More News on the Commuter Tax -- Confusion Comes to this Side of the Hudson

Published: January 31, 2000
Source: R & H Letter to Clients & Friends

Last spring, in a highly political and controversial move, New York State repealed the New York City nonresident earnings tax (the "Commuter Tax") for residents of New York State. The Commuter Tax on earnings of nonresidents of New York State was not repealed. Given New York's continued imposition of Commuter Tax on residents of other States, this "partial repeal" legislation was immediately recognized as raising constitutional issues. Two courts have already held that the partial repeal is unconstitutional, but the controversy continues, with oral argument in the Court of Appeals now scheduled for February 15, 2000. Because nonresidents may not know the outcome of the constitutional litigation before filing their 1999 tax returns, they may have to decide whether to follow the letter of the Tax Law (and pay the Commuter Tax), or instead follow the lower courts' decisions (and not pay the tax, on the basis that it is unconstitutional).

Being confused about the effect of Commuter Tax repeal is, however, no longer solely the province of nonresidents. Recent developments have brought to light another issue that, while not as lofty as the Constitution, will nevertheless affect many individuals -- both residents and nonresidents -- who file New York Commuter Tax returns. Specifically, for partners in partnerships with New York City earnings, it is not clear what portion of their distributive shares of 1999 (and possibly 2000) partnership income is subject to the Commuter Tax.

The problem is both simple and commonplace. The repeal of the Commuter Tax was effective July 1, 1999. That effective date is a certainty for residents; and it will be the effective date of repeal for nonresidents as well if the partial repeal is determined to be unconstitutional. For partners whose 1999 income includes a distributive share of partnership income, however, it is not clear how the mid-year repeal of the Commuter Tax should be applied. There are several possible answers to this question, and the treatment prescribed in New York State's recent Instructions for the 1999 Commuter Tax return is not necessarily the correct one.

The analysis of this question begins with the statute itself. The effective date provisions of the repeal legislation provide as follows:

"For taxable years commencing on or before June 30, 1999, which include such a date, a taxpayer no longer subject to [the Commuter Tax] . . . shall compute such taxpayer's liability for such taxable year as if such taxpayer's taxable year for federal income tax purposes ended on June 30, 1999." (S.5594--B, Search7RHSearch7RH6 and 7, emphasis added.)

Under normal income tax accounting rules, if a partner's tax year ends on June 30, 1999, he or she would include in income all of the partnership income, loss, etc. for any partnership year ending on or before June 30, 1999, and would include none of the income or loss for any partnership year ending after June 30. See Internal Revenue Code Search7RH706(a). Thus, an individual partner in a calendar-year partnership would include none of the partnership's 1999 income or loss in a federal tax year deemed to end on June 30, 1999. Under these principles, none of the 1999 partnership income of commuting partners would be subject to the Commuter Tax.

This was precisely the interpretation of the repeal statute announced by New York's Department of Taxation and Finance on September 1, 1999. TSB-M-99(6)I, entitled "Important Notice for Estimated Tax Filers," set forth a variety of instructions for resident, part-year resident and nonresident sole proprietors and partners. For full-year New York State resident partners, the effect of the June 30 repeal of the Commuter Tax was explained as follows:

"If the taxable year of your partnership ends on or before June 30, 1999, your entire distributive share of net earnings . . . is subject to the [Commuter Tax]. If the taxable year of your partnership ends on or after July 1, 1999, your entire share of net earnings from self-employment allocated to the City is exempt from the [Commuter Tax]."

That seemed pretty clear. However, shortly after this Notice was issued the New York State Tax Appeals Tribunal issued its decision in Robert T. and Susan M. Greig. DTA No. 815529, 1999 N.Y.T.C. T-294 (September 16, 1999). Greig involved the proper treatment of partnership income where an individual becomes a New York resident part way through his partnership's taxable year. The applicable regulations required such a partner to include all of his or her partnership income in the resident return, based on the fact the partner was a New York resident on the day the partnership year ended. The Tribunal held, however, that this regulation was invalid, and permitted the Greigs to "prorate the annual amount of their partnership distributions and allocate the amount proportionately between resident and nonresident periods."

Apparently in reaction to this Tribunal decision (which is not appealable), the Tax Department prepared instructions for the 1999 Commuter Tax returns which reflect a new interpretation of the repeal statute. The 1999 Instructions NYC-203-I set forth a "Special rule for tax year 1999" which includes the following instructions for "Partners in a New York City Partnership."

"Full-year New York State nonresidents - Include on line 5 your total distributive share of net earnings from self-employment allocated to the City from a trade or business carried on in New York City by a partnership of which you are a member.

"Full-year New York State residents (who were not residents of New York City for any part of 1999) - Include on line 5 one-half of your total distributive share of net earnings from self-employment allocated to New York City from a trade or business carried on by a partnership of which you were a member."

The treatment of nonresidents is not surprising, given the State's ongoing litigation of the constitutional issue. However, the Instructions for residents are quite a surprise, for several reasons. One surprise is that these Instructions reflect a theoretical approach that clearly differs from the rules set forth in the September Notice. Rather than excluding all 1999 partnership income, the new Instructions effectively prorate, and lead to the imposition of Commuter Tax on the January-June share (determined mathematically) of a calendar year partnership's 1999 income.

It is far from clear that this change is correct. Greig involved the validity of a regulation that was "not in harmony with the statute." By contrast, it is the repeal legislation itself, not a regulation, which specifically sets forth the concept of a federal taxable year ending on June 30, 1999. Moreover, the repeal statute's reference to federal tax law seems to have invoked the Code Search7RH706 principles first expressed in the September Notice. Finally, the issue under the Commuter Tax is one of rate, not of source. There have been other mid-year shifts in New York's personal income tax rate in recent years (1985, 1992 and 1993), but in each of those cases the legislature specifically provided by statute for an averaged tax rate to give effect to the mid-year rate reduction. Tax Law Search7RH699; see also Ch. 29, Search7RH47, Laws of 1985. Here, by contrast, the Commuter Tax repeal legislation took the entirely different approach of specifically mandating a deemed June 30 year-end. There are therefore a number of reasons to question whether the new Instructions are correct.

For partners in fiscal year partnerships the new Instructions present another surprise. For any such partner, the instruction to report "one-half" of his or her income as subject to Commuter Tax is inconsistent with both the Notice and the decision in Greig. If applicable, Greig would result in the imposition of Commuter Tax on all partnership income attributable to periods prior to July 1, 1999. A partner in a partnership with a September 30 fiscal year end would, therefore, be instructed to report three-fourths of his 1999 distributive share as subject to Commuter Tax. Perhaps the "one-half" rule reflects an administrative attempt to achieve the same result as in the cases of mid-year rate reductions, but without some statutory basis this is of questionable validity.

In light of the foregoing, partners in New York partnerships, both those who reside in the New York suburbs and those who reside out-of-State, should be aware that simply following the instructions to the 1999 Commuter Tax Form may not produce the correct amount of Commuter Tax. Computerized tax return programs (which are generally designed to follow official tax return instructions) will likely raise the same issues. It may be that some enterprising attorney will take on this issue, and eventually establish the correct application of the mid-year Commuter Tax repeal for all partners. (Such litigation may become more likely if the State's computers generate underestimated tax penalties for partners who followed the September Notice.) Until this question is resolved, however, partners filing their 1999 Commuter Tax returns need to decide which interpretation to follow. Stay tuned!