United States: A Review Of The Tax Implications Of Governor Cuomo's New York State Executive Budget

At a Glance...

On January 16, 2017, New York State Governor Andrew Cuomo released his 2018–2019 New York State Executive Budget and accompanying legislation containing proposed amendments to New York's corporate franchise tax, sales and use tax, personal income tax, and tax procedure. In conjunction with the Governor's Executive Budget, the Department of Taxation and Finance (the "Department") released its Preliminary Report on the Federal Tax Cuts and Jobs Act to address the impact of the Act on New York. Reed Smith will be monitoring these proposals as they move through the legislative process.

Here is a synopsis of a number of the proposed changes in the FY 2019 Budget Bill (the "Budget Bill"). We encourage you to consider the impact of these proposals on your business, and to reach out with any additional questions.

(i) Extending the statute of limitations for amended returns

The Budget Bill would extend the statute of limitations for the Department to assess additional taxes on New York taxpayers reporting changes on amended returns. Currently, the Department typically has three years from the original filing date of a tax return to audit and assess additional tax. Filing an amended return does not extend the statute of limitations for the Department to audit and assess additional tax. The proposed change would extend the Department's statute of limitation to audit and assess taxpayers within three years of filing the amended return. This provision would take effect immediately and apply to all amended returns filed on or after the effective date the bill becomes law.

Reed Smith insight: The Governor noted that the proposal was in response to the filing of questionable amended tax returns requesting a refund that take place at or near the statutory deadline. This proposed change would restart the three-year statute of limitations clock when an amended return is filed with the Department. This proposal is intended to disincentivize taxpayers from filing amended returns as late as possible in order to avoid an audit. If this proposal is enacted, taxpayers will no longer obtain any advantage from waiting to file amended returns and, as a consequence, they should seek any refunds by filing amended returns as soon as possible.

(ii) Closing the carried interest loophole

The Budget Bill would change the treatment of partners and other investors ("members") in pass-through entities with respect to the members' distributive share of income attributable to "investment management services" provided by the members. For purposes of the corporation franchise tax, a member's distributive share attributable to investment management services would be treated as a business receipt for services. For purposes of the personal income tax, a member's distributive share attributable to investment management services would be treated as income attributable to a trade, business, profession or occupation (ordinary income). The rule recharacterizing a member's distributive share attributable to investment management services would not apply to partnerships or S corporations that have at least 80 percent of the average fair market value of their assets in the form of real estate held for rental or investment.

A taxpayer providing investment management services will also be subject to an additional 17 percent carried interest "fairness fee" on the member's carried interest apportioned to New York. If the partner providing investment management services is not a New York resident, the 17 percent fee is based on the amount derived from New York sources. This proposal will only take effect if Connecticut, New Jersey, Massachusetts and Pennsylvania enact legislation having substantially the same effect.

Reed Smith insight: Carried interest has been a frequent topic of discussion. The potential impact of this provision, however, is limited because it is contingent upon Connecticut, New Jersey, Massachusetts and Pennsylvania enacting similar legislation. The contingent nature of the proposal is intended to prevent its enactment putting New York at a competitive disadvantage relative to surrounding states.

A similar bill has been in committee in the Massachusetts legislature since May 2017, and like this proposal, the effectiveness of the Massachusetts bill is dependent on passage of similar bills in Connecticut, New York and New Jersey. A similar bill was also proposed in Connecticut in 2017 but was not enacted. A new proposal is expected to be introduced in the Connecticut legislature when the new legislative session starts in February 2018. In New Jersey, a similar bill was introduced in January 2018, where enactment would again depend on similar bills being enacted in Connecticut, New York and Massachusetts. The Pennsylvania legislature has remained silent on the issue. In the absence of agreement by Connecticut, New Jersey, Massachusetts and Pennsylvania to tax carried interest as ordinary income, New York's treatment of carried interest will remain unchanged.

(iii) Allowing the Department to appeal from Adverse Tax Appeals Tribunal determinations

The Budget Bill would allow the Department to appeal adverse decisions of the Tax Appeals Tribunal (the "Tribunal"). Currently, only Taxpayers may appeal adverse Tribunal decisions to the Supreme Court of New York, Appellate Division. This proposal would take effect immediately upon passage of the legislation, and would apply to Tribunal decisions and orders issued on or after the date of enactment.

Reed Smith insight: This proposal would be a significant departure from current practice, as a taxpayer victory at the Tribunal concludes an appeal. Allowing the Department to appeal adverse decisions will have the effect of increasing litigation costs on taxpayers, as they now will be forced to defend their victories at the Supreme Court of New York, Appellate Division. While the proposal would bring New York in-line with the majority of states that have an independent tax administrative body, it conflicts with the original intent underlying New York's tax appeal structure.

Further, the Department's Memorandum in Support cites as an example the recent Tribunal decision in Matter of Bayerische Beamtenkrankenkasse AG.¹ In that case, the Tribunal relied on a bilateral income tax treaty between the United States and a foreign government in voiding the Department's assessments. In many instances, the Department will address an adverse decision by turning to the legislature to change the underlying law. However, in Matter of Bayerische, because a U.S. income tax treaty was at issue, the New York legislature does not have the authority to pass a law overruling the Tribunal's decision. While we recognize the Department's concern, it appears that the proposed fix is far broader than needed to address the issue presented in Matter of Bayerische.

(iv) Clarifying New York residence requirements for purposes of the 183-day rule

The Budget Bill would require New York part-year residents to include days spent in New York during any domiciliary period for purposes of applying the statutory residency 183-day rule. This proposal would take effect immediately and would apply to all tax years for which the statute of limitations is open both for taxpayers seeking a refund and for the Department assessing additional tax.

Reed Smith insight: The proposal is in response to the decision in Matter of Sobotka² in which an administrative law judge recently interpreted the statutory definition of "resident" to preclude counting the days an individual is domiciled in New York for purposes of determining whether they meet the 183-day rule to be considered a statutory resident. Following Sobotka, when a taxpayer's nondomiciliary period covers only part of a tax year, the taxpayer must exceed the 183-day test during the nondomiciliary part of that tax year in order to be taxed as a statutory resident. This retroactive proposal raises multiple concerns, including its potential impact on individuals with open residency audits or litigation.

(v) Deferral of certain business credits exceeding $2 million in any year

The Budget Bill would require taxpayers to defer the use and refund of certain business tax credits beginning on or before January 1, 2018, through January 1, 2021, if those tax credits in the aggregate exceed $2 million on an annual basis. A taxpayer would first calculate the total amount of credits they would otherwise use for a year, and if the total exceeds $2 million, then the taxpayer would be required to reduce each credit proportionately. The credits that exceed $2 million would be converted into one of two new credits to be used on the taxpayer's returns for 2021 and later years: (i) a temporary deferral nonrefundable payout credit, and (ii) a temporary deferral refundable payout credit.

As the name suggests, the temporary deferral nonrefundable payout credit would be made up of the taxpayer's nonrefundable credits that are deferred from January 1, 2018 through January 1, 2021. Those nonrefundable credits could then be used on the taxpayer's 2021 return and carried forward indefinitely. Taxpayers would be able to claim up to 50 percent of the temporary deferral refundable payout credit on their 2021 returns, and would be able to claim 75 percent of the amount accumulated on their 2022 return, and the entire remaining credit on their 2023 return. Taxpayers claiming tax credits of $2 million or less on an annual basis would not be affected and would be able use the full value of those credits, without any deferral. This proposal would take effect immediately.

Reed Smith insight: This proposal raises revenue for the period FY 2019 through FY 2022, while reducing revenue for the period FY 2023 through FY 2025. This proposal may be in conflict with agreements previously entered into between the Department and taxpayers regarding the use and carry forward of certain credits.

(vi) Providing responsible person relief for minority LLC owners

The Budget Bill would allow minority members of LLCs or limited partnerships to obtain relief from responsible person liability for sales tax collection obligations. Currently, personal responsibility for payment of sales tax is imposed on certain owners, directors, employees, managers, partners or members of businesses with outstanding sales tax liabilities. A responsible person is jointly and severally liable for the sales taxes owed. Strict liability applies to all LLC members and limited partners of limited partnerships. This strict liability standard allows an individual to be held liable for the entire tax liability of a limited partnership or LLC, even if they have no involvement in the collection of sales tax.

This provision would allow an eligible individual to show that (i) they are not under a duty to act for the limited partnership or the LLC in regard to complying with the sales tax, and (ii) their ownership share or the distributive share of the profits is less than 50 percent. If the application submitted to the Department is approved by the Commissioner, that individual would only be responsible for their pro rata share of the liability. This proposal would take effect immediately.

Reed Smith insight: The Governor's proposal is a codification of the Department's current published guidance regarding the responsible person liability for minority members of LLCs and limited partnerships in TSB-M-11(17)S. This is a welcome proposal for individual members in LLCs and limited partnerships, as it will help avoid potentially unjust results and will reduce potential liability for those minority members who have little to do with the organization's tax collection and remittance. Importantly, minority members would still need to apply to the Department and be accepted in order to reduce their responsible person liability to only their pro rata share of the outstanding sales tax liability under this proposal.

(vii) Healthcare insurance windfall profits tax

The Budget Bill would impose a 14 percent windfall profits tax on health insurance companies' net underwriting gain from the sale of health insurance to New York residents. For purposes of this tax, "health insurance" is defined as comprehensive hospital and medical insurance. This tax would not be deductible for purposes of computing any other New York tax liability. This proposal would take effect immediately and apply to all tax periods beginning after December 31, 2017.

Reed Smith insight: The Governor explained that the proposed 14 percent windfall profits tax is intended to capture a portion of the federal tax rate reduction health insurance companies are expected to receive as a result of federal tax reform.

(viii) Requiring marketplace providers to collect sales tax

The Budget Bill would require marketplace providers that facilitate sales of tangible personal property by third-party vendors to collect sales tax on such sales. A person facilitates a sale of tangible personal property when they provide the forum where the transaction occurs (physical or virtual) and collects the purchase price. As written, the proposal does not impose a sales threshold to determine when a person is treated as a marketplace provider. It does, however, exclude from the definition of marketplace providers a person who facilitates sales exclusively over the Internet if the aggregate amount of facilitated sales is less than $100 million during every calendar year after 2016. So, while marketplace providers who facilitate sales through non-Internet forums – or through both non-Internet and Internet forums – have a collection obligation regardless of their aggregate sales, marketplace providers facilitating sales exclusively over the Internet would still need to exceed the $100 million annual sales threshold before being required to collect tax on sales to New York purchasers. If enacted, these amendments would apply to sales made and uses occurring after September 1, 2018.

The proposed legislation would also impose notice and reporting requirements on a "non-collecting seller", defined as a person who makes taxable sales of tangible personal property to locations in New York who is not required to collect New York sales tax. If a non-collecting seller makes $5 million or more in sales to New York purchasers, the non-collecting seller must file an annual information return reporting their receipts for those sales. Reporting requirements for non-collecting sellers would apply beginning January 1, 2019.

Reed Smith insight: This is the third time the Governor's Executive Budget and supporting legislation has included a marketplace sales tax collection proposal. The absence of a sales threshold for imposition of the marketplace sales tax collection obligation raises serious constitutional questions under both the Commerce Clause and Due Process Clause of the United States Constitution. Under current law, Quill prohibits New York from imposing a sales tax collection obligation on a marketplace provider that is not physically present in New York that is facilitating sales on behalf of marketplace sellers who are also not physically present in New York. Even if the United States Supreme Court overturns Quill's physical presence rule in Wayfair v. South Dakota, this marketplace collection proposal may nevertheless raise Due Process Clause issues because it does not include any sales volume threshold for determining whether a marketplace provider is subject to New York's taxing authority.

(ix) Alternatives to address federal tax reform

On Wednesday, January 17, 2018, the Department released its Preliminary Report on the Federal Tax Cuts and Jobs Act. The Department's report outlined several proposals for consideration and comment to address the impact federal tax reform, specifically the drastic limitations on the state and local tax deduction, will have on New York taxpayers. The proposals include: (i) increasing opportunities for charitable contributions; (ii) shifting the state from an income tax to a statewide employer compensation expense tax; and (iii) enacting a new statewide unincorporated business tax that would be offset by personal income tax credits for business owners.

In describing these proposed changes, State Budget Director Robert Mujica said, "We'll run two parallel systems. If there's a desire not to make any of these changes, then you wouldn't participate in the system. The goal here is for a business, at the end of the period, it should cost them nothing. It would cost the employee nothing." As for the proposed switch from an income tax to a statewide employer compensation tax, Mr. Mujica told Politico that "[businesses are] not getting hit with a new tax. It's just for the purpose of getting deductibility, and no business will have to pay out anything more than they already do."

Reed Smith insight: We anticipate additional information on a proposed alternative to be rolled out over the next few weeks. Until then, both resident and nonresident New York taxpayers can remain hopeful that a legislative fix will be made to offset the additional federal tax resulting from the loss of the state and local tax deduction

Footnotes

1. DTA No. 824762 (N.Y.S. Tax App. Trib., September 11, 2017).

2. DTA No. 826286 (August 20, 2014).

This article is presented for informational purposes only and is not intended to constitute legal advice.