Some retirees hold qualified stock options granted by a New York employer. What if the nonresident retiree realizes a gain through the exercise of the option? The gain will be taxable unless there is evidence that the options were issued other than as a form of compensation for services to the employer.⁽⁵⁾

What if the retiree purchases a lottery ticket when he is in New York and receives the funds when he is back in Florida? It is probably taxable even if he is domiciled in Florida. The New York regulations provide that prizes, awards and similar payments are derived from New York State sources as long as they are incidental to the nonresident's presence or other activities in New York State.⁽⁶⁾

What if the retiree is a stockholder in a family owned corporation that operates a store in New York State and he receives a dividend? If the retiree is not a New York resident for income tax purposes, then the dividend will not be taxable.⁽⁷⁾

What if the nonresident retiree sells real or tangible property located in New York State and, as a result of such sale, receives a promissory note which generates interest income? The interest income is not taxable because the note generates the income, not the New York property.⁽⁸⁾

Some retirees may be only semi-retired and may continue to perform some services in Florida for an employer in New York. This is apt to become more commonplace. With the use of a fax machine, conference phone, and Florida home computers tied into the company's New York main-frame, an individual working in Florida can duplicate many services that previously had to be performed at the New York office. A nonresident does not pay any New York tax if none of the services are rendered in New York State.⁽⁹⁾

But what if a nonresident employee continues to perform some services in New York State? The New York regulations set forth the method of allocating income and deductions from sources within and without New York State based upon the number of working days in each place.⁽¹⁰⁾ The regulations do not permit an individual to exclude working days in Florida unless they are "based upon the performance of services which of necessity, as distinguished from convenience, obligate the employee to out-of-state duties in the services of his employer".⁽¹¹⁾ In other words, if the individual performs the services in Florida, not because he is required to do so by his employer but rather for his own convenience, the services will be treated the same as services actually rendered in New York. This "tough" provision does not apply to salesmen and other persons whose commissions or compensation depend directly upon the volume of business transacted by him. It is probably aimed at the corporate officer of a family owned New York business who has changed his domicile to Florida and spends less than 183 days each year in New York but who, during much of that time, for his own convenience, works out of an office in his Florida condominium.

In Wachsman,⁽¹²⁾ the Tribunal reiterated the general rule "that work performed at an out of state home which could just as easily have been performed at the employer's New York office is work performed for the employee's convenience and not for the employer's necessity and cannot be utilized to allocate income outside of New York." It notes that the policy justification for the rule "lies in the fact that since a New York state resident would not be entitled to a special tax benefit for work done at home, neither should a nonresident." The Tribunal noted that a taxpayer does not sustain his burden simply by showing that some work had to be performed outside of the state or even that a non-New York office had to be maintained.

No allocation is provided where the income is from the rental or gain from New York real property even though some services are rendered in Florida or a sale is consummated in Florida.⁽¹³⁾

A semi-retired person may not perform any personal services as an employee but may have a business, trade, profession or occupation which he carries on, to some extent, in New York State. When will he pay New York income taxes if he is domiciled in Florida and not present in New York State for more than 183 days a year? He will be taxable if while in New York state he "occupies, has, maintains or operates desk space, an office, a shop, a store, a warehouse, a factory, an agency or other place where [his] affairs are systematically and regularly carried on, notwithstanding the occasional consummation of isolated transactions without New York State".⁽¹⁴⁾ But this definition is not exclusive. Business will be considered as carried on within New York State if activities in the State are conducted "with a fair measure of permanency and continuity".⁽¹⁵⁾

No New York income taxes are payable on New York State municipal bonds or obligations issued by the United States whether the retiree is domiciled in New York or in Florida. Where the retiree has changed his domicile from New York to Florida but he is concerned that it may be challenged, he may wish to consider investing some of his assets in New York State municipal bonds and United States notes or bonds. Even if New York State should successfully contend that he is a New York resident for New York income tax purposes, his interest from these securities will remain tax-free.

SEVERANCE PAY

The New York Tax Appeals Tribunal in Matter of McSpadden,⁽¹⁷⁾ issued a very significant decision favoring the taxpayer in 1994. It was indeed refreshing to observe the Tribunal taking a more "even handed" approach to determining what should be considered New York based income. The issue was whether a lump-sum payment received by Mr. McSpadden was New York based income. The amount was substantial: $1.85 million. The taxpayer was employed by an advertising agency and executed a five-year employment contract which was to end on December 31, 1990. The employment contract provided that the taxpayer need not perform duties which required his principal office or residence to be maintained outside New York, except with his consent. The advertising agency was consolidated with another agency and a termination arrangement was worked out for Mr. McSpadden. He rendered no services in New York at any time after May 31, 1988. The administrative law judge held that Mr. McSpadden possessed a right to future employment through December 31, 1990, secured by his employment contract, and that the remaining term value was an item of intangible personal property. The judge concluded that the lump-sum payment was received for his relinquishment of this right and thus was not taxable by New York. The judge further held that the lump-sum payment was not taxable as compensation for personal services because it was neither an amount received in connection with the termination of employment, an amount received upon early retirement for past services, an amount for consultation services, nor an amount received in consideration for a covenant to compete.

The Department asserted that the lump-sum payment was taxable New York source income because it was an amount received in connection with the termination of employment, it was received upon early retirement for past services rendered, it was received upon retirement for consultation services, and it was received upon retirement in consideration for a covenant not to compete. In the alternative, the Department argued that if a lump-sum payment was received in exchange for Mr. McSpadden's relinquishment of his right to future employment, the right to future employment was secured by consideration having a connection with New York State and, thus, properly taxable by New York. In response, Mr. McSpadden asserted that the lump-sum payment was not attributable to personal services rendered in the past or to be rendered in the future. Instead, he contended that the lump-sum payment was received in exchange for his relinquishment of the right to future employment and this right had no connection to New York sources. He also argued that no amount of the lump-sum payment be allocated to the covenant not to compete because there was no amount assigned to the covenant in the termination agreement, nor was it likely that the covenant to compete would have been enforceable.

Surprisingly, the Tribunal affirmed the determination of the administrative law judge. It specifically held that the lump-sum payment was consideration for the relinquishment of his right to future employment and was not subject to taxation by New York. The Department argued before the Tribunal that had Mr. McSpadden continued in the corporation's employ, the contract rights would have been exercised in New York and were, thus, subject to taxation by New York. The Department referred to language in the employment agreement that he was not required to perform duties which required his principal office or his residence to be maintained outside of New York. The Tribunal pointed out the fact that the provision of the employment agreement was the corporation's promise to Mr. McSpadden and not a promise by him to work in New York. Furthermore, the Tribunal pointed out that the employment agreement provided that Mr. McSpadden could have consented to work outside of New York if he so desired.

The Department also asserted that it elicited from Mr. McSpadden on cross-examination that he would have continued to work in New York had he continued in the employment. The Tribunal rejected that argument, pointing out that the evidence was speculative at best.

The Tribunal also rejected the Department's argument concerning the covenant not to compete. It held that the covenant was not an integral part of the termination agreement and was already secured by consideration. Specifically, it pointed out that in the restrictive covenant, Mr. McSpadden agreed that in consideration of his continued employment, he would abide by the terms of the restrictive covenant during the duration of his employment and for a period of two years thereafter. The Tribunal pointed out that since the taxpayer was already legally bound by the terms of the restrictive covenant, that his promise to abide by the terms of the restrictive covenant was not consideration for the lump-sum payment.

The Tribunal also held that the facts did not support a conclusion that the lump-sum payment was received in connection with the termination of employment, was received upon early retirement in consideration of past services, or was received upon retirement for consultation services.

HOW SEVERANCE PAYMENTS FROM A PARTNERSHIP ARE CHARACTERIZED MAY HAVE A BIG IMPACT ON THE TAX BITE

The Schibuk case decided in 1999 by the New York Tax Appeals Tribunal involved the New York/Vermont connection, but it teaches the same lesson for the New York/Florida connection (18).

When Mr. Schibuk left his partnership he was to receive $3 million in payments over five years. It was characterized as a guaranteed payment. The issue was whether it was compensation for services or a payment for a partnership interest. New York State claimed it was a guaranteed payment for his partnership interest and had to be accrued in its entirety in 1988. The Tax Appeals Tribunal agreed and also affirmed the imposition of substantial penalties. The facts are too complicated to review here. But it appears that in similar instances in the future the retiree may be able to fashion the "departure" arrangement to avoid New York income taxes in a more effective way. Have your professional advisors review the Schibuk case before you sign any agreement with your partner if you are selling out and retiring to Florida. The case also teaches a useful lesson in "timing" the domicile change. The result may have been different if Mr. Schibuk had cut off his New York ties in June rather than in September. In Session 6, the Seminar discusses how to time the domicile change to Florida.

COVENANTS NOT TO COMPETE

The New York Tax Appeals Tribunal in 1997 liberalized its position of payments received pursuant to a covenant not to compete.

In Matter of Albanese,⁽¹⁹⁾ the Administrative Law Judge had determined that a covenant not to compete restricted Albanese from engaging in certain business activities in New York and Connecticut for a period of five years. Mr. Albanese received amounts in each year of the audit pursuant to the covenant. The Administrative Law Judge decided that since petitioners failed to show what portion of the income was allocable to Connecticut, the Division was correct in apportioning all of the income from the covenant to New York.

The Division argued that the source of a covenant not to compete is the place where the promisor forfeits his right to act (citing Korfund Co. v. Commissioner, 1 TC 1180), and that abstinence of performance is sourced for tax purposes in the place that the performance would have occurred and that such income is taxable for New York State personal income tax purposes citing the regulations.⁽²⁰⁾

The Tribunal in the Albanese case rejected the Division's argument, noting that it had recently held that the income received pursuant to a covenant not to compete was not attributable to a business, trade, profession or occupation carried on in New York where the agreement provided that the nonresident recipient would not compete with the employer, either directly or indirectly, for a period of five years as a specialist broker on the New York Stock Exchange in specific securities, citing Matter of Haas.⁽²¹⁾ The Tribunal also cited the Penchuk case where it decided that payments received by a taxpayer pursuant to a covenant not to compete were in lieu of future employment which was unconnected with a New York source.⁽²²⁾ Mr. Penchuk gave up his right in the future to be self-employed or to be employed by a competitor of the corporation and, given the national and international nature of the business, there was no basis to assume that the competitive business would be located in New York. The Tribunal in the Penchuk case noted that even if Mr. Penchuk had engaged in a competitive business located outside New York State, the amount received under the covenant could not be construed as being from New York sources on the mere speculation that the petitioner could have located a competitive business in New York State as well as outside the State.

In the Albanese case, the Tribunal found that there was no basis to hold that Mr. Albanese would engage in a competitive business located in New York as opposed to Connecticut. Based upon the reasoning in Haas and Penchuk, the Tribunal in the Albanese case held that the amount received under the covenant was not derived from or connected with New York sources and was, therefore, not New York source income of a nonresident.⁽²³⁾

This 180 degree turnaround was especially gratifying to me because I represented Mr. Haas in the case before the Tribunal that for the first time departed from the long-standing position of the Department on this issue.

RETIREMENT INCOME

Some "snowbirds" have all the requisite factors that would enable them to effectively change their domicile to Florida but have chosen to remain New Yorkers because it did not make that much difference financially. They asked themselves: How Much in New York Income Taxes Can I Save by Changing my Domicile to Florida? Where a good portion of the taxable income was New York retirement income, the answer was often "Not much." New York still taxed it even after a change of domicile. A dramatic change was made by new federal legislation. In January 1996 Congress passed legislation that prohibits New York from imposing its income tax on any retirement income of an individual who is no longer a resident or domiciliary of New York.⁽²⁴⁾

The law defines "retirement income" to include all qualified plans and some non-qualified plans. It applies to all distributions on and after January 1, 1996.

Whether or not an individual is a resident or domiciliary is determined under the laws of the state attempting to impose the tax. Thus, where a person continues to maintain a home both in New York and Florida it will be up to the New York taxing authorities to determine whether or not the individual is a resident or domiciliary of New York.

The house report on the bill states that its purpose is "to prohibit state taxation of certain retirement income of a nonresident of the taxing state" and points out that it "would protect all income received from pension plans recognized as `qualified' under the Internal Revenue Code. . . [and] it would also exempt income which is received under deferred compensation plans that are `non-qualified' retirement plans under the tax code, but which meet additional requirements."

The report also notes that to "be exempt from state taxation, distributions from non-qualified plans will have to be made in substantially equal installments, not less frequently than annually, over the lifetime of the beneficiary or at least ten years." The report also points out that "the bill protects from state taxation any `excess benefit' plans that are set up because a qualified plan (1) exceeds the $150,000 in employee compensation that may be considered in qualifying for such a plan, (2) exceeds the present limit on the amount of allowable benefits from a defined benefit plan, or (3) exceeds the present limit on contributions to a defined contribution plan."

Some insight as to the broad scope of the new law is found in comments made in the dissenting views expressed by one of the congressional committees that reviewed the proposed legislation. It pointed out that the new law does not limit the tax exemption to a specified dollar amount and noted:

Non-qualified plans are not recognized as pension plans under federal law, and are not subject to any rules, regulations, guidelines or limitations on their use. They are typically used by a small number of highly compensated executives to defer taxes on large sums of compensation. No case has been made that taxing such non-qualified plans is in any way inequitable or that the states are being overly-aggressive in taxing such distributions.

By including non-qualified plans in the legislation, Congress will be opening broad new loopholes for lucrative compensation arrangements, such as golden parachutes, partnership buy-outs, and large severance packages.

It will be interesting to see what new "loopholes" are structured by "creative" professionals.

As noted above, it is up to New York State to determine if the individual is no longer domiciled in New York. The response of some auditors to this new federal legislation may be to apply stricter standards to a domicile change.

SHOULD YOU TAKE THE STANDARD DEDUCTION?

A retiree who changes domicile to Florida may find it more advantageous to take the standard deduction in his federal income tax return. In the July 28, 1999 Wall Street Journal, it was reported that in Florida only 78% of filers with income of $200,000 or more took itemized deductions in 1977. 22% therefore took the standard deduction. This compared to 7% nationally. The reason --- no Florida income tax to deduct. Also, retirees are generally covered by health insurance and are entitled to the extra standard deduction. Make sure your accountant compares both methods in choosing the right one for you.

DEDUCTIONS ALLOWED NONRESIDENTS

New York Tax Law § 631(b)(6) denies nonresidents of New York the deduction for alimony that it allows its own residents.  In a 1996 decisaion in the Lunding case, the New York Court of Appeals sustained that provision.  The United States Supreme Court, in a six to three decision, has now reversed and holds that it does violate the privileges and immunity clauses of the United States constitution. ⁽²⁵⁾

The court held that a state such as New York must show "substantial justification" for treating the nonresidents differently, and by requiring nonresidents to pay more tax than similarly situated residents solely on the basis of whether or not the nonresidents are liable for alimony payments, the statute violates the rule of substantial equality of treatment.

Judge Ginsburg observed in the dissent that the majority's correlation with a taxpayer's "total income" approach is leading to the requirement that the state also allow nonresidents deductions for medical expenses, and even such things as real estate taxes, school taxes and mortgage interest payments (all paid in the nonresident's home state), if such are allowed to residents.

The majority did not anticipate such a risk and reasoned that states may adopt "justified and reasonable distiinctions between residents and nonresidents in the form of tax deductions or tax credits."  The majority opinion noted the inequities that result when a nonresident with alimony obligations derives nearly all of her income from New York.

The Lunding case may prove to be very important because it "opens the door" to claims by nonresidents for the type of deductions referred to in the dissenting opinion.

TRANSFERABLE STOCK OPTIONS

A more recent technique to avoid compensation being included in the recipient's taxable estate is for companies to issue transferable stock options to their employees.  This permits the executive to then give the stock options to their children, grandchildren or family trusts.  Gifts of transferable stock options to any one child are subject to gift taxes if their value is greater than $12,000.  Many estate professionals suggest that executives place very small values on these options.  Once a gift is made, the option can be exercised, generating profits for the child without further gift or estate taxes.

If an executive exercised the option himself and then gave the stock to his children (on or before his death), substantially higher taxes could be due.  On the other hand, if an executive assigns a relatively low value to the options and the Internal Revenue Service does not challenge that value, a large number of options can be transferred with the payment of minimal gift taxes or, alternatively, by using a part of the unified credit.

When the options transferred to the children are exercised, income taxes are due on the profit.  The Internal Revenue Service has ruled that the executives -- not the children -- must pay the income taxes because the profit was part of their compensation.   As a result, children can retain the entire gain on the stock option, while the payment of the income taxes reduces the size of the parent's estate, thereby reducing the overall level of estate taxes.

Some executives, rather than giving the options to their children, prefer to transfer the options to trusts.  Often, the gift to the trust has strings attached that make it less valuable for gift tax purposes.  For example, over the term of the trust, the donor must receive back the value of the assets he placed in the trust, plus some annual rate of income.  Usually the minimum rate of income is set by the Internal Revenue Service.  Whatever is left in the trust after these payments will flow to the children without being subject to either gift or estate taxes.

If the price of the shares falls and the options have not been exercised, the downside is that some gift tax may have been paid and legal and accounting fees expended.

CAUTION: Before making any decision to change domicile, the retiree should request his attorney and accountant to review the most recent tax laws, regulations and cases and determine his potential liability for New York income taxes both as a resident and a nonresident.

1. N.Y. Tax Law Sec. 631 and Sec. 632.

2. N.Y. Tax Law Sec. 631(b)2. The discussion of New York State income is illustrative only and is not intended to include all income that may be subject to New York taxes after the retiree has ceased to be domiciled there.

3. See New York State Department of Taxation and Finance Nonresident and Part-Year Resident Instructions - Form IT-203-1.

4. But undistributed taxable income of an S corporation apportioned to the S Corporation as out-of state income does not constitute income or gain derived from New York State sources to the shareholder. (20 NYCRR 132.8)

5. Michaelsen v. New York State Tax Commission, 122 Misc.2d 824, 471 N.Y.S.2d 789 (1984).

6. 20 NYCRR 134.4(e).

7. 20 NYCRR 132.5(a).

8. 20 NYCRR 132.5(b); Matter of Delmhorst v. State Tax Commission, 92 A.D.2d 981, 461 N.Y.S.2d 499 (3rd Dept. 1983).

9. 20 NYCRR 132.4(b).

10. 20 NYCRR 132.18.

11. 20 NYCRR 132.18; Matter of Kitman v. State Tax Commission, 92 A.D.2d 1018, 461 N.Y.S.2d 448 (3rd Dept. 1983).

12. See Wachsman, DTA No. 806930; 1995 N.Y. Tax Lexis 622.

13. 20 NYCRR 132.16.

14. 20 NYCRR 132.4.

15. 20 NYCRR 132.4

16. See, Matter of Alfus, DTA No. 812408; 1995 N.Y. Tax Lexis 556, which seems to imply that a husband and wife can only have one domicile unless they are separated in fact.

17. Matter of McSpadden, DTA No. 810895

18. Matter of Schibuk, 1999 WL 417893 (N.Y. Tax App. Trib.) DTA No. 815095 (1999).

19. Matter of Albanese, Tax Appeals Tribunal, July 17, 1997.

20. 20 NYCRR 132.4[d](1).

21. Matter of Haas, Tax Appeals Tribunal, April 17, 1997.

22. Matter of Penchuk, Tax Appeals Tribunal, April 24, 1997.

23. Tax Law § 631[a].

24. 4 USCA Sec. 114 and at PL 104-95, 109 STAT 979.

25 Lunding v. NY Tax Appeals Tribunal, 118 S. Ct. 766 (January 21, 1998)