Could new Rhode Island residents use a California-tax basis instead of federal basis for IRC § 1042 replacement securities or claim a Rhode Island income modification on sale?

Plain-English summary

The taxpayers could not use a different Rhode Island basis from their federal basis for the IRC § 1042 replacement securities, and the later sale did not qualify for a subtraction under § 44-30-12(c). Rhode Island followed the federal nonrecognition election even though California had taxed the original ESOP stock sales.

In 1987 and 1988, while California residents, the taxpayers sold common stock of three private corporations to the corporations' employee stock ownership plans. They elected federal nonrecognition under IRC § 1042 and bought qualifying replacement securities.

California did not recognize that federal provision at the time and taxed the original transactions. The taxpayers wanted Rhode Island, once they became residents, to use a stepped-up basis tied to the California-taxed selling price and tax only later appreciation.

The Division rejected the request. Section 44-30-12(c) covered specified modifications for interest on U.S. obligations and the separate modification referenced in § 44-30-25(f); it did not cover common stock of private corporations.

Rhode Island personal income tax was “piggybacked” on federal income-tax law. Because the taxpayers chose federal nonrecognition, Rhode Island used the same treatment and basis. California's separate tax treatment did not alter Rhode Island law.

What this means for you

Taxpayers moving to Rhode Island

Tax paid to a former state did not automatically create a new Rhode Island basis where Rhode Island followed federal tax treatment.

ESOP sellers and investors

The federal § 1042 election carried through to Rhode Island. The order did not allow taxpayers to keep federal nonrecognition while substituting a higher state basis.

Accountants and tax professionals

Do not use § 44-30-12(c) as a general equitable adjustment for income taxed by another state. The quoted subsection listed specific modifications and did not reach these private-company securities.

Common questions

Could the taxpayers use the California-taxed sale price as Rhode Island basis? No. Rhode Island required the same basis used for federal income tax.

Did California tax paid create a Rhode Island subtraction? No. The order found no applicable modification.

Why did § 44-30-12(c) not apply? Its quoted provisions concerned qualifying U.S. Government obligation income and another specifically referenced modification, not private-company common stock.

Did the federal § 1042 election matter in Rhode Island? Yes. Rhode Island followed the federal nonrecognition treatment.

What was the final result on sale of the replacement securities? No different Rhode Island basis and no modification on the individual income-tax return.

Citations and references

• Internal Revenue Code § 1042 — nonrecognition election for the ESOP stock sales.
• R.I. Gen. Laws § 44-30-12(c) — modifications reducing federal adjusted gross income, found inapplicable.
• R.I. Gen. Laws § 44-30-25(f) — separate modification referenced in the quoted statute.

Source

• Landing page: Rhode Island Declaratory Rulings
• Declaratory order: Declaratory Order 1993-01

Original ruling text

Ruling Request No. 93-01

Declaratory Rulings

Ruling Request No. 93-01

Re: Modifications Reducing Federal Adjusted Gross Income

Request for Ruling

Taxpayers request a ruling concerning the income tax treatment of the sale of "Replacement Securities" pursuant to the Internal Revenue Code Section 1042. The taxpayers are seeking to treat the sale of certain replacement securities as a modification to their income pursuant to R.I.G.L. 44-30-12(c).

Facts

In 1987 and 1988, as residents of California, the taxpayers elected the non-recognition provision of Internal Revenue Code 1042 for the sale of common stock of three private corporations to the corporation's ESOP. The taxpayers filed the necessary elections and purchased qualified Replacement Securities to qualify the transaction under Section 1042.

At the time of the transaction, California Tax Law did not recognize this particular Internal Revenue Code Section. As a result of their lack of recognition the taxpayers paid California an income tax on the entire transaction. The taxpayers would like to use as a basis for Rhode Island income tax a step up in basis to the selling price that was used in computing the California income tax as well as the tax paid to California paid on the transaction. The tax due and payable to the State of Rhode Island would be on the appreciation from the date of purchase of the Replacement Securities until the day sold.

Ruling Requested

The following rulings are respectfully requested:

1. That when the individuals become residents of the State that they will be allowed to use a different basis for figuring Rhode Island income taxes than they do for figuring Federal Income taxes.

2. That the sale of the Replacements Securities will be treated as a modification to their individual income tax return pursuant to R.I.G.L. 44-30-12(c).

Discussion

The taxpayers ask that the sale of the Replacement Securities be treated as a modification to income under R.I.G.L. 44-30-12(c) which reads in pertinent part as follows:

44-30-12. Rhode Island income of a resident individual. -- (a) General...

(c) Modifications reducing federal adjusted gross income. There shall be subtracted from federal adjusted gross income (1) any interest income on obligations of the United States and its possessions to the extent includible in gross income for federal income tax purposes, and any interest or dividend income on obligations, or securities of any authority, commission, or instrumentality of the United States to the extent includable in gross income for federal income tax purposes but exempt from state income taxes under the laws of the United States; provided that the amount to be subtracted shall in any case be reduced by any interest on indebtedness incurred or continued to purchase or carry obligations or securities the income of which is exempt from Rhode Island personal income tax, to the extent the interest has been deducted in determining federal adjusted gross income or taxable income; (2) the modification described in section 44-30-25(f).

R.I.G.L. 44-30-12(c) is inapplicable to the relief sought by the taxpayers. That section speaks to modifications resulting from interest on obligations of the United States which is taxable for federal purposes but not for state purposes. The items referred to in this matter are items of common stock of private corporations.

The Rhode Island personal income tax is imposed on the Rhode Island income of residents and nonresidents equal to a percentage of the taxpayer's federal income tax liability. Federal income tax liability is the amount of a taxpayer's federal income tax minus certain adjustments not relevant to this matter.

The Rhode Island personal income tax is "piggybacked" on Federal income tax law. Accordingly, if a taxpayer elects a non-recognition provision for federal tax purposes, that treatment applies for Rhode Island purposes as well. The fact that California has an income tax independent of Federal tax law has no impact on Rhode Island law.

Ruling

1. When the taxpayers become residents of Rhode Island they will not be allowed to use a different basis for computing Rhode Island income taxes than they do for computing federal income taxes.

2. That the sale of the Replacement Securities will not be treated as a modification on their Rhode Island individual income tax return.

This ruling may be relied upon by this taxpayer and shall be valid until the applicable statutory provisions are amended in a manner requiring a different result or until the underlying factual presentation changes

**R. Gary Clark

Tax Administrator

February 17, 1993**