New York’s Tax Reform and Its Impact on Small Business

Editor: Sarah McGahan, J.D., LL.M.

The New York executive budget legislation for fiscal year 2014–2015 was signed by Gov. Andrew Cuomo on March 31, 2014. Much has been said and written about the corporate tax reform measures and their potential impact on various taxpayers. It appears one of the goals of this legislation was to improve the state business climate through broadening the tax base, lowering tax rates, and reducing some of the inherent complexities of New York’s corporate tax framework. In fact, according to the Tax Foundation, these measures have likely raised New York’s corporate tax system ranking from 25th to fourth, falling behind only three states that do not impose a corporate income tax. The state’s overall tax structure ranking, however, improved by only two positions to 48th, from dead last.1

Most significantly affected by New York’s corporate tax reform are banking institutions, as they will no longer be subject to a separate method of taxation but will be rolled into the significantly revised corporate tax regime. The law adopts unitary combined reporting and elective combined reporting for certain groups of corporations. The changes eliminate the separate treatment of subsidiary capital and income, along with the alternative tax on minimum taxable income. But what impact does New York’s tax reform have on smaller, nonbanking businesses? And further, what is the impact on smaller businesses primarily located outside New York state? That is the focus of this column.

Nexus

One of the most significant changes under New York’s corporate tax reform is the implementation of a bright-line economic nexus standard. Corporations deriving receipts from New York sources of $1 million or more will be deemed to have nexus with the state beginning in 2015. New York has joined others, most notably California, in adopting a “factor presence” standard (which generally provides that nexus is established if any one of three thresholds for property, payroll, or receipts is exceeded) for purposes of imposing its franchise tax. However, the only factor that is relevant for New York taxes is the receipts factor since both property and payroll factors had already been eliminated from the corporate allocation formula.

To determine whether the New York receipts threshold of $1 million has been met, the sourcing rules for determining the state’s allocation percentage are used. If receipts are required to be included in the numerator of the receipts factor, they will be considered New York receipts for purposes of meeting the threshold.2

It is important to note that, because the new economic nexus provisions are contained in New York’s statutes under Article 9-A, Franchise Tax on Business Corporations, the new provisions apply exclusively to corporations. Small businesses are most often formed as S corporations, partnerships, limited liability companies (LLCs), or sole proprietorships to avoid double taxation at both the federal and state level. Two standards now apply for determining nexus in New York, depending on whether the business is conducted in corporate or noncorporate form, and therefore apply differently to small businesses organized as S corporations compared to other, noncorporate, forms.

S corporation taxation is determined under the corporate tax provisions in Article 9-A.3 S corporations, however, are only subject to the fixed-dollar minimum tax at the corporate level, and cannot be included in a combined return.4 For S corporations, the fixed-dollar minimum tax remains unchanged under corporate tax reform, and it maxes out at $4,500 for corporations with more than $25 million in New York receipts.5 Unfortunately, the new economic nexus provisions contained in Article 9-A apply to all corporations, including S corporations.6 Therefore, beginning in 2015, any S corporation with $1 million or more of New York-source receipts will automatically be deemed to have nexus and be subject to tax. This includes both the fixed-dollar minimum fee at the corporate level and the personal income tax at the shareholder level.

If the corporation’s receipts from New York taxpayers are derived entirely from sales of tangible personal property, and contacts with the state are limited to the solicitation of sales as further defined under the Wrigley7decision,federal Public Law 86-272 should apply.8 P.L. 86-272 prevents any state from imposing an income tax in these situations. However, P.L. 86-272 does not offer any protection from the imposition of the fixed-dollar minimum tax or any other non—income-based tax.

Nexus determinations for nonresident individuals conducting business as sole proprietors or partnerships are contained in New York’s statutes under Article 22. LLCs treated as partnerships for federal tax purposes are also treated as partnerships for New York tax purposes, causing individual members of LLCs to fall within the partnership provisions.9

The personal income tax is imposed on all nonresidents deriving income from sources within the state.10 For nonresident individual taxpayers, New York-source income includes any federal adjusted gross income derived from or connected with New York sources. This includes income from a business, trade, profession, or occupation carried on within the state; a distributive share of New York partnership income; and any pro-rata share of New York S corporation income.11

Partnership income is considered New York-source if it is “derived from or connected with New York State sources, i.e., attributable to the ownership by the partnership of any interest in real or tangible personal property in New York State or to a business, trade, profession, or occupation carried on in New York State by the partnership.”12 This definition, which remains unchanged by corporate tax reform, has historically been interpreted as requiring some physical presence within the state.

As a result, nonresident individual partners should be subject to New York income tax only if the partnership derives income from the ownership of property in New York or from carrying on business within the state. This is far different from the corporate economic nexus provisions, which trigger tax once a certain amount of receipts are obtained from New York sources. Serious consideration should be given to entity form when planning to do business in New York, and the associated tax ramifications should be evaluated.

It’s also important to note that if an S corporation owns a partnership or LLC interest, the corporate economic nexus provisions apply.13 For example, a partnership that has more than $1 million of receipts from New York customers may not have nexus or a corresponding filing requirement if there is no physical presence within the state, as explained above. If a partner were to contribute its interest in the partnership to an S corporation, the economic nexus provisions would be triggered, and both the S corporation fixed-dollar minimum tax and shareholder income tax would apply to the income flowing through from the partnership.

To date, there have been no significant taxpayer wins in defending against economic nexus challenges where a factor-presence nexus standard is used. Ohio affirmed its factor-presence nexus standard earlier this year. The Ohio Board of Tax Appeals ruled that L.L. Bean had nexus with the state since its gross receipts met the state’s threshold (i.e., greater than $500,000).14 The fight is not over yet, asL.L. Bean has appealed the decision to the Ohio Supreme Court.

Apportionment

New York generally uses the term “allocation” as opposed to “apportionment” when referring to its method of dividing the tax base among the states for multistate taxpayers. Since the state’s meaning of the term “allocation” more closely resembles the Uniform Division of Income for Tax Purposes Act’s15 meaning of apportionment, for purposes of this discussion, the term “apportionment” will be used.

In conjunction with the new nexus standard, and to achieve the intended effect, a market-based approach to sourcing corporate receipts has also been adopted. Certain types of receipts have been specifically identified in the statute along with their sourcing requirements for amounts attributable to New York. These receipts include sales of tangible personal property, electricity, real property, rents, royalties, digital products, financial transactions, railroad and trucking businesses, aviation services, advertising, and receipts from the transportation or transmission of gas.16

Receipts not addressed separately are sourced to the “location of the customer.” A hierarchy method has been adopted for making this determination, and the taxpayer must exercise due diligence at each level of the hierarchy before dismissing it and moving to the next level. The taxpayer must base its determination on information known or information that would be known to the taxpayer upon reasonable inquiry.17

The hierarchy of methods for sourcing other receipts to New York is as follows:

1. The benefit is received in this state;
2. Delivery destination;
3. The apportionment fraction for such receipts within the state determined pursuant to this subdivision for the preceding taxable year; or
4. The apportionment fraction in the current taxable year determined pursuant to this subdivision for those receipts that can be sourced using the hierarchy of sourcing methods in subparagraphs one and two of this paragraph.18

And, of course, as provided in most state apportionment provisions, if it appears that the apportionment does not result in a proper reflection of the taxpayer’s business income within the state, the New York state tax commissioner is authorized to adjust it, or the taxpayer may request that the commissioner adjust it in order to effect a fair and proper apportionment of the business income reasonably attributable to the state.19

The new sourcing provisions are a significant departure from the current method, where corporate taxpayers source service receipts to New York to the extent the services are actually performed in the state, or other receipts to the extent they are earned in New York. As is the challenge in all states that have adopted a market-based approach, depending on the taxpayer’s business, significant complexities can obviously arise in determining where the “benefit is received” by the customer. In fact, it appears the taxpayer must now ask its customers where the benefit of its services is being received, before using the methods listed lower in the hierarchy. For those businesses with service or “other” receipts, it is hard to say that the law has been simplified on this point.

When determining New York-source income of nonresident S corporation shareholders, the personal income tax statutes point back to the corporate apportionment provisions.20 As a result, the new market-based sourcing provisions discussed above apply to S corporations and their shareholders. S corporations generally apportion income using a single-receipts factor, which remains unchanged and is identical to the C corporation requirements.

For nonresidents owning sole proprietorships and interests in partnerships (including LLCs treated as partnerships), different apportionment provisions apply. If New York income can be separately accounted for by maintaining separate books and records, then apportionment is not required. If separate records are not adequately maintained, an equally weighted three-factor apportionment percentage must be used, based on property, payroll, and gross income.21

The gross income percentage used by flowthrough entities and sole proprietors is computed by

dividing (1) the gross sales or charges for services performed by or through an office, branch or agency of the business located within New York State, by (2) the total of all gross sales or charges for services performed within and without New York State. The sales or charges to be allocated to New York State include all sales negotiated or consummated, and charges for services performed, by an employee, agent, agency or independent contractor chiefly situated at, connected by contract or otherwise with, or sent out from, offices, branches of the business, or other agencies, situated within New York State.22

The difference in methodology of sourcing the receipts of partnerships vs. S corporations is extreme. Take, for example, a service business primarily located in Pennsylvania that has nexus with New York and customers located in New York. The business performs all its services at its Pennsylvania office, and all payroll and property is located in Pennsylvania. If the business is formed as an S corporation, all sales to New York customers would be included in the New York receipts-factor numerator, thus resulting in New York income tax being imposed on its shareholders. If the business is formed as a partnership (or an LLC treated as a partnership), no receipts would be attributable to New York, resulting in no personal income tax within New York.

Alternatively, an S corporation that earns significant service income from customers located outside of New York and performs its services within the state of New York may benefit from corporate tax reform. The S corporation will have the opportunity to reduce its New York receipts factor by sourcing those receipts outside New York state, assuming nexus exists with another state. Of course, tax benefits will be achieved only if the S corporation shareholders reside in a state that does not impose income tax or imposes it at a lower rate. Shareholders residing in New York ultimately pay state income tax on all passthrough income.

Manufacturing

In addition to the nexus and apportionment disparities between S corporations and partnerships, significant disparities now exist for New York manufacturers. A C corporation that falls within the definition of a qualified New York manufacturer has a 0% entire net income tax rate for tax years beginning on or after Jan. 1, 2014. Qualified New York manufacturers are still subject to the capital tax (although reduced rates apply as the tax is being incrementally phased out) and the minimum tax based on New York receipts. Qualified New York manufacturers doing business in the Metropolitan Commuter Transportation District will also be subject to the MTA surcharge.23 Previously, a reduced rate was provided to eligible manufacturers and small business corporations.24

To fall within the definition of a “manufacturer,” the taxpayer must be principally engaged in the production of goods by manufacturing, processing, assembling, refining, mining, extracting, farming, agriculture, horticulture, floriculture, viticulture, or commercial fishing. A “qualified New York manufacturer” is a manufacturer that has manufacturing property in New York with an adjusted basis of at least $1 million or, alternatively, all of its real and personal property located in New York.25

Manufacturers located exclusively outside of New York, but that still have New York nexus, will not receive any benefit from the change in corporate tax rate. In addition, no reduced rate is available to individuals who have ownership interests in flowthrough entities. New York manufacturers should determine how best to structure their business in light of this change. Alternatives should be explored, which may include choosing not to make a New York S corporation election or establishing a C corporation. To the extent income remains in the corporation, it will escape New York taxation or at least be deferred. Federal tax consequences must be carefully weighed in this type of planning to avoid the potential double taxation that is inherent with C corporations. Typically, double taxation occurs through the taxation of C corporation dividends (i.e., income already taxed within the entity) or if the business assets are ultimately sold and the proceeds distributed to shareholders.

Credits

Numerous credits were also included in the legislation that may assist in reducing taxes on businesses within New York. These include a new investment tax credit and real property tax credit for manufacturers; employment incentive credits; empire zone investment tax credit and empire zone employment incentive credit; qualified empire zone employment (QEZE) credit for real property taxes; QEZE tax reduction credit; qualified emerging technology company employment credit; qualified emerging technology company capital tax credit; credit for the special additional mortgage recording tax; credit for servicing certain mortgages; an agricultural property credit; credits for film production and film post-production; credits for commercial production; credits for environmental remediation; and a number of others.

Estate Tax

Succession planning is on the minds of many small business owners who do not want to surrender to the government what they have worked so hard for over a lifetime. To that end some favorable reforms to the estate tax were made. The basic exclusion amount increases from $1,000,000 to $2,062,500 for decedents dying on or after April 1, 2014, and before April 1, 2015; $3,125,000 for decedents dying on or after April 1, 2015, and before April 1, 2016; $4,187,500 for decedents dying on or after April 1, 2016, and before April 1, 2017; and $5,250,000 for decedents dying on or after April 1, 2017, and before Jan. 1, 2019. The basic exclusion will equal the federal basic exclusion amount with annual indexing for those dying on or after Jan. 1, 2019.26 In addition, the generation-skipping transfer tax was repealed as of April 1, 2014.27

Conclusion

In summary, New York corporate tax reform will significantly affect S corporations. Out-of-state S corporation shareholders with no physical contact with the state will find themselves subject to tax in New York. Depending on the taxpayer’s business, the taxpayer may also encounter significant complexities in determining whether the $1 million in receipts threshold for nexus has been met. Taxpayers may find themselves in the position of having to ask their customers where the “benefit” of their services is received in order to determine appropriate sourcing. If the location where the benefit of services is received cannot be easily identified, significant further analysis may be necessary. These tasks all place additional administrative burdens on taxpayers.

While sole proprietorships, partnerships, and LLCs treated as partnerships are less affected by corporate tax reform, there is now a greater degree of disparity between the tax treatment of these entities and S corporations. Noncorporate entities are not subject to the new $1 million nexus threshold standard. In addition, market-based sourcing does not apply. Small business taxpayers will undoubtedly be confused by the differences in tax treatment.

All businesses should carefully review the tax impact and potential opportunities arising from corporate tax reform in New York. Entity form now takes on greater importance in evaluating tax implications of doing business within the state. Favorable reforms in the estate tax and new opportunities in the credits and incentives area are sure to be well-received by New York small business owners. Tax advisers have the opportunity to provide additional value to their clients by helping them understand the overall impact and the opportunities created by this new legislation.

Footnotes

¹ Henchman, “New York Corporate Tax Overhaul Broadens Bases, Lowers Rates, and Reduces Complexity” (Tax Foundation April 14, 2014).

² N.Y. Tax Law §209.1(b).

³ N.Y. Tax Law §660(a).

⁴ N.Y. Tax Law §210.1; N.Y. Tax Law §210-C.2(c).

⁵ N.Y. Tax Law §210.1(d)(1).

⁶ N.Y. Tax Law §209.1(b).

⁷ Wisconsin Dep’t of Rev. v. Wrigley, 505 U.S. 214 (1992).

⁸ Interstate Income Act of 1959, P.L. 86-272.

⁹ N.Y. Tax Law §601(f).

¹⁰ N.Y. Tax Law §601(e).

¹¹ N.Y. Tax Law §631(a)(1).

¹² N.Y. Tax Law §632; N.Y. Comp. Codes R. & Regs. tit. 20, §١٣٧.١.

¹³ N.Y. Tax Law §209.1(f).

¹⁴ L.L. Bean Inc. v. Levin, 2010 No. 2853 (Ohio Bd. Tax App. 3/6/14), appeal docketed, No. 2014-0456 (Ohio 3/24/14).

¹⁵ Uniform Division of Income for Tax Purposes Act (1957), available at www.uniformlaws.org.

¹⁶ N.Y. Tax Law §§210-A.2—.9.

¹⁷ N.Y. Tax Law §210-A.10(a).

¹⁸ N.Y. Tax Law §210-A.10(b).

¹⁹ N.Y. Tax Law §210-A.11.

²⁰ N.Y. Tax Law §632(a)(2).

²¹ N.Y. Comp. Codes R. & Regs. tit. 20, §§١٣٢.١٥(b) and (c).

²² N.Y. Comp. Codes R. & Regs. tit. 20, §132.15(f).

²³ The metropolitan transportation business tax (MTA surcharge) applies to corporations that do business, employ capital, own or lease property, or maintain an office in the Metropolitan Commuter Transportation District (MCTD). The MCTD includes the counties of New York (Manhattan), Bronx, Kings (Brooklyn), Queens, Richmond (Staten Island), Rockland, Nassau, Suffolk, Orange, Putnam, Dutchess, and Westchester.

²⁴ N.Y. Tax Law §210.1(a)(vi).

²⁵ Id.

²⁶ N.Y. Tax Law §952(c)(2).

²⁷ N.Y. Tax Law §952.