing sourcing of intangible personal property income and loss

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1992.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a92_9i.pdf

Original ruling text

New York State Department of Taxation and Finance

TSB-A-92 (9) I
Income Tax
October 13, 1992

Taxpayer Services Division
Technical Services Bureau
STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I920721A

On July 21, 1992, a Petition for Advisory Opinion was received from
Christopher L. Doyle, Esq., c/o Hodgson, Russ, Andrews, Woods & Goodyear, 1800
One M & T Plaza, Buffalo, New York 14203.
The issue raised by Petitioner, Christopher L. Doyle, is what are the
personal income tax ramifications of the liquidation of a New York S corporation
owned by nonresident shareholders pursuant to Article 22 of the Tax Law under the
fact pattern hereinafter presented.
Taxpayers are individuals who are not residents of New York State. In Year
1, for $100x, Taxpayers purchased all the stock of a New York corporation for
which the previous shareholder had made a proper and timely election under
section 660(a) of the Tax Law to be treated as a New York S-Corporation
(hereinafter "NYS-Corp"). Taxpayers filed all required notices and consents for
continued treatment of NYS-Corp as a New York S-Corporation after the acquisition
of the NYS-Corp stock. Taxpayers are not in the business of trading stock.
The sole asset held by NYS-Corp is a general partnership interest
(hereinafter "Partnership Interest") in a partnership which owns rental real
estate located in New York. NYS-Corp has no employees. NYS-Corp's sole source
of revenue is distributions from the partnership. The partnership's sole source
of revenue is rents received on the New York property. NYS-Corp has a business
allocation percentage which allocates 100 percent of its income, gain, loss and
deduction to New York State for franchise tax (Article 9-A) purposes.
For valid business reasons, Taxpayers wish to liquidate NYS-Corp, and
operate the rental real property business as a partnership owned directly by
Taxpayers. At the time of the liquidation, the Partnership Interest will have a
fair market value of $100x and NYS-Corp will have a $5x basis in the Partnership
Interest. Immediately prior to the liquidation, Taxpayers will have in the
aggregate a $100x basis in their stock of NYS-Corp.
When NYS-Corp liquidates and distributes the Partnership Interest, NYS-Corp
is deemed under section 336 of the Internal Revenue Code (hereinafter "IRC") as
having sold the Partnership Interest at its fair market value.
As a result,
NYS-Corp will realize a $95x gain from the hypothetical sale of the Partnership
Interest (the excess of the $100x fair market value of the Partnership Interest
over NYS-Corp's $5x basis in the Partnership Interest).
Section 1366(a) of the IRC requires that Taxpayers take the $95x gain
realized by NYS-Corp into their personal adjusted gross incomes for federal
income tax purposes.

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TSB-A-92 (9) I
Income Tax
October 13, 1992

Section 1367(a) of the IRC permits Taxpayers to increase their basis in
NYS-Corp stock by $95x (the amount passed through as income). Therefore,
Taxpayers will have in the aggregate a $195x basis in their NYS-Corp stock (their
$100x original basis increased by $95x).
Under section 331 of the IRC, the liquidation will cause Taxpayers to be
deemed to have sold their stock in NYS-Corp for the fair market value of the
property received in liquidation.
At the time of the hypothetical stock sale,
the fair market value of the Partnership Interest will be $100x, and Taxpayers
will have a $195x basis in their NYS-Corp stock. Therefore, Taxpayers will
realize a $95x loss on the hypothetical sale of their NYS-Corp stock.
Section 601(e)(1) of the Tax Law provides that personal income tax is
imposed for each taxable year on the taxable income which is derived from sources
in New York State of every nonresident individual which shall be equal to the tax
computed under sections 601(a) through (d) of the Tax Law, as the case may be,
reduced by the credits permitted under section 606(b) and (c) of the Tax Law, as
if such nonresident were a resident, multiplied by a fraction, the numerator of
which is such individual's New York source income determined in accordance with
sections 631 through 638 of the Tax Law and the denominator of which is such
individual's federal adjusted gross income for the taxable year.
Section 631(a) of the Tax Law provides that the New York source income of
a nonresident individual shall be the sum of the net amount of items of income,
gain, loss and deduction entering into the individual's federal adjusted gross
income derived from or connected with New York sources including, where the
election provided for in section 660(a) of the Tax Law is in effect, an
individual's pro rata share of S corporation income, loss and deduction,
increased by reductions for taxes described in section 1366(f)(2) and (3) of the
IRC, and shall be determined under section 632 of the Tax Law.
Section 632(a)(2) of the Tax Law provides that, in determining New York
source income of a nonresident shareholder of an S corporation where the election
provided for in section 660(a) of the Tax Law 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 the shareholder's federal adjusted gross income, increased by
reductions for taxes described in section 1366(f)(2) and (3) of the IRC, as such
portion shall be determined under the Business Corporation Franchise Tax
Regulations, promulgated under Article 9-A of the Tax Law, consistent with the
applicable methods and rules for allocation under Article 9-A.
Section 631(b)(2) of the Tax Law and section 132.5(a) of the Personal
Income Tax Regulations provides that items of income, gain, loss and deduction
attributable to intangible personal property of a nonresident individual,
including annuities, dividends, interest, and gains and losses from the
disposition of intangible personal property; do not constitute items of income,
gain, loss and deduction devised from or connected with New York State sources,
except to the extent attributable to property employed in a business, trade,
profession or occupation carried on in New York State.

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TSB-A-92 (9) I
Income Tax
October 13, 1992

Herein, NYS-Corp allocates 100 percent of its income, gain, loss and
deduction to New York State for franchise tax purposes.
Therefore, all of
Taxpayers pro rata share of NYS-Corp's $95x gain from the deemed sale of the
Partnership Interest is New York source income under section 632(a)(2) of the Tax
Law.
However, the Taxpayers $95x loss attributable to the deemed sale of the
NYS-Corp stock is a loss from the disposition of intangible personal property
that was not employed by Taxpayers in a business trade, profession or occupation
carried on in New York State and is not New York source income under section
631(b)(2) of the Tax Law and section 132.5(a) of the Personal Income Tax
Regulations.
There is no provision in Article 22 of the Tax Law that gives the
Commissioner of Taxation and Finance the authority to accept alternative methods
for determining New York source income.
It should be noted that if Taxpayers, as nonresidents, had not made the
election pursuant to section 660(a) of the Tax Law, the $95x gain from the
disposition of the Partnership Interest would not be New York source income. By
making the election pursuant to section 660(a) of the Tax Law, the Taxpayers have
subjected themselves to personal income tax as provided herein and are bound by
the consequences of such election.
The laws of New York State are presumed to be constitutional by the
Commissioner of Taxation and Finance.
There is no jurisdiction at the
administrative level to declare such laws unconstitutional; therefore, it must
be presumed that the relevant sections of the law are constitutional to the
extent that they relate to the imposition of the tax liability on Taxpayers.

DATED: October 13, 1992

s/PAUL B. COBURN
Deputy Director
Taxpayer Services Division

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