New York State 2007 Tax Legislation Affecting PC Partners

On April 9, 2007, New York State Governor Eliot Spitzer signed Part K of Chapter 60 of the Laws of 2007 into law. This law added Section 632-A, which potentially changes the way that nonresident personal service corporations or S-corporations (PC’s) are taxed in New York. This law is effective for tax years beginning on or after January 1, 2007.

The new law is aimed at taxing New York sourced income of nonresidents who avoid personal income taxation by funneling through a PC earnings derived from another corporation or partnership. In most cases, a partner’s distributive share of partnership income passes through to the partner at the individual level, and the individual files a New York State income tax return (whether through a group return or otherwise). Alternatively, for partners that have formed one, the income received from the partnership goes through to that partner’s PC. The employee-owner of the PC then pays out the pass-through income as salary. The result is that the PC pays the New York State minimum tax, while the employee-owner does not pay New York personal income tax because the services of the PC are not performed in the state.

Under the new law, the Commissioner may, at his or her discretion, reallocate income, deductions, credits, exclusions, and any other allowances between the PC and the employee-owner. Reallocation may occur if 1) substantially all of the services are performed for one other entity, and 2) the effect of the formation of the personal service corporation or S corporation is the avoidance of New York income tax. It now seems that the Commissioner may be able to ignore the corporate structure and treat the employee-owner of the personal service or S-corporation as having directly received a share of the profits of the partnership. Therefore, the employee-owner would, in all likelihood, have to file an individual New York tax return, sourcing income according to the apportionment rules applicable to the partnership, in addition to the PC’s corporate New York return.

It remains to be seen to what extent this new law will be applied. It has been reported that a NYS Department of Taxation spokesperson indicated this discretionary authority would not be invoked in a situation where the corporation provided services to a number of corporations and partnerships. The implication of this comment; it is likely the Department will exercise this new authority in the law firm context where the partner is a personal service corporation that provides services exclusively to a single law firm.

Also, it is uncertain whether or not the state has the authority to overlook the corporate structure of an entity that is organized outside of New York and treat what would have been taxable wages in one state as a share of partnership profits taxable in another state.

We are not presently aware of additional “guidance” from NYS that would assist taxpayers in determining the applicability of this new law in your current circumstances and proactively complying with it, but will be alert for such guidance.

You may contact Bruce Levi at (214) 461-1411 or James Youngblood at (214) 461-1404 if you have questions or need assistance.

Disclaimer: “IRS Treasury Regulations require us to inform you that any tax advice contained in the body of this communication (including any attachments) was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.”