LUMP-SUM PAYMENTS MADE TO NONRESIDENTS MAY BE TAXABLE TO NEW YORK

By Rose Litvack, CPA, Kingsborough Community College

New York Tax Law Sec. 632 provides that a nonresident must include any income derived from "business, trade, profession or occupation" carried on in New York as New York source income for personal income tax purposes. Income may be received in the form of a lump-sum payment, such as an annuity, pension, or employment severance pay.

Pursuant to New York State regulations, pensions or other retirement benefits that constitute an annuity are not taxable for New York State personal income tax purposes to a nonresident. Sec. 132.4(d) of the regulations defines an annuity as a payment that is paid in cash and at regular intervals, at least annually for the life of the individual receiving it or at least over a period that is not less than half of such individual's life expectancy as of the date the payments begin. If the pension or other retirement benefit does not constitute an annuity, it is compensation for personal services and taxable to a nonresident to the extent that the services were performed in New York State.

The New York Appellate Court has held that where a nonresident has a right to future employment which has no connection to New York and the nonresident relinquishes this right in exchange for a lump-sum settlement, the lump-sum settlement will not be taxable in New York (Matter of Donahue v. Chu, 104 AD2D 523, 479 NYS2d NYS2d 889).

Based on the Donahue decision, the Tax Appeals Tribunal (The Tribunal), in the Matter of the Petition of Peter F. and Barbara D. McSpadden (DTA No. 910896, September 15, 1994), agreed with the Appellate Division, and decided that a lump-sum payment made to a nonresident that had no connection with employment in New York was not considered New York source income. Pete McSpadden, a Connecticut resident, negotiated a settlement with his employer wherein he would relinquish his rights under an existing employment contract in exchange for a lump-sum payment. The employment agreement provided that at no time would the taxpayer have to maintain an office or residence in New York. The Tribunal reasoned that since the taxpayer's rights under the employment agreement had no connection with New York, the lump-sum payment received by the taxpayer was not taxable by New York.

In contrast, when a nonresident receives a lump-sum payment for termination of employment in New York, the payment is taxable as New York source income. Two such cases were recently decided by the New York Division of Tax Appeals. In the Matter of the Petition of Ulrich and Barbara Hoffman (DTA No. 809966, November 23, 1994), the taxpayer was a Connecticut resident who had been employed in New York. When the company the taxpayer worked for changed ownership, the taxpayer was given a lump-sum severance payment. The taxpayer argued that the payment was not compensation for services rendered within New York State but rather a settlement negotiated to avoid litigation. The taxpayer failed to submit the severance agreement, employment contract, or any other evidence in support of his argument that the payment was given as consideration for the termination agreement. The Tribunal ruled that since the taxpayer relinquished claims in relation to his New York employment, the payment was New York source income.

In the third case, which was an administrative law judge decision (ALJ), two lump-sum severance payments made to a New Jersey resident by his former New York employer were found to be New York source income and subject to New York personal income tax. In the Matter of the Petition of Martin and Linda Brophy (DTA No. 812052, November 23, 1994), the taxpayer and his employer entered into an oral agreement, whereby the taxpayer would remain with the company for three years in exchange for guaranteed compensation of $1 million in 1987 and $750,000 for each of the next two years. At the end of 1987 the taxpayer was laid off after his employer merged with another company. In February 1989, in settlement of an arbitration agreement, the taxpayer was paid $600,000 by his former employer. The taxpayer argued that the payments were made as damages for breach of his three-year employment contract and were only made after demands of payment from the taxpayer's lawyer. The ALJ ruled that under the Statute of Frauds, the oral agreement of employment for three years between the taxpayer and his former employer was not an enforceable contract of definite duration.

In addition, an attorney's written or oral demand for payment does not constitute litigation. Moreover, the $840,000 payment, when combined with the taxpayer's 1987 base salary, satisfied the minimum compensation guarantee for 1987 defeating a breach of contract claim. The ALJ ruled that both lump-sum payments were connected to the taxpayer's New York employment and therefore, New York source income and subject to New York personal income tax. *

NEW YORK ENTIRE NET INCOME AND DEDUCTIONS ATTRIBUTABLE TO SUBSIDIARY CAPITAL

By Zev Landau, CPA, Lopez Edwards Frank & Co., LLP

In a 1988 Technical Service Bureau memorandum, TSB-M-88(5)(c)(TSB), the New York State Division of Taxation and Finance (Division) discussed which expenditures were considered directly related to business capital and which to subsidiary capital. Two examples of subsidiary capital expenses set forth by the Division in the TSB were interest incurred to purchase subsidiary capital and legal expense relating to subsidiary capital. New York court cases have supported the Division's provisions in the TSB and held that parent corporations that borrow money from third parties and advance it to their manufacturing subsidiaries are required to add back to Federal taxable income the amount of interest incurred on the loan to calculate entire net income for New York franchise tax purposes. No New York court cases or other policy provisions have addressed situations where there was an intention to acquire subsidiaries and related expenses were incurred, but no acquisition was made. In a situation as immediately described, is it appropriate to classify those expenses as subsidiary capital expenditures for purposes of the income add back?

Sec. 208.9(b)(6) of New York State tax law states:

Entire net income shall be determined without the deduction of any amount of interest directly or indirectly attributable as a carrying charge or otherwise to subsidiary capital or to income, gains or losses from subsidiary capital.

The phrase "directly or indirectly attributable to subsidiary capital" is a cause for controversy.

Petition of MacAndrews & Forbes Holding, Inc., DTA No. 812227, March 16, 1995, is a victory for taxpayers. MacAndrews deals with a holding company engaged in the acquisition of other companies. Acquisitions, and all the expenditures connected with them, were a significant part of the corporation's business. In order to finance an acquisition, the company would apply for a loan and request the bank to commit itself to granting the financing when the acquisition was consummated. The bank would agree to commit itself in exchange for a payment of a nonrefundable commitment fee. If the subsidiary was acquired, the loan costs would more likely be classified as subsidiary capital charges, since the acquired company became a subsidiary. But how should expenditures, such as nonrefundable commitment fees, be classified if the acquisition was not consummated?

The taxpayer in MacAndrews contended that being in the business of acquiring companies justifies labeling those expenditures as related to business capital rather than subsidiary capital, particularly where the unacquired company never became a subsidiary. Moreover, New York Tax Law Sec. 208.7 defines business capital as all assets other than subsidiary capital, investment capital, and stock. If the acquisition did not take place, a commitment fee cannot be directly related to subsidiary capital, investment capital or stocks, and instead, by a process of elimination, must be directly attributable to business capital.

The Division was not willing to adopt the all-or-nothing position and claimed that the expense was related to subsidiary capital either directly or indirectly and attempted to increase the business income subject to tax. The Division maintained that if the corporation declares that it is in the business of corporate mergers and acquisitions and no acquisition is made, the related expenses cannot be directly related to business capital. The expenses are also not directly related to any asset on its books included in the other two types of capital recognized by the tax law (i.e., investment capital and subsidiary capital). The Division concluded that the corporation must allocate the expenditures related to the failed acquisition between the three types of capital based on a formula in which the commitment fee is multiplied by a fraction, the numerator of which is the average business capital, investment capital, or subsidiary capital (depending upon what allocated value is being computed) and the denominator is the average value of the assets.

The New York Division of Tax Appeals was reminded that the purpose of disallowance of deductions indirectly related to subsidiary capital was required by law "to prevent the obvious unfairness that results from deducting such expenses while the income therefrom is not taxed to the parent." The Division of Tax Appeals noted that some relationship between the deductible expense and the subsidiary's income must exist to activate the provision just cited. If there is no acquisition, no subsidiary was added to the parent's balance sheet and there was no benefit to the target company, because no loan was granted to the parent. Therefore, the Division of Tax Appeals concluded that a corporation may be a candidate for acquisition, but it does not become a subsidiary until the acquisition is consummated. If it is acquired, the deductible expenses related to the acquisition should be classified as subsidiary capital deductions and must be added back to the Federal taxable income in arriving at the entire net income.

Focus on the Business

Further, The Division of Tax Appeals favored the transaction approach of the taxpayer in determining whether the expenditure was attributable to business or subsidiary capital. The Division of Tax Appeals rejected the Division's position that salaries paid to employees may be suspect because they are not directly traceable to a business asset. Instead, the Division of Tax Appeals held that failure to trace a commitment fee paid to a bank to a specific asset is not sufficient to deny the taxpayer to attribute the fee directly to business capital.

The focus must be on the business of the corporation and the link between the business of the corporation and the transaction under consideration. Transaction is the key word and this classification method assures that a business expense is attributable to business capital and is not allocable to investment capital or subsidiary capital. The challenge is to rebut the Division's argument that the existence of a business asset is the only condition which allows associating an expense with business capital. The success of MacAndrews in deducting the commitment fee paid in connection with a planned acquisition is proof that the transaction approach works. *

CONNECTICUT 1995 BUDGET BILL

By Elizabeth Knoll, CPA, Eisner & Lubin

The 1995 Connecticut budget bill reduces personal, corporate, and sales taxes and establishes a limited tax amnesty.

Personal Income Tax Reduction

Lower brackets have been established for individual income taxes as follows:

Tax Year 1996:

Single and married filing separately:

Up to $2,250 3%

Over $2,250 $ 67.50 plus 4.5%

of excess over $2,250

Head of household:

Up to $3,500 3%

Over $3,500 $105.00 plus 4.5% of excess over $3,500.

Married filing jointly:

Up to $4,500 3%

Over $4,500 $135.00 plus 4.5% of excess over $4,500

Tax year 1997 and thereafter:

Single and married filing separately:

Up to $4,500 3%

Over $4,500 $135.00 plus 4.5% of excess over $4,500

Head of household:

Up to $7,000 3%

Over $7,000 $210.00 plus 4.5% of excess over $7,000

Married filing jointly:

Up to $9,000 3%

Over $9,000 $180.00 plus 4.5% of excess over $9,000.

The formula for calculating nonresident and part-year resident taxes will automatically incorporate the new lower tax in the calculation. Tax rates remain the same for estates and trusts.

Effective January 1, 1996, Connecticut residents will become eligible for a personal income tax credit, up to $100 for real property taxes paid on the taxpayer's primary residence or for personal property taxes paid on motor vehicles. The prior personal income tax credit for personal property taxes paid on motor vehicles has been repealed, effective June 1, 1995.

Corporate Tax Rates Are Reduced

The 1995 budget and tax bill incorporates changes affecting the corporation business tax, modifying the previously scheduled general rate reductions. Connecticut has had one of the highest corporate tax rates in the country: 111*2%. The corporate tax rates are now scheduled to be reduced to 71*2% by January 1, 2000, using the following schedule:

Income year commencing on or after Rate

1996 1/1/96 103*4%

1997 1/1/97 101*2%

1998 1/1/98 91*2%

1999 1/1/99 81*2%

2000 1/1/2000 and thereafter 71*2%

Other corporate tax changes are less dramatic. Corporate income tax credits are delayed. The machinery and equipment tax credit has been delayed from years commencing on or after January 1, 1995, to January 1, 1997. Similarly, the transportation management program expenditures credit has been delayed from years commencing on or after January 1, 1995, to January 1, 1997.

The credit for personal property taxes paid on computer equipment (Conn. Gen. Stat. Sec. 12-217t) remains the same for corporation business tax or the unrelated business taxable income tax; however, the credit has been delayed from years commencing on or after January 1, 1995, to January 1, 1997, for insurance companies, air carriers, railroad companies, telecommunications companies, utility companies, and public service companies.

The gross earnings tax exemption for water companies has been delayed to July 1, 1997.

Tax Amnesty

An amnesty has been scheduled from September 1, 1995, through November 30, 1995, inclusive for taxpayers owing delinquent personal or corporate income tax, sales and use tax, or any other tax administered by the Department of Revenue Services, applicable to any tax period ending on or before March 31, 1995. Amnesty is not available to any taxpayer who has received notice of an audit examination for a taxable period for which amnesty is sought, or who is a party to a criminal investigation or a civil or criminal proceeding that is pending on June 1, 1995.

To be eligible, taxpayers are required to apply and to pay all delinquent tax, plus interest of 1% per month. Amnesty will apply to any penalties that might otherwise be imposed, interest in excess of the 1% per month, and criminal prosecution.

Other Changes Affecting Corporate and Noncorporate Taxpayers

Sales and use tax reductions and exemptions have been delayed. The phaseout of sales and use tax on computer and data processing services has been revised to:

Sales occurring on or after Rate

The current rate 6%

7/1/97 5%

7/1/98 4%

7/1/99 3%

7/1/2000 2%

7/1/01 1%

7/1/02 and thereafter, exempt

An exemption applies to (outsourcing) the sale of computer and data processing services by a retailer who acquired the computer operations from the customer in a transaction that occurs on or after July 1, 1995. Excluded from the exemption are related persons buying or selling the service.

Some medical repair services have been made exempt. Other exemptions are delayed until July 1, 1997, including a sales and use tax exemption for nonbusiness related income tax preparation services.

New exemptions have been enacted effective July 1, 1997, pinpointing very specific groups and transactions.

The expiration of the tire tax of $2 per tire has been delayed to July 1, 1997. *

State and Local Editor:
Kenneth T. Zemsky, CPA
Ernst & Young LLP

Interstate Editor:
Marshall L. Fineman, CPA
David Berdon & Company LLP

Contributing Editors:
Henry Goldwasser, CPA
M.R. Weiser & Co. LLP

Leonard DiMeglio, CPA
Coopers & Lybrand L.L.P.

Steven M. Kaplan, CPA
Konigsberg Wolf & Co., PC

OCTOBER 1995 / THE CPA JOURNAL