New York Tax Tribunal Upholds Mandatory S Corporation Elections
On May 17, 2021, the New York State Tax Appeals Tribunal issued its decision in Matter of Lepage, DTA No. 828035. At issue was whether the entities involved were deemed to be S corporations for New York state income tax purposes. When a corporation makes a federal election to be treated as an S corporation, New York state requires a separate state S corporation election as well. However, even if the New York state S corporation election is not made, the corporation may still be treated as an New York state S corporation if an often overlooked “investment ratio” test is satisfied. The Tribunal decided that the “investment ratio test” was met using the income reported on the federal S corporation tax returns, triggering mandatory S elections and ultimately resulting in additional New York tax liability for the shareholders on the gain from the sale.
Background
The taxpayers in this case are nonresident individuals that owned Lepage, Inc., and Bakeast, Inc. (the entities). Both entities are Delaware corporations that made valid federal S corporation elections but did not make separate New York state S corporation elections.
In July 2012, Flowers, Inc., acquired 100% of the stock of Lepage, Inc. and Bakeast, Inc. from the nonresident individuals. For non-tax purposes, the sale was structured as a stock sale. However, for federal income tax purposes, the buyer and sellers properly made an Internal Revenue Code (IRC) Section 338(h)(10) election to treat the sale as a deemed sale of the entities’ assets.
For federal and New York state income tax purposes, the entities filed short-year 2012 returns. Each entity reported and paid New York state corporation franchise tax on its entire net income as apportioned to New York state as C corporations. The entities reduced their federal taxable income starting point by the amount of gain attributable to the deemed asset sale.
For federal income tax purposes, the individual shareholders reported their share of the deemed asset sale gain on their individual federal returns. Because the entities were not treated as S corporations for New York state income tax purposes, and standalone C corporations cannot make a Section 338(h)(10) election, the shareholders reported the transaction with New York as a sale of stock. Further, the taxpayers argued that because the shareholders were nonresidents, the gain on their sale of stock would be sourced to their states of residence, not to New York state.
New York State’s S Corporation Rules
Although New York state’s S corporation treatment is generally voluntary and requires a separate state election, under certain circumstances New York state S corporation treatment is required regardless of whether the state election was made. For example, an “eligible S corporation” is deemed to have made a New York state S corporation election in any tax year if the entity’s “investment income” for that year is greater than 50% of its “federal gross income” for that year.
An “eligible S corporation” is a corporation that made a federal S corporation election but did not make the separate New York state S corporation election and is subject to either New York state corporation franchise tax or New York state banking corporation franchise tax.
“Investment income” is the sum of an eligible S corporation’s gross income from interest, dividends, royalties, annuities, rents and “gains derived from dealing in property” (real, tangible and intangible), including the corporation’s share of such items from a partnership, estate or trust, to the extent such items would be includable in federal gross income for the taxable year.
Tribunal Finds that the Entities are NY S Corporations Under Investment Ratio Test
The New York state Department of Taxation and Finance argued that the transaction triggered mandatory New York state S corporation elections for the entities under the investment ratio test. As a result, the Department argued that the entities sold their assets under a valid Section 338(h)(10) election, and the transactions were not sales of stock by nonresident C corporation shareholders. The Department then contended that gain from the deemed sale of goodwill was investment income included in the investment ratio test. The Tribunal agreed with the Department.
The taxpayers argued that “federal gross income” refers to the eligible S corporation’s federal gross income computed as if it were a federal C corporation. The Tribunal disagreed. Instead, the Tribunal concluded that the meaning of “federal gross income” is the sum of the eligible S corporation’s actual items of federal gross income as reported on its actual federal S corporation return, which included the deemed asset sale gain.
The taxpayers next argued that “investment income” must refer only to income from passive investments and may not include gain from the sale of goodwill. The Tribunal once again disagreed. The Tribunal explained that “investment income” includes “gains derived from dealings in property,” which is a term that is used in IRC Section 61(a)(3). Further, the applicable federal regulations specifically indicate that the sale of “intangible items, such as goodwill” is considered “gains derived from dealings in property.”
Based on the Tribunal’s reasoning, the entities’ “investment income” far exceeded the 50% threshold. Therefore, the entities were deemed to have made a New York state S election and the federal Section 338(h)(10) election was then also respected for New York state tax purposes. As a result, the nonresident shareholders’ New York state source income included their distributive share of the deemed asset sale gain apportioned to New York state.
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