Taxability of S Corporation Capital Gains to Part-Year Residents

TAXATION

State and Local Taxation

Taxability of S Corporation Capital Gains to Part-Year Residents

By Mark H. Levin

In a recent Advisory Opinion [TSB-A-03(1)I, March 4, 2003], the New York State Department of Taxation and Finance described how a part-year resident S corporation shareholder should report capital gains earned by the S corporation. TSB-A-03(1)I states the facts as follows:

The taxpayer moved from New York to Connecticut in February of 1999. At the time of the taxpayer’s move to Connecticut she owned a one-third interest in MTE Inc. (MEA, an electing New York S corporation). … MEA held cash and shares in RMS Corporation (RMS), a closely held Canadian corporation. RMS did not pay any dividends. Prior to 1999, MEA’s only taxable income was a small amount of interest income. In August 1999, MEA sold its interest in RMS and realized a capital gain. MEA filed a New York franchise tax return for 1999 reporting this gain. Under the New York business corporation franchise tax, MEA’s investment allocation percentage was zero.

The question raised is whether and how much of the capital gain realized by MEA is taxable to the taxpayer on her New York State part-year personal income tax return.

The facts raise several possibilities as to the taxability of MEA’s capital gain to the part-year taxpayer:

The taxpayer was a New York State nonresident at the time MEA’s gain was recognized, so none of the gain should be taxable to New York.

Under federal rules, all items of income, loss, and deduction are to be prorated, so a portion of MEA’s gain should be taxable to New York.

New York Tax Law section 632(a)(2) states that a nonresident shareholder of an electing New York S corporation shall include as New York source income only the shareholder’s pro rata share of items of income, loss, and deduction of the S corporation derived from or connected with New York sources.

Section 638(a) of the Tax Law states that a New York source income of part-year resident equals the sum of the following:

New York adjusted gross income for the period of residence, determined as if the taxpayer’s taxable year for federal income tax purposes were limited to the period of residence.

New York source income for the period of nonresidence, determined as if the taxpayer’s taxable year for federal income tax purposes were limited to the period of nonresidence.

In TSB-M-00(1)I, the Department of Taxation and Finance states its position on the method to be used by a nonresident in computing the amount of the distributive share of income, gain, loss, and deduction from an S corporation. In reaching its position, the Department of Taxation and Finance relied on Matter of McNulty v. New York State Tax Commission (70 NY2d, 788, 522 NYS2d 103) and Matter of Greig [Dec St Tax Trib, September 16, 1999, TSB-D-99-(21)I]. In both McNulty and Greig it was decided that all items of income, gain, loss, and deduction included in the distributive share from a partnership must be allocated pro rata between the periods of residence and nonresidence.

Accordingly, any capital gain (or loss) included in the shareholder’s distributive share of income, gain, loss, and deduction from an S corporation may not be included in the period of residence and nonresidence during which the gain (or loss) was incurred, but must be prorated between the periods of residence and nonresidence.

In computing New York adjusted gross income (AGI) for the resident period, the taxpayer must include his pro rata share of the capital gain (or loss) from the S corporation during the period of residence. In computing the New York AGI for the nonresident period, the taxpayer must include his pro rata share of the capital gain (or loss) from New York sources of the S corporation during the period of nonresidence [the pro rate share of the capital gain (or loss) multiplied by the S corporation’s investment allocation percentage].

Mark H. Levin, CPA, is manager, state and local taxes, at H.J. Behrman & Company, LLP

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