How is a dividend that a New York S corporation receives from its foreign (alien) subsidiary sourced for a nonresident shareholder's New York personal income tax?

Plain-English summary

Petitioner, Robert Kaplan, CPA of LEF & Co., asked the Department how to source dividend income received from a subsidiary of a New York S corporation, for purposes of a New York nonresident individual shareholder's personal income tax. The facts: a New York S corporation owns more than 50 percent of the capital stock, by both value and voting power, of an alien (foreign) corporation operating outside the United States. The alien corporation pays a dividend to the S corporation, and that dividend is treated as portfolio income on the nonresident shareholder's Schedule K-1. For purposes of Article 9-A of the Tax Law, the alien subsidiary's issuer's allocation percentage is zero.

The Department explained that because the dividend comes from a controlled foreign corporation under IRC § 957, it is portfolio income under Temp. Treas. Reg. § 1.469-2T(c)(3)(i), a separately stated item under Prop. Treas. Reg. § 1.1366-1(a)(2), and is reported by the shareholder as dividend income, retaining that character under IRC § 1366(b). For New York purposes, Tax Law § 632(a)(2) requires that the source of a nonresident shareholder's pro rata share of S corporation items be determined consistent with the allocation methods of Article 9-A of the Tax Law. Article 9-A separately allocates business income and capital, investment income and capital, and subsidiary capital. The Department's Publication 35 explains how the S corporation's business and investment allocation percentages apply to business and investment income, respectively, but does not address the method for allocating income from subsidiary capital.

Since the dividend is paid by the S corporation's subsidiary, the Department treated it as income from subsidiary capital under Article 9-A, and concluded it should be sourced the same way subsidiary capital itself is allocated under Tax Law § 210.7: by multiplying the amount by the issuer's allocation percentage of that subsidiary, as defined in Tax Law § 210.3(b)(1) and 20 NYCRR § 4-10.1. Applying that method here, the alien subsidiary's issuer's allocation percentage was zero.

As a result, under Tax Law § 631(a), none of the nonresident shareholder's pro rata share of the dividend is derived from or connected with New York sources, and under Tax Law § 601(e), none of that dividend is included in the numerator of the shareholder's New York source income fraction (the denominator of which is the shareholder's New York adjusted gross income).

What this means for you

Nonresident shareholders of NY S corporations with foreign subsidiaries

If you are a nonresident individual who owns stock in a New York S corporation that in turn owns a foreign subsidiary, a dividend the subsidiary pays up to the S corporation is not automatically fully taxable, or fully exempt, in New York. Instead, your pro rata share of that dividend is New York source income only to the extent of the foreign subsidiary's issuer's allocation percentage under Article 9-A of the Tax Law. If that percentage is zero, as it was in this case, none of the dividend counts as New York source income, even though it appears as portfolio/dividend income on your federal Schedule K-1.

Accountants preparing nonresident K-1 allocations

When a New York S corporation client has a dividend-paying subsidiary reported as portfolio income on a nonresident shareholder's Schedule K-1, do not default to applying the corporation's ordinary business allocation percentage or investment allocation percentage to that item. Because the dividend originates from subsidiary capital, source it under the Article 9-A subsidiary capital method in Tax Law § 210.7 and § 210.3(b)(1): multiply the shareholder's pro rata share of the dividend by the paying subsidiary's issuer's allocation percentage to determine the New York source amount reported for the nonresident's Tax Law § 601(e) source fraction.

Common questions

Q: Does a dividend from a foreign subsidiary automatically become New York source income just because the payor is a subsidiary of a New York S corporation?
A: No. The dividend is New York source income only to the extent determined by the subsidiary's issuer's allocation percentage under Article 9-A of the Tax Law (Tax Law § 210.7 and § 210.3(b)(1)); it is not treated as fully New York source merely because the paying entity is owned by a New York corporation.

Q: Why does this ruling apply the subsidiary capital allocation method instead of the business or investment allocation percentage?
A: Because the dividend is paid by the S corporation's subsidiary, the Department treated the dividend as income from subsidiary capital under Article 9-A of the Tax Law. Publication 35 explains how to apply the business and investment allocation percentages to business and investment income, but does not address subsidiary capital income, so the Department applied the same method Article 9-A already uses to allocate subsidiary capital itself.

Q: What was the New York source result in this specific case?
A: The alien subsidiary's issuer's allocation percentage was zero, so under Tax Law § 631(a) none of the nonresident shareholder's pro rata share of the dividend was derived from or connected with New York sources, and under Tax Law § 601(e) none of it belonged in the numerator of the shareholder's New York source income fraction.

Q: Does the dividend's character as portfolio income for federal purposes matter to the New York analysis?
A: Yes, as background. The dividend is a controlled foreign corporation dividend under IRC § 957, treated as portfolio income under Temp. Treas. Reg. § 1.469-2T(c)(3)(i), separately stated under Prop. Treas. Reg. § 1.1366-1(a)(2), and it retains that character when passed through to the shareholder under IRC § 1366(b) and Tax Law § 632(e)(2). But New York's sourcing question - how much of it is New York source income - is answered separately, using the Article 9-A subsidiary capital method described in this opinion.

Q: Where is the source of S corporation items determined - at the corporate level or the shareholder level?
A: At the corporate level. As explained in Publication 35 and applied here, the source determination is made at the S corporation level, and the resulting allocation percentage is then applied to the nonresident shareholder's pro rata share of the item.

Q: Would the answer differ if the alien subsidiary's issuer's allocation percentage were greater than zero?
A: Yes. The opinion's method multiplies the shareholder's pro rata share of the dividend by the subsidiary's issuer's allocation percentage, so a nonzero percentage would produce a corresponding nonzero amount of New York source income includible under Tax Law § 631(a) and in the § 601(e) source fraction numerator.

Citations and references

• Tax Law § 601(e) - imposes personal income tax on a nonresident's New York source taxable income, computed as if the individual were a resident and apportioned by the New York source fraction
• Tax Law § 631(a) - New York source income of a nonresident includes the individual's pro rata share of New York S corporation income, loss, and deduction derived from or connected with New York sources
• Tax Law § 632(a)(2) - the New York source of a nonresident shareholder's pro rata share of S corporation items is determined under regulations consistent with Article 9-A allocation methods
• Tax Law § 632(e)(2) - the character of S corporation items for a nonresident shareholder is the same as for federal income tax purposes
• Tax Law § 210.7 and § 210.3(b)(1) of Article 9-A - the portion of subsidiary capital allocated to New York is determined by multiplying capital invested in each subsidiary by that subsidiary's issuer's allocation percentage
• 20 NYCRR § 4-10.1 - regulation implementing the Article 9-A subsidiary capital allocation method
• New York State Department of Taxation and Finance Publication 35 (2/96), Part VII.A - explains that S corporation item sourcing is determined at the corporate level, using business and investment allocation percentages for business and investment income
• IRC § 1366(a) and (b) - a shareholder takes into account a pro rata share of S corporation items, which retain the character they had when realized by the corporation
• IRC § 957 - defines a controlled foreign corporation as one more than 50 percent owned (by vote or value) by United States shareholders
• Prop. Treas. Reg. § 1.1366-1(a)(2) - portfolio income is among the items an S corporation shareholder must take into account separately
• Temp. Treas. Reg. § 1.469-2T(c)(3)(i) - portfolio income includes dividends from a controlled foreign corporation

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1999.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a99_3i.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-99(3)I
Income Tax
June 25, 1999

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I990311B

On March 11, 1999, a Petition for Advisory Opinion was received from Robert Kaplan, CPA,
LEF & Co. 70E Sunrise Highway, Valley Stream, New York 11582-0547.
The issue raised by Petitioner, Robert Kaplan, CPA, is how to source dividend income
received from a subsidiary of a New York S corporation for a New York nonresident individual
shareholder of the S corporation.
Petitioner submits the following facts as the basis for this Advisory Opinion.
A New York S corporation owns more than 50 percent of the capital stock in value and in
voting power of an alien corporation operating outside of the United States. The alien corporation
pays the S corporation a dividend. The dividend is treated as portfolio income on the nonresident
shareholder's Schedule K-1. For purposes of Article 9-A of the Tax Law, the alien corporation has
an issuer's allocation percentage of zero.
Discussion
Section 1366(a) of the Internal Revenue Code ("IRC") provides that
(1) ... In determining the tax under [Subchapter S] of a shareholder for the
shareholder's taxable year in which the taxable year of the S corporation ends ... there
shall be taken into account the shareholder's pro rata share of the corporation's –
(A) items of income (including tax-exempt income), loss, deduction, or credit
the separate treatment of which could affect the liability for tax of any shareholder
....
Section 1366(b) of the IRC provides that the character of any item included in a shareholder's
pro rata share under section 1366(a)(1) of the IRC shall be determined as if such item were realized
directly from the source from which realized by the corporation, or incurred in the same manner as
incurred by the corporation.
Section 1.1366-1(a)(2) of Proposed Treasury Regulations lists several items that each
shareholder must take into account separately, and includes "[a]ny of the corporation's items of
portfolio income or loss, and expenses related thereto, as defined under section 469 [of the IRC]."

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Section 1.469-2T(c)(3)(i) of the Temporary Treasury Regulations provides that portfolio
income includes all gross income, other than income derived in the ordinary course of a trade or
business (within the meaning of section 1.469-2T(c)(3)(ii)), that is attributable to –
(A) Interest ... annuities; royalties ... dividends of C corporation stock; and
income (including dividends) from a real estate investment trust ... regulated
investment company ... real estate mortgage investment conduit ... common trust
fund ... controlled foreign corporation (within the meaning of section 957), qualified
electing fund ... or cooperative ....
Section 957 of the IRC states that the term "controlled foreign corporation" means any
foreign corporation if more than 50 percent of (1) the total combined voting power of all classes of
stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is
owned (within the meaning of section 958(a)), or is considered as owned by applying the rules of
ownership of section 958(b), by United States shareholders, on any day during the taxable year of
such foreign corporation.
The dividend at issue in this case is a dividend from a controlled foreign corporation pursuant
to section 957 of the IRC, that is treated as portfolio income pursuant to section 1.469-2T(c)(3)(i)
of the Temporary Treasury Regulations. As such, it is a separately stated item pursuant to section
1.1366-1(a)(2) of Proposed Treasury Regulations that is reported as portfolio income by the S
corporation on the shareholder's Schedule K-1, and is reported, by the shareholder, as dividend
income on the shareholder's federal income tax return.
Section 601(e) of the Tax Law imposes a personal income tax for each taxable year on a
nonresident individual's taxable income which is derived from sources in New York State. The tax
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.
Section 631(a) of the Tax Law provides that the New York source income of a nonresident
individual shall include the individual's pro rata share of New York S corporation income, loss and
deduction derived from or connected with New York sources.
Section 632(a)(2) of the Tax Law provides that the New York source of a shareholder's pro
rata share of New York S corporation items shall be determined under regulations of the
Commissioner of Taxation and Finance consistent with the applicable methods and rules for
allocation under Article 9-A of the Tax Law. Article 9-A of the Tax Law provides for separate
allocations of business income and business capital, investment income and investment capital, and
subsidiary capital. Part 4 of the Business Corporation Franchise Tax Regulations provides the
applicable methods and rules for such allocations.

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Section 632(e)(2) of the Tax Law provides that the character of S corporation items for a
nonresident shareholder shall, as under section 617(b) of the Tax Law, have the same character as
for federal income tax purposes.
The New York State personal income tax treatment of items of income, gain, loss and
deduction of a nonresident shareholder of a New York S corporation is explained in the New York
State Department of Taxation and Finance Publication 35 (2/96) New York Tax Treatment of S
Corporations and their Shareholders in Part VII.A. It provides that the source of S corporation items
is made at the corporation level. It also provides that when computing a nonresident shareholder's
New York source income, the S corporation's business allocation percentage, as determined under
Article 9-A of the Tax Law, is applied to items of business income, and the S corporation's
investment allocation percentage, as determined under Article 9-A of the Tax Law, is applied to
items of investment income. However, it does not reference the allocation method to be applied to
S corporation income from subsidiary capital.
Section 210.7 of Article 9-A of the Tax Law and section 4-10.1 of the regulations, provides
that the portion of the subsidiary capital of a taxpayer to be allocated within New York State shall
be determined by (a) multiplying the amount of its subsidiary capital invested in each subsidiary
during the period covered by its report by the issuer's allocation percentage, as defined in section
210.3(b)(1) of the Tax Law, of each such subsidiary and (b) adding together the sums so obtained.
As explained in Publication 35, supra , the source of the dividend income, at issue in this
case, is determined at the S corporation level. Since the dividend received by the S corporation is
from its subsidiary, the dividend is treated as income from subsidiary capital for purposes of Article
9-A of the Tax Law. It is consistent with the prescribed methods for allocating business income and
investment income, for such shareholder to allocate such subsidiary income by the method used to
allocate subsidiary capital under section 210.7 of Article 9-A of the Tax Law, that is, by the issuer's
allocation percentage of the subsidiary.
Accordingly, for purposes of section 632(a)(2) of the Tax Law, the portion of the nonresident
shareholder's pro rata share of the dividend received by the S corporation from its foreign subsidiary,
that is separately treated as portfolio income on the shareholder's Schedule K-1 and as dividend
income on the shareholder's federal income tax return, that is derived from or connected with New
York sources is determined by multiplying the shareholder's pro rata share of the dividend by the
alien subsidiary's issuer's allocation percentage as determined under section 210.3(b)(1) of Article
9-A of the Tax Law. In this case, the alien subsidiary's issuer's allocation percentage is zero.
Therefore, pursuant to section 631(a) of the Tax Law, no portion of the shareholder's pro rata share

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of the dividend is derived from or connected with New York sources, and for purposes of section
601(e) of the Tax Law, no portion of the dividend would be included in the numerator of the New
York source fraction of the nonresident shareholder.

DATED: June 25, 1999

NOTE:

/s/
John W. Bartlett
Deputy Director
Technical Services Bureau

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