Partner Taxed on Out-of-State Investments in Partnership's Name
From time to time, we have pointed out the difficulties the Division of Tax Appeals has had in determining the source of income derived by a nonresident individual through a partnership. A recent State Administrative Law Judge determination points out some of the problems that exist. (Richard F. and Diane L. Horowitz, DTA No. 813726, October 10, 1996)
The case involved a nonresident individual who was a partner in a law firm that maintained its only office in New York. During 1976, Richard Horowitz and 16 other partners in the firm invested, apparently through the law firm, in various tax-shelter partnerships, including a California movie deal, a Kentucky coal mine, and a record deal 91976 being the unofficial high-water point of the tax-shelter industry). Subsequently, the IRS disallowed many or all of the deductions claimed and determined that the taxpayer had additional federal taxable income. It appears that Horowitz failed to notify New York State of the federal change, so the Division contacted Horowitz following the Division's notification of the federal adjustment by the IRS. The Division asserted additional State personal income tax and new York City nonresident earnings tax, concluding that the additional income was from New York sources.
Most of the determination was devoted to the taxpayer's claim that the tax-shelter investments were actually personal investments of nonresident individuals and unrelated to the activities of the law firm -- and thus not taxable by New York State or City. The Division argued, and the ALJ went on to reject the claim that, whether or not the income was realized by the partnership, the income was derived from businesses conducted outside New York and the income, therefore, was not from New York sources. The ALJ indicated that "[all] of the income of the law firm was New York source income since it has no office outside of New York. Accordingly, despite the fact that three of the four tax shelter partnerships were located in other states, the income. . . . is New York source income.
New York state several years ago removed by statute the requirement in the Corporate Franchise Tax that a corporate taxpayer was required to maintain an out-of-state place of business in order to apportion its income. The City agreed to modify the General Corporation Tax in a similar fashion last year. Therefore, it is surprising to see the Tax Division and an ALJ resurrect the concept underlying the doctrine. Most tax practitioners believe the doctrine raises significant constitutional issues under the so-called internal consistency doctrine since non-New York corporations can and are regularly taxed despite the absence of a regular place of business within the State.
It seems likely that the case could have been resolved on far more narrow grounds. The IRS adjustments involve the disallowance of tax-shelter deductions. If Horowitz originally deducted such losses against his New York source income (a reasonable assumption), it would seem appropriate to require consistent treatment upon the federal disallowance of such deductions.
Nevertheless, the approach taken by the Division and the ALJ in this case raises numerous problems for the tax authorities in the future. As we have noted in the past, taxpayers frequently have several options as to how to structure their investments. It would be ironic if taxpayers can cite this case as a basis for deducting from new York source income losses realized from out-of-state activities simply by running them through a New York law firm or similar partnership.
Another issue raised by this case involves whether to report federal changes. Until recently, many taxpayers have believed that despite the clear statutory obligation to report, failure to do so was a reasonable gamble and that there was a good chance of avoiding discovery. Recent improvements in information sharing and computer matching has made it far more likely that a taxpayer who fails to make a timely notification will be caught.