Confusion in Allocating Partnership Income from Property
Over the years we have noted that the issue of the allocation of partnership income is in a state of complete confusion and that it is now impossible to conclude with any degree of certainty what categories of partnership income are -- or are not -- New York source income. The degree of confusion is starkly demonstrated by two recent determinations by the same Administrative Law Judge involving taxpayers who had each previously litigated the same issue with respect to earlier years.
The first case, Matthew and Rachel Domber, (DTA No. 813972, March 13 1997) was a reprise of their 1993 case which was written up in Inside New York Taxes that year. The case involved a nonresident who was a partner in a law firm with offices in New York City. The issue was the allocation of certain categories of income attributable to low income housing developments in Pennsylvania and West Virginia. The taxpayers argued first that the income in question was not income of the New York law firm but, rather, was income derived separately by the partners from their personal investments in the real estate developments. The taxpayers also argued, primarily relying on Reg. former section 131.16, that income attributable to non-New York real property cannot be New York source income. The Division primarily emphasized that the income was deposited into the law firm's operating bank account and that the firm had no out-of-state office.
As occurred in the earlier case, the ALJ agreed with the Division that the taxpayers had failed to prove that the income was not income of the law firm. The taxpayers were hampered in this regard by the fact that one of the partners apparently could not hold the interest in his own name because of Housing and Urban Development conflict of interest rules.
With respect to the second argument, the ALJ began by noting the two controlling (albeit impenetrable) Court of Appeals cases, Ausbrooks v. Chu, 66 NY2d 281 (1986) and Voght v. Tully, 53 NY2d 586 (1981) which were discussed at length in our article on the earlier Domber case four years ago. Quoting from the Tax Tribunal decision in the earlier Domber case, the ALJ said:
"the focus of the present inquiry is on where the income was generated notwithstanding the location of the real property. Specifically, our inquiry is whether the revenue from out-of-state real property was generated by active management which took place in New York State, or whether the revenue represents passive investment income flowing from the out-of-state real property...."
The ALJ primarily relied on the decision of the Appellate Division in the earlier Domber case, 210 AD2d 529 (1993), most significantly on a statement in a footnote in which that Court specified that "this is not a situation where the income transmitted to the New York law firm was either net rental income or gross rents from out-of-state rental properties which would result in the application of 20 NYCRR former 131.16." The Appellate Division, in the earlier case, had concluded that the taxpayer had failed to disprove the Division's claim that the income was fees for work done by the firm which could properly be sourced to New York. The ALJ concluded that, under the test set forth by the Appellate Division, if the income was shown to be rental income or sales gain, such items would be sourced according to the situs of the property regardless of whether they are "run through" the New York partnership.
The ALJ agreed that the taxpayers had shown that certain income was attributable to real estate sales and concluded that such income was not from New York sources. With respect to other items alleged to be net rental income, the ALJ agreed with the Division that due to the fact that all items were deposited into the law firm's bank account, it could not be proven what income was fees and what was rental income.
The second ALJ determination, George and Carol Bello, (DTA No. 814360, February 6, 1997) also involved a taxpayer who litigated the same issue in 1993. In contrast to Domber which involved income from alleged out-of-state activities, in Bello the issue was the deductibility of losses derived from a partnership, Reliance Figueroa Associates, which, in turn were attributable to the partnership's operation of a hotel in California. Thus, the positions of the parties were the exact opposite of those in Domber. The taxpayers were arguing that the active management of the property in New York City made the losses New York source while the Division argued that the source must be attributable to the situs of the property.
The ALJ first concluded that the fact that the taxpayer had previously lost on this issue is irrelevant. The earlier Bello case involved solely a "failure of proof" and did not preclude the taxpayer from litigating the same issue for later years. In contrast, the taxpayers in this case put in substantial evidence that the partnership was managed in New York including extensive testimony from Henry Lambert, one of the general partners of the partnership and one of the officers of the corporate general partner. Mr. Lambert testified that he personally devoted a substantial amount of his time to partnership matters concerning the renovation of the hotel. While professionals were employed in both California and New York, Mr. Lambert testified that he would ultimately "make the call" regarding renovation decisions. He was also involved in marketing and advertising decisions. During 1989, the year at issue, Mr. Lambert was also involved in the decision to dispose of the hotel through a "like-kind exchange" and was involved in analyzing potential exchange properties to acquire.
In analyzing the issue, the ALJ went through the same steps described above, discussing in detail the guidelines set out in the Ausbrooks, Voght and Domber decisions. In particular, the ALJ again focused on the Appellate Division decision in Domber which distinguished between fees and income from rental property. In this case, however, the ALJ concluded that the income must be considered attributable to the active management conducted in New York. The ALJ reasoned that "the partnership owned not only real estate, but also an accompanying ongoing hotel business.... [t]he partnership was involved in overseeing the quality of hotel services and, most directly, was fully involved in the renovation, presentation and maintenance of the Hotel's physical facilities. The income (here losses) in question did not represent simply net rental income or gross rents from out-of-state rental properties, but rather resulted from a hotel business comprising the full range of hospitality services...."
Observations:Although the ALJ's attempt to distinguish hotels from other forms of real property has some potential appeal, we suspect that it will not last. The taxpayers in Bello acknowledged that the day-to-day business decisions regarding the operations of the hotel were made in California. Senior management decisions concerning renovations, marketing and exchanging of real property are just as likely to arise in other types of real estate.
As we have pointed out in the past, the Division of Taxation, in its aggressiveness, has become the ultimate loser in the mess it has made of the law. By seeking to tax nonresidents who derive income from out-of-state properties, it has allowed the courts to draw a road map that any competent tax professional can use to avoid New York taxes. Properties such as the one in Bello, which throw off losses will be shown to be actively managed by persons in New York to facilitate the use of the losses. Before the properties begin to generate income or are sold, the management of the properties can easily be moved outside New York, possibly by dropping the property into a lower-tier partnership or limited liability company, so that the income or gain is not from New York sources. Moreover, it is simply a matter of time before a nonresident convinces a court that income from New York real property is not New York source income because the property is actively managed out-of-state and because the same test must be used for New York and non-New York properties to avoid constitutional problems.