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Options for Allocating Stock Option Income: New York's New Allocation Rules and Their Effect on Taxpayers, Multistate Employers, and Other States

Originally published in: The Tax Lawyer August 1, 2007 Options for Allocating Stock Option Income: New York’s New Allocation Rules and Their Effect on Taxpayers, Multistate Employers, and Other States Debra Silverman Herman I. BACKGROUND Determining the allocation of income from stock options for nonresidents is inherently challenging, given the difficulty in determining when the income accrues relative to the period that the nonresident performed services in the state. Recent developments in the State of New York provide some helpful guidance in understanding the nature of these issues. Taxpayers who are nonresidents of New York and have been compensated for services performed in New York with stock options, and who have exercised the options in 2006 and earlier years, currently have significant flexibility in allocating income to New York, provided the statute of limitations is still open for those tax years. Taxpayers and counsel currently engaged in audits with the New York State Department of Taxation and Finance (Department) should be aware of their choices. Significant refund opportunities may also exist for taxpayers who have recently concluded an audit with the Department, or have voluntarily paid tax to the state based on the prior rules. For 2007 and subsequent tax years, however, nonresidents have less flexibility in allocating stock option income to New York as a result of new allocation rules that have taken effect in New York on January 1, 2006 (N.Y. Option Income Allocation Rules). These rules dictate how and when New York calculates the New York portion of income derived from stock options, stock appreciation rights and restricted stock. Importantly, the method the Department has adopted in the new N.Y. Option Income Allocation Rules – that is elective for tax year 2006, but required for tax years thereafter – is one that it had not previously used to calculate the amount of income allocable to New York. The divide between the pre- and post-2006 allocation rules reflects a long history of confusion and conflict in the allocation of nonresidents’ deferred compensation income. Over the past decade, the Department, the New York administrative tribunals, and the courts have analyzed and adopted diverse allocation approaches for determining the amount of option income subject to New York tax. Part II of this Article provides an overview of these approaches through a discussion of the In re Stuckless decisions. Each of these decisions created substantial confusion regarding how taxpayers should allocate option income between New York and other jurisdictions, due in large part to the fact that litigation tends to resolve only the specific question presented, and not to provide a comprehensive framework for taxation. Part III of this Article sets forth the responses that New York’s former Governor, and the Department, had to each of the In re Stuckless decisions. The end result of the back-and-forth of this particular case has been the N.Y. Option Income Allocation Rules. Inasmuch as the N.Y. Option Income Allocation Rules adopt the general method chosen by the U.S. Treasury to calculate the amount of stock option income allocable to the United States by nonresident aliens, Part IV of this article examines the federal regulations and existing federal authority. Part V of this Article highlights the effects of New York’s new wage allocation rules and the Stuckless decisions on taxpayers, multistate employers, and other states. Several states currently employ the option income allocation approach challenged and rejected in Stuckless and in the N.Y. Option Income Allocation Rules. It is unclear whether these states will revise their methodology and adopt the allocation approach set forth in the N.Y. Option Income Allocation Rules, or will continue their current policies. Since the new allocation approach is based upon a period of time that is shorter than the period formerly considered in New York, and still considered elsewhere, concern for the potential for double taxation that could result from dueling sourcing rules may be limited. However, because states’ allocation formulae generally depend upon the relationship of New York and non-New York days during the relevant measuring period, it is possible that the application of different measuring periods may lead to adversely conflicting results. Moreover, multistate employers need to be aware of New York’s new allocation approach, since it may lead to different withholding tax liabilities. Employees will also likely request a new set of day count records from employers demonstrating working days spent inside and outside New York for the new allocation period. Finally, the Stuckless decisions provide an example of the importance of promulgating regulations, rather than guidance in the form of technical memoranda, since tribunals may chose, as happened in Stuckless, to give no deference to the taxing authorities’ informal interpretation of the relevant statutes and regulations. Other states may be stuck with results far worse than New York’s Stuckless scenario. II. THE STUCKLESS DECISIONS Mr. E. Randall Stuckless, an employee of Microsoft Corporation (Microsoft), was granted incentive stock options (ISOs) in 1991 and 1992 while he worked in and was a resident of New York. On September 1, 1996, Mr. Stuckless and his wife moved to Seattle, Washington. From September 1, 1996 through July 5, 1998, Mr. Stuckless worked for Microsoft in Seattle, and during this period he exercised several of the ISOs and contemporaneously sold the stock. During that time period Mr. Stuckless was neither a resident of New York, nor an employee performing any services in New York. On July 6, 1998, Mr. Stuckless returned to New York, exercised several more ISOs, and sold the stock, while a resident of New York. Mr. Stuckless did not file a New York income tax return for 1997; he filed a joint Nonresident and Part-Year Resident income tax return for 1998 reporting the income from the sale of stock during the resident period. The Department audited Mr. Stuckless, and he was assessed tax on income he realized during the nonresident years (1997 and 1998, the Audit Period), plus interest and penalties. The Department determined that Mr. Stuckless’s income in the Audit Period constituted New York source compensation income, and that the compensation portion of the income was the difference between the option exercise price and the fair market value of the option on the date of exercise. Further, the method used by the Department to allocate the option income to New York was based on a fraction, the numerator of which was the number of New York working days from the date the option was granted to the date of exercise, and the denominator of which was the total number of days worked both inside and outside of New York for the same period. This grant-to-exercise day count allocation was the allocation methodology set forth in a Technical Services Bureau Memorandum, and in the Department’s District Office income tax audit guidelines (the “1995 Memorandum Allocation Methodology”). Mr. Stuckless protested, and the following decisions ensued. A. The Administrative Law Judge Decision Mr. Stuckless filed a Petition with the New York State Division of Tax Appeals and asserted two main arguments: (1) New York was not entitled to tax any portion of the option income; and (2) in the alternative, the amount of option income New York was entitled to tax was limited to the amount of gain that had accrued to the date he moved from New York, as if he exercised the option on that date (i.e., the difference between the option price and the fair market value of the stock as to which he held an option on the date his employment and residency in New York ended). Administrative Law Judge Thomas C. Sacca (ALJ) rejected both of Mr. Stuckless’s arguments. The ALJ determined that the option income upon which the Department assessed tax was New York source income. New York, like most states, considers New York source income to include items of income, gain, loss or deduction attributable to “a business, trade, profession or occupation carried on in the state.” The regulations further provide that a nonresident individual rendering personal services as an employee, include the compensation for personal services entering into the individual’s federal adjusted gross income, to the extent the individual’s services were rendered in New York. Mr. Stuckless maintained that there was no “compensation” subject to tax until the ISOs were exercised and sold during the nonresident period. The ALJ, however, citing Michaelson v. New York State Tax Commission, ruled that when determining whether option income constitutes New York source income, the activities of the taxpayer at the time the options are secured and earned (that is, date of grant) are controlling, rather than at the time when the benefit was actually received or realized (that is, date of exercise). The ALJ found that the language of the plan under which the ISOs were granted demonstrated that they were intended as compensation for services Mr. Stuckless rendered to Microsoft while he was a resident of New York. Further, the ALJ stated, as set forth by the Court of Appeals in Michaelson, only the income from the exercise of the stock options is taxable New York compensation. Thus, the ALJ concluded that the Department properly determined that the total amount of compensation subject to tax is measured based on the amount of gain incurred over the period from the date of grant of the options to the date of exercise of the options. The ALJ also sustained the Department’s use of the 1995 Memorandum Allocation Methodology. During the Audit Period, New York’s statute provided (and it continues to provide) that in the case of nonresident individual employees who work partly inside and partly outside New York, the income derived from New York sources is required to be determined based on “apportionment and allocation” under [the Department’s] regulations.” The regulations in effect during the Audit Period provided that the portion of an employee’s wages derived in New York is determined by comparing the number of working days in New York to the total number of working days; however, these regulations did not provide any specific guidance in regard to option income. Instead, the Department’s policy for allocating the New York portion of the stock option income was set forth in a Technical Services Memorandum – the 1995 Memorandum. The Department issued the 1995 Memorandum as a direct result of the court of appeals decision in Michaelson. The beginning portion of the 1995 Memorandum summarizes the Michaelson decision, in particular the holding that the total amount of compensation subject to tax is measured based on the amount of gain incurred over the period from the date of grant of the options to the date of exercise of the options. It further states that the Department has chosen to align its allocation method for determining the portion of the compensation subject to New York tax based upon the same general measure, which it deemed the “compensable period” and is referred to herein as the 1995 Memorandum Allocation Methodology. However, it limited the compensable period to the date employment ceases. Significantly, the methodology adopted by the Department in the 1995 Memorandum represented a reversal of its historical policy, which required an allocation based upon the number of days worked inside and outside New York during the year of exercise. As such, many practitioners, as well as Mr. Stuckless, have argued that the Department was required under the state’s Constitution and its Administrative Procedures Act to promulgate formal regulations setting forth the new policy. Since the Department did not proceed in this fashion, the argument follows that the Department had no regulatory authority to impose the 1995 Memorandum Allocation Methodology on Mr. Stuckless and other taxpayers. The ALJ was not impressed with this argument. He stated that the Department was not required to issue regulations, and further ruled that the allocation method set forth in the 1995 Memorandum represented a reasonable interpretation of the Michaelson decision, New York’s statute and its regulations. Thus, the ALJ rejected Mr. Stuckless’s alternative argument that the amount of option income New York was entitled to tax was limited to the amount of gain that accrued on the date he moved from New York. In other words, the ALJ refused to adopt Mr. Stuckless’s position that he be treated as if his employment terminated on the date he moved to Washington. As explained above, the ALJ found that this methodology did not represent the employment benefit Mr. Stuckless received (that is, the grant of the ISOs) while he was a resident of New York. Mr. Stuckless disagreed with this result. In response, he filed an exception, and sought review of the ALJ determination by the New York State Tax Appeals Tribunal (Tribunal). B. Stuckless I – The Initial Tax Appeals Tribunal Decision In May, 2005, the Tribunal rendered its first decision in Stuckless I. It determined that the fair market value of the stock as to which Mr. Stuckless held options on the day he moved from New York should be used to determine Mr. Stuckless’s New York income tax, and it rejected the Department’s use of the 1995 Memorandum Allocation Methodology. Specifically, the Tribunal ruled that the accretions in value of the stock during the period when Mr. Stuckless worked in Washington represented compensation for his work in that state and therefore was not attributable to employment in New York. The ALJ’s interpretation of Michaelson was held to be incorrect and in contravention of Tax Law Search7RH631(c) and Regulations sections 132.4(b)and(c), and 132.18. “Neither Tax Law Search7RH631(c) nor the . . . regulation (20 NYCRR 132.18) make provision for imposing tax on the income of a nonresident working in another state.” Thus, the Tribunal adopted Mr. Stuckless’s alternative argument. The Tribunal did disagree with Mr. Stuckless’s assertion that the Department improperly issued the 1995 Memorandum, but stated that it did not view the 1995 Memorandum as legal authority. Most importantly, the Tribunal held that the 1995 Memorandum Allocation Methodology simply did not apply to the facts presented, since (unlike the petitioner in Michaelson) Mr. Stuckless was neither a resident nor performing services in New York when the option income was realized. It also held that regulations section 132.18(a), which states that the portion of an employee’s wages derived in New York is determined by comparing the number of working days in New York to the total number of working days, was not applicable to the facts presented, for the same reason. The Tribunal thus ruled that Mr. Stuckless, and other taxpayers, are entitled to adopt an alternative allocation methodology. It further sustained Mr. Stuckless’s alternative – the use of a mark-to-market allocation based upon workdays, and appreciation, between the date of grant of the options and the date that he left New York for Washington. We agree with Petitioner that his New York employment terminated on the date he moved to Washington and that the fair market value of the stock on the date he moved out of New York must be used to determine the gain realized for New York state income tax purposes. State and local tax practitioners were generally surprised by the Tribunal’s adoption of a mark-to-market approach. Many envisioned scenarios in which both the 1995 Memorandum Allocation Methodology and a mark-to-market methodology could apply, with confusing results. Some practitioners were also disappointed that the validity of the 1995 Memorandum had been upheld. C. The Order on Motion For Rehearing Before The Tax Appeals Tribunal Faced with its loss in Stuckless I and the resulting “confusion for the Division and tax practitioners” as to when the 1995 Memorandum Allocation Methodology would apply, the Division of Taxation (Division) made the rather unusual move of petitioning the Tribunal to rehear the case. Under New York law, there is no statutory authority for the Tribunal to reconsider a decision. However, the Tribunal’s rules expressly provide the authority to reconsider a Tribunal decision by granting a motion for reargument. The purpose of this procedural mechanism, and the standard applied by the Tribunal when determining whether to grant such a motion, is whether it will “afford a party an opportunity to establish that the court overlooked or misapprehended the relevant facts, or misapplied any controlling principle of law.” The Division’s primary argument in its memorandum in support of its motion for reargument was that the Tribunal in Stuckless I had overlooked a controlling principle of law, namely a decision issued by the Court of Appeals in Brady v. State of New York. The Division argued that Brady approved the use of a formula apportionment method when determining a nonresident individual’s total income subject to tax, and that just such a formula apportionment method was set forth in the 1995 Memorandum. The “direct accounting method” or “mark-to-market” approach (that is, the exclusion of accretions in value while Mr. Stuckless was employed in Washington) chosen by the Tribunal in Stuckless I, it was argued, did not comport with Brady. The Division thus requested the opportunity to address the principle set forth in the Brady decision. The Division further argued that the “direct accounting method” adopted in Stuckless I incorrectly assumes that each day of work coincides with the appreciation or depreciation in the value of the stock for that day. It also maintained that it would be impracticable to administer this approach, and overly burdensome on taxpayers to keep the records required. In his memorandum of law in opposition to the Division’s motion for reargument, Mr. Stuckless argued that Brady was irrelevant to the matter. Many state and local tax practitioners informally agreed. Moreover, Mr. Stuckless’s main argument, as viewed by the Tribunal, was that the Division omitted any discussion of section 132.18(b) of the state’s regulations. Specifically, section 132.18(b) “deals with a nonresident who severs his ties with New York and ceases to have any New York employment” and “[u]nder subparagraph (b) no income from out of state employment is taxed in New York where there is no New York employment.” By contrast, the Division (and the Tribunal in Stuckless I) addressed only section 132.18(a), which Mr. Stuckless explained is the provision that deals with a nonresident who “works both in and out of New York” within the same taxable year. It should be noted that section 132.18(a) of the regulations does not expressly state in its text that the day count allocation is limited to a taxable year, although it does provide an example of a day count calculation that is limited to the taxable year of receipt of income. Nevertheless, based on the fact that he had not worked in New York one single day during the tax year in which he realized the ISO income, Mr. Stuckless argued that the 132.18(a) regulation, and the 1995 Memorandum, were irrelevant to his matter. Significantly, Mr. Stuckless agreed with the Division that the Tribunal in Stuckless I had erroneously concluded that section 132.4 of the regulations authorized a permissible alternative method of allocation. The Tribunal agreed with both parties and granted the motion for reargument in December 2005. In granting reargument the Tribunal also articulated four other items that it thought should be addressed during rehearing: (1) whether Stuckless I properly interpreted the scope of the 1995 Memorandum; (2) whether section 132.4 of the regulations applies; (3) whether the 1995 Memorandum represents an alternative method the Division is authorized to apply pursuant to section 132.24 of the regulations; and (4) if the Division was not authorized to adopt an alternative method pursuant to section 132.24 of the regulations, whether there is any legal authority for imposition of the tax assessed against Mr. Stuckless. D. Stuckless II – The Final Tax Appeals Tribunal Decision When the Tribunal examined Mr. Stuckless’s case upon rehearing and made its determination in Stuckless II, the Division fared far worse than it had in Stuckless I. In general, the Tribunal ruled in Stuckless II that the Department had no authority to impose the multiple year 1995 Memorandum Allocation Methodology. Rather, it found that the regulations authorize an allocation based solely on work days within the taxable year income is realized – a year of exercise allocation methodology. Further, the Tribunal ruled that the 1995 Memorandum was not entitled to any deference, thereby impairing the Division’s ability to rely on the 1995 Memorandum in the future. Notwithstanding the Division’s reliance on Brady (and its principles) in its memorandum in support of its motion for reargument, the Tribunal made no specific mention of the decision in Stuckless II, including in its summary of the Division’s arguments. Instead, it detailed the following four arguments that it viewed as the Division’s arguments on rehearing: (1) the ALJ determination was correct and should be sustained; (2) the date of grant of the ISOs was a crucial factor in Michaelson because under the Code the strike price of the option must equal the fair market value of the stock on the date of grant; (3) the 1995 Memorandum reflects Michaelson and is a reasonable interpretation of the state’s nonresident income tax regulations; and,(4) the 1995 Memorandum Allocation Methodology is an alternative method authorized by section 132.24 of the state’s regulations. According to the Tribunal, Mr. Stuckless asserted five main arguments: (1) the ALJ erred in finding the option income was secured and earned through New York employment; (2) the multiple year allocation set forth in the 1995 Memorandum and applied by the Department violated the annual accounting concept of Tax Law section 638(2), and only services rendered during the year of exercise of the options should be considered in determining New York source income; (3) regulations section 132.18(b)controls and should have been applied, rather than regulations section 132.18(a); (4) the 1995 Memorandum violates New York’s State Administrative Procedure Act; and (5) the Department should have permitted a more equitable method of allocation pursuant to regulations section 132.24, in particular an allocation between the appreciation that occurred while he lived and worked in New York and the appreciation that occurred while he lived and worked in Washington. Thus, Mr. Stuckless maintained his primary argument from below, but tweaked his alternative argument. The Tribunal began its opinion with a lengthy discussion of the Michaelson decision. Although the Tribunal concluded that both of the issues in Michaelson – the character of option income (that is, capital gain or ordinary income) and the timing of recognition of option income – were not at issue in Stuckless, a few items are worth noting. First, New York does not provide federal capital gain treatment, as set forth in the Code, for statutory stock options or any other kind of asset, all gain is subject to tax at the same rates as ordinary income. Second, New York law conforms to federal law in regard to the timing of the recognition of gain for statutory stock options. Since the calculation of New York tax begins with federal adjusted gross income, a legislatively enacted modification would be necessary if New York were to tax statutory stock options at the same time as nonstatutory stock options (that is, taxation on the date of exercise). To avoid imposing an overly burdensome recordkeeping obligation on taxpayers and administratively difficult enforcement standards on the Department, such a change has not been pursued legislatively. Third, the Tribunal emphasized that in Michaelson the petitioner and the Department agreed to an allocation of the option income based solely on a day count during the year of exercise. Therefore, although the Michaelson decision did not expressly address the allocation issue, the Tribunal could not “find any express or implied support in Michaelson” for the 1995 Memorandum Allocation Methodology “when the facts before the State Tax Commission and the courts included an allocation based on a day count ratio for the year in which the income was realized.” In addressing Mr. Stuckless’s argument that New York’s law and regulations dictate an annual mark-to-market approach in regard to the option income, the Tribunal explained that although the law (sections 638 and 639 of the New York Tax Law) and regulations (section 132.18(b)) provides a closing of the books approach when there is a change in residence, the law (Tax Law Search7RH631) and regulations (section 132.18(a)) also require a pro-ration of the income for determining source. Further, the fact that the statutory accrual provision that applies when a nonresident becomes a resident of New York expressly excludes New York source income from the calculation, implied to the Tribunal that the general sourcing rules are meant to apply before and independent of the change-in-residence rules. Based on this analysis, the Tribunal concluded that Mr. Stuckless’s mark-to-market approach was inconsistent with the state’s general sourcing rules and therefore without merit. As a result, Stuckless II held that the Tribunal’s decision in Stuckless I was incorrect. Furthermore, the valuation of the ISOs on the date Mr. Stuckless moved out of New York was found to be contrary to the basic premise of the income taxation of such options: options are subject to tax if there is a readily ascertainable fair market value when granted, and if not they are subject to tax, upon exercise. Based on these analyses, the Tribunal concluded that its earlier decision had to be withdrawn. In the remaining portion of its opinion, the Tribunal articulated its new analysis of New York’s law and regulations as applied to Mr. Stuckless’s option income. Importantly, the Tribunal highlighted the specific authority granted to the Department to promulgate regulations setting forth allocation rules for compensation income. It also described some of the regulations that the Department had promulgated under this authority when the general allocation rules set forth in regulations section 132.18 produced a distortive result. For example, the Department has promulgated special rules for nonresident athletes, sales people, securities and commodities brokers, and recipients of pensions and certain other retirement benefits. The Tribunal also emphasized that the allocation required under each of these rules, with the exception of the rule for nonresident individuals that receive pension and retirement benefits, is limited to the taxable year in which the income is received. Further, it explained that even under the pension and retirement benefit regulation, where the allocation spans multiple tax years, a separate day count calculation is required to be made for each tax year. Since the day count calculation set forth in the 1995 Memorandum Allocation Methodology is based on the entire compensable period, rather than each tax year, it follows that such allocation is contrary to New York’s other regulatory provisions involving multiple year deferred compensation income. The Tribunal also examined section 132.18(a) of the regulations, as outlined in its opinion granting the motion for reargument, and concluded that the rules and examples set forth therein “express, or strongly imply, an allocation based on work days within the taxable year in which the income is realized, subject to the flexibility afforded by section 132.4(c) and section 132.24.” On this basis, the Tribunal ruled that the allocation of option income by a nonresident is required to be based on the individual’s New York work day count during the year in which the option income is exercised. Based on that methodology, and given that Mr. Stuckless had zero New York workdays in the year of exercise, the Tribunal concluded he owed no tax on his option income. The Tribunal also, importantly, stated that “if the Division wishes to depart from the rules provided by those sections [of the regulations] and create a new separate set of rules for identified special circumstances, we think such a change should be effected through legislation or adopted in regulations . . .” Since the Department did not promulgate regulations, but rather set forth the 1995 Allocation Methodology in the 1995 Memorandum, and since such methodology was inconsistent with the existing regulations, the Tribunal concluded that the Department had no statutory or regulatory authority to impose the 1995 Memorandum Allocation Methodology on Mr. Stuckless. In so concluding, the Tribunal rejected the Division’s argument that section 132.24 of the regulations – the provision that grants the Department the authority to require taxpayers to use an alternative to the allocation methods expressly set forth in the regulations – was sufficient authority to impose the 1995 Memorandum Allocation Methodology on Mr. Stuckless and other taxpayers. Specifically, the Tribunal ruled that section 132.24 of the regulations applies only to “accommodating ad hoc situations” when the existing regulations would produce an unfair and inequitable result. The 1995 Memorandum, in contrast, “is clearly not such a special tailoring. It is a highly articulated set of rules of general application.” The Tribunal thus concluded that the issues present in the Stuckless case were purely legal in nature, and that it could reach its determination based on its own interpretation of the statutory and regulatory authority, as applied to the agreed facts. According no deference to the 1995 Memorandum, the Tribunal ultimately handed a victory to Mr. Stuckless. III. THE EXECUTIVE’S RESPONSES TO THE STUCKLESS DECISIONS A. Governor Pataki Requests Regulations In response to Stuckless I, former Governor George E. Pataki included a provision in his fiscal year 2006-2007 Budget Bill requiring the Department to issue regulations to clarify the tax treatment of option income. Enactment of this provision was “necessary to implement the 2006-2007 Executive Budget.” The Memorandum in Support further provides: This bill will require the Commissioner of Taxation and Finance to issue regulations which would clarify New York State’s tax treatment of stock options, restricted stock, and stock appreciation rights received by a nonresident or part-year resident taxpayer. The bill would provide that a nonresident or part-year resident, who performs services or is employed within New York, would allocate compensation income attributable to stock options restricted stock or stock appreciation rights pursuant to regulations prescribed by the Commissioner of Taxation and Finance. The bill would require that the Commissioner of Taxation and Finance propose rules and regulations within 180 days of this act becoming law and that such rules and regulations may apply to taxable years beginning on or after January 1, 2006. The recent decision by the Tax Appeals Tribunal in the Matter of E. Randall Stuckless has raised significant confusion for both taxpayers and the Department of Taxation and Finance as to the proper allocation of New York source income from stock options, restricted stock, and stock appreciation rights. Although the Department had developed allocation rules which were published in a Technical Services Memorandum, that memorandum was ignored by the Tribunal in Stuckless. As a result, there are currently no clear rules for taxpayers, practitioners and the Tax Department staff to follow. This bill would require the Commissioner to develop clear guidelines for the allocation of income from stock options, restricted stock and stock appreciation rights with input from taxpayers and practitioners pursuant to the State Administrative Procedure Act regulation process. The Legislature enacted the provision into law and the Department had 180 days to draft regulations. During this time period, the Department also awaited the result of the Tribunal’s decision in Stuckless II. Almost anticipating the unfavorable result of Stuckless II, the Budget Bill stated that the rules to be promulgated by the Department “shall be controlling for such taxable years [taxable years beginning on or after January 1, 2006] notwithstanding any tax appeals tribunal decision to the contrary. Also, the provision the Legislature enacted set forth the statutory authority for the Department to promulgate option income regulations, which as it turned out was recommended by the Tribunal in Stuckless II as well. The end result of this legislation was statutory amendments to sections 631 and 638 of the Tax Law, the sections that set forth the general income tax sourcing rules for nonresident individuals and part-year resident individuals. For taxable years beginning on or after January 1, 2006, subsection (g) of section 631 of the Tax Law (nonresidents) and subsection (c) of section 638 of the Tax Law (part-year residents) provide: Stock option grants, stock appreciation rights and restricted stock. A [nonresident or part-year resident]taxpayer who has been granted statutory stock options, restricted stock, nonstatutory stock options or stock appreciation rights and who, during such grant period, performs services within New York for, or is employed within New York by, the corporation granting such option, stock or right, shall compute his or her New York source income as determined under rules and regulations prescribed by the commissioner. B. The Department’s Draft Regulations 1. August 2006 Draft Regulations, and the New York State Bar Association’s Comment Thereon. In fulfillment of its statutory obligation to draft regulations and obtain input from practitioners, the Department provided the Tax Section of the New York State Bar Association (NYSBA) with a draft of its regulations dated August 9, 2006 (Draft Regulations). In the Draft Regulations, the Department rejected:(1) Mr. Stuckless’s and the ALJ’s mark-to-market workday allocation approach; (2) the Department’s historical year-of-exercise workday allocation approach (which, as we know from the discussion above, the Tribunal would adopt eight days later as its chosen allocation method in Stuckless II); and (3) the grant-to-exercise workday allocation approach set forth in the 1995 Memorandum. Instead, the Department adopted a grant-to-vesting workday allocation approach (set forth in new section 132.24). To limit the potentially harsh effect of this methodology on nonresidents who exercised options in 2006, the Department included a provision allowing them to elect to allocate option income from the date of grant of the options to the earliest of the date the option or right is exercised (the 1995 Memorandum Allocation Methodology), the date employment services terminate, or the date that the compensation is recognized for federal income tax purposes. The NYSBA applauded the Department’s Draft Regulations in a report issued on September 20, 2006 (Report). In contrast to the Department when it drafted the Draft Regulations, the NYSBA had knowledge of the Tribunal’s decision in Stuckless II, which is reflected in its Report. In its Report, the NYSBA noted that it had suggested the grant-to-vesting approach during discussions with the Department’s Regulations Bureau. It also stated that this allocation approach “makes the most sense” because it correlates with the period of time during which an employee satisfies all employment-related conditions to exercise the option or right. It also conforms with the method adopted by the Internal Revenue Service for nonresident aliens. As part of its general comments in its Report, the NYSBA advised the Department to not include any carve outs from the day-counting rule set forth in the Draft Regulations (that is, a rule that no income would be allocated to New York if the employee was a nonresident during the period from date of grant to date of vesting). It also requested that the Department engage in an advertising campaign upon promulgation of the Draft Regulations to make employers aware of the new rules. The NYSBA also articulated nine specific comments in its Report, only one of which the Department adopted and included in the regulations it proposed to the public. The suggestion the Department adopted was to revise the term “federal adjusted gross” to “federal gross income” in its definition of the word “compensation” because an optionee who is not an employee (that is, independent contractor or a non-employee officer) may have federal adjustments relating to the option. Of the eight remaining comments, three addressed stylistic concerns: alphabetizing the definitions, simplifying language and eliminating specific references to the Code and adopting instead a general description of certain federal tax concepts. The five remaining comments addressed substantive concerns. The NYSBA advised the Department to revise its definition of the term “compensation” to reflect the different character of income and timing rules that apply to statutory stock options under New York’s law compared to federal law. More significantly, it recommended that the Department include a clear definition of the term “date of vesting” since the Draft Regulations included varied language to describe the vesting concept. Specifically, it advised the Department to adopt “the date the stock is vested (transferable or not subject to substantial risk of forfeiture)” as its definition throughout the regulation. Importantly, the NYSBA advised the Department to make clear that the grant-to-vesting methodology set forth in new section 132.24 is the presumptive allocation method for stock option income under the new regulations. In addition to that methodology, which was set forth in new section 132.24 of the Draft Regulations, new section 132.25 of the Draft Regulations, captioned “other methods of allocation,” allows the Department and taxpayers to utilize an alternative method of allocation when the methods set forth under new section 132.24 and sections 132.15 through 132.23 of the regulations (that is, the other special allocation rules for nonresident individuals discussed above in Part II) do not result in a fair and equitable allocation. The NYSBA found that “[t]he Draft Regulation[s] in its present form suggests that the allocation method set forth in new section 132.24, like the allocation methods contained in sections 132.15 through 132.23 of the regulations, is just one of many methods and the Department auditors as well as taxpayers may feel free to apply other methods.” The Report also suggested that new section 132.25 be revised to make clear that taxpayers can propose an alternative allocation method other than through the filing of their personal income tax returns. Another NYSBA comment was that the regulations should expressly provide that taxpayers have an election to choose, for all open years prior to taxable years beginning on or after January 1, 2006, to apply either the 1995 Memorandum Allocation Methodology or the Stuckless II year-of-exercise methodology. As discussed below, the Department informally adopted this approach through a Technical Services Memorandum issued on October 12, 2006 (the “2006 Memorandum”) . However, adopting substantive rules through yet another Technical Services Memoranda suggests that the Department may have ignored the NYSBA’s final advice in its Report, that the “Department might wish to review other situations where amended regulations might be necessary to effect the intention of other provisions of Technical Services Bureau Memoranda.” While it would be unfortunate, a new chapter in the Stuckless confusion may have been spawned by the Department’s decision to issue an informal policy memorandum, rather than regulations, to address open tax years. This is addressed in section III.C, below. 2. October, 2006 Proposed Regulations On October 10, 2006, the Department issued proposed regulations that were virtually identical to the August Draft Regulations (Proposed Regulations). In accordance with the State’s Administrative Procedure Act, the Department provided a 45-day public comment period. By this time, the public already had approximately two months to understand and analyze the Tribunal’s decision in Stuckless II; and many practitioners in the area were well acquainted with the Draft Regulations. As explained in its Assessment of Public Comment, the Department received written comments from a certified public accountant, a practitioner and The Business Council of New York State, Inc. (Business Council) in regard to the Proposed Regulations. The accountant requested that the timing of recognition of the option income occur at vesting, rather than at exercise. For the reasons articulated above in Part II.D of this Article – conformity with federal timing rules – the Department rejected the accountant’s request. The practitioner and the Business Council both advocated a year-of-exercise workday allocation approach. The Department summarized six justifications provided by the Business Council for this approach, including less recordkeeping, flexibility in the regulations promulgated under the Code that may authorize this result notwithstanding their general grant-to-vesting allocation approach, and the general opinion that the year-of-exercise rule in Stuckless II is a valid, reasonable and more appropriate measure for sourcing option income. The Department considered these justifications and rejected them, primarily by reiterating one of the justifications cited by the NYSBA in its Report on the Draft Regulations – the rules correlate with the time period during which all service-related conditions to exercise occur, and therefore more appropriately match the compensation element inherent in the grant of the options. The Department also explained that the Proposed Regulations were not meant to “entirely duplicate” the method chosen by the Service. The Department’s specific response is important, because it indicates how the Department might respond to a taxpayer’s challenge in the future when it is based on federal authority, and because it also points to the path taxpayers should take if the one-size-fits-all regulation proves to be a poor fit: The Internal Revenue Code sourcing rule for nonresident aliens was viewed by the Department as a reasonable and fair apportionment for stock option income, but federal conformity was not the Department’s main goal. The proposed regulation does not entirely duplicate the IRS sourcing rule, which provides a great deal of flexibility dependent upon an individual’s facts and circumstances. The proposed regulation provides a specific rule which applies to everyone. In situations where the proposed rule may produce an unfair result, the Department’s regulations already provide individuals with an option to use an alternate allocation that would more fairly apportion their New York source income (section 132.25). 3. December, 2006 Final Regulations – The New N.Y. Option Income Allocation Rules. On December 12, 2006 the Department adopted the October Proposed Regulations, with one slight change. The definition of the term “New York workday fraction” now says: a ‘New York workday fraction’ is a fraction the numerator of which is the number of days worked within New York State for the grantor during the allocation period and the denominator of which is the number of days worked both within and without New York State for the grantor during the allocation period. The term “grantor” is generally defined as the corporation granting such options, rights or stock, as set forth in the Draft Regulations and Proposed Regulations. The insertion of this language raises a question whether the performance of services for an entity other than the corporation that granted the stock options or rights enters into the day count allocation; inasmuch as individuals may well hold options to purchase a publicly-traded parent’s shares while working for an affiliate, this is not an idle concern. The final N.Y. Option Income Allocation Rules, effective for 2006 and subsequent years, thus provide that income in respect of statutory stock options, nonstatutory stock options with no readily ascertainable value, and stock appreciation rights will be allocated based on where the employee worked during the period between (1) the date of grant and (2) the date the option or right became exercisable (date of vesting). Income from restricted stock will generally be allocated based on where the employee worked during the period between (1) the date when the employee acquired the stock and (2) the date on which the stock became vested. Under each approach, the comparison will be New York workdays to total workdays. Further, in regard to nonstatutory stock options with a readily ascertainable value, or restricted stock for which an election has been made under section 83(b), the workday allocation is based on the New York and total workdays in the year in which the income is recognized for federal tax purposes. For tax year 2006, however, taxpayers may elect the date-of-grant-to-date-of-vesting allocation approach, or the period from the date of grant to the earliest of the date that the option or right is exercised, the date that employment terminates, or the date that the compensation is recognized for federal income tax purposes. C. Technical Services Bureau Memorandum Regarding 2005 and Earlier Years – TSB-M-06(7)I On October 12, 2006, subsequent to the issuance of its Proposed Regulations and prior to the promulgation of the final regulations, the Department issued a Technical Services Bureau Memorandum entitled Revised New York Tax Treatment of Stock Options, Restricted Stock and Stock Appreciation Rights Received by Nonresidents and Part-Year Residents (the 2006 Memorandum). The 2006 Memorandum authorizes taxpayers to utilize the allocation methodology adopted in Stuckless II, or the 1995 Memorandum Allocation Methodology, for tax year 2005 and earlier years, where the statute of limitations is still open. Thus, taxpayers who filed tax returns for 2005 or earlier years may wish to amend their tax returns to reflect an alternate method of allocation. For open years, some observers have questioned whether the 1995 Memorandum Allocation Methodology is alternatively permissive or required, assuming it is determined that the “general rule” of year-of-exercise should not apply. The Department largely answered this question in the following language in the 2006 Memorandum: For full year-nonresidents, the general rule is that the nonresident uses the days-in-and-out allocation for the tax year the options or rights were exercised or the restricted stock vested (or, if earlier, the year the stock was sold) as set forth in section 132.18 of the regulations. The Department will accept, however, the use of the grant to exercise method explained in TSB-M-95(3)I as an alternative method. There may be special circumstances where the allocation for the year of exercise or vesting does not result in a fair and equitable allocation. For example, the Department recognizes that where an employee exercises stock options and leaves the employment of the company that granted the stock options early in that year, using the allocation in effect for the year the options are exercised may not result in a fair and equitable allocation of the option income. In this situation, it may be necessary to use an alternative allocation such as the one set forth in TSB-M-95(3)I. IV. THE FEDERAL RULES The method adopted by the Department mirrors the general rule set forth in Treasury Regulations, effective for federal income tax purposes beginning in 2006 for determining the source of multi-year compensatory option income for services performed by nonresident aliens within and without the United States. In general, the federal method is a time-based approach over an “applicable period,” where the applicable period is determined on a “facts-and-circumstances basis.” In regard to option income, the facts and circumstances are presumed to relate to an applicable period consisting of the period between the grant of an option and the date of vesting of the option. Specifically, Regulation section 1.861-4(b)(2)(ii)(F) states: Multi-year compensation arrangements: The Source of multi-year compensation is determined generally on a time basis, as defined in paragraph (b)(2)(ii)(E) of this section, over the period to which such compensation is attributable. For purposes of this paragraph (b)(2)(ii)(F), multi-year compensation means compensation that is included in the income of an individual in one taxable year but that is attributable to a period that includes two or more taxable years. The determination of the period to which such compensation is attributable, for purposes of determining its source, is based upon the facts and circumstances of the particular case. For example, an amount of compensation that specifically relates to a period of time that includes several calendar years is attributable to the entirety of that multi-year period. The amount of such compensation that is treated as from sources within the United States is the amount that bears the same relationship to the total multi-year compensation as the number of days (or unit of time less than a day, if appropriate) that labor or personal services were performed within the United States in connection with the project bears to the total number of days (or units of time less than a day, if appropriate) that labor or personal services were performed in connection with the project. In the case of stock options, the facts and circumstances generally will be such that the applicable period to which the compensation is attributable is the period between the grant of an option and the date on which all employment-related conditions for its exercise have been satisfied (the vesting of the option). Although the general allocation sourcing rule set forth above is substantially similar to the new sourcing rule set forth in the N.Y. Option Income Allocation Rules the federal provision by its terms is a “facts and circumstances test.” As discussed above, the Department therefore takes the position that the federal rule “does not entirely duplicate the IRS sourcing rule, which provides a great deal of flexibility dependent upon an individual’s facts and circumstances.” As such, federal authority may not be extremely helpful when challenging or substantiating a taxpayer’s allocation position on the state level. The Treasury Regulations were recently promulgated, and there has been as yet no further guidance from the Service discussing their application to specific taxpayers. Taxpayers and their counsel can however look to rulings issued by the Service that predate the regulations, where it adopted the same approach. Significantly, in 2005, the Organization for Economic Cooperation and Development (OECD) issued an updated version of its model treaty (the Model Tax Convention) and commentary. Included within the updated commentary are recommendations for common tax treaty approaches to employee stock options. With respect to employment services that are provided in more than one country, the commentary provides that “the only days of employment that should be taken into account are those that are relevant for the stock option plan, e.g., those during which services are rendered to the same employer or to other employers the employment by whom would be taken into account to satisfy a period of employment required to acquire the right to exercise the option.” Thus, the OECD also chose the grant-to-vesting period as the “most appropriate one” when an allocation is necessary as a result of the performance of services in multiple jurisdictions. It will be interesting to see how many international jurisdictions adopt this method. Within the same month that the OECD adopted its commentary, Belgian Tax Authorities aligned their commentary to reflect the grant-to-vesting rule. V. EFFECT ON TAXPAYERS, MULTISTATE EMPLOYERS, AND OTHER STATES The number of working days within and without New York between the date of grant of statutory stock options, nonstatutory stock options with no readily ascertainable value and stock appreciation rights, and the date the options and rights are vested has significant consequences for tax year 2007 (for tax year 2006 the consequences are less significant since taxpayers have a choice) and subsequent years for nonresident employees and part-year employees. The key questions that should be considered in connection with such day counts are whether and how such employees who have as yet unvested options and, employees who relied on the former regulations, or the 1995 Memorandum, and contemplated that days between vesting and exercise would “count,” should be subject to tax in New York. If an employee limits the number of working days in New York for the entire grant-to-vesting period, then a limited amount of the option income would be subject to New York tax. However, the employee might not have much flexibility in limiting the number of days spent in New York during this period, since it is the period during which all employment-related conditions must occur to allow the employee the right to exercise the options. Presumably, the grant of an option to purchase the employer’s stock as compensation for services rendered in New York assumes the performance of services in New York. Accordingly, if the employee is to achieve the economic advantages of the grant of the options (that is, participation in the appreciation in the stock’s value that occurs from the date of grant), the employee must perform services wherever the employer expects, including in New York. As such, it may be difficult for employees to limit their New York tax exposure, unless the employer allows the employee to primarily perform services outside New York during the entire grant-to-vest period. It is also important to note New York’s general wage allocation rules which employ a “convenience of the employer” test under which all of the employee’s income may be allocated to New York, unless the employee is able to prove that he or she performed work away from the employer’s location due to employer necessity. The convenience of the employer test is often juxtaposed with the “physical presence test” where employee income is allocated to the employee’s location at the time the work was performed. Although the Department has recently revised, and more importantly relaxed, its position concerning the application of the convenience of the employer test to certain nonresident and part-year resident telecommuters and other nonresidents and part-year residents that meet certain requirements, the new regulations do not expressly or impliedly adopt the favorable position. Instead, the new regulations direct taxpayers to the regulation that imposes the convenience of the employer test for guidance on determining how to compute the day count (i.e., the New York work day fraction) under the regulations. This means that “the number of days worked in New York” under the N.Y. Option Income Allocation Rules is likely subject to the convenience of the employer test, and not based purely on the taxpayer’s physical presence. Thus, certain days that a taxpayer asserts are non-New York days based on the taxpayer’s physical presence in another state, may be challenged by the Department on audit and recharacterized as New York days, on the basis that the work was done outside New York for the convenience of the employee. Once again, the Department has implemented its changes to the state’s general wage allocation rules, through the issuance of a Technical Service Bureau Memoranda, rather than through the promulgation of regulations. As such, courts may narrowly decide that the Department’s revised “convenience of the employer” position does not apply in the area of stock option income taxation, or more broadly decide, as in Stuckless, that the Department has no statutory or regulatory authority to apply such rules on taxpayers. Under either scenario, the taxpayer may be precluded from determining its day count based on physical presence, unless the taxpayer provides documentation to support presence outside the state due to employer necessity. Since the 2006 Memorandum does not specifically address the issue, it seems likely that the Department would apply the convenience of the employer test to all open years when determining the portion of option income that should be allocated to New York. Notwithstanding the above, taxpayers and their counsel should be pleased that the Department issued the 2006 Memorandum because it provides a practical and flexible approach for determining the amount of option income allocable to New York for tax years prior to tax year 2006. As discussed above, taxpayers can apply the rule of Stuckless II (day count during the year of exercise), or can follow the 1995 Memorandum Allocation Methodology for tax year 2005 and earlier open years. In light of this option, taxpayers and their counsel should perform both calculations, to determine what position should be advocated on audit (if applicable), or to determine whether a claim for refund for tax paid to the state should be pursued. In general, under New York law, a claim for refund must be filed within three years from the date the tax return was filed or two years from the date the tax was paid, whichever period expires later. If the taxpayer did not file a tax return, then the claim for refund must be filed within two years from the date the tax was paid. Further, the amount of the refund may not exceed the amount of tax paid within the applicable two-or-three year period preceding the filing of the claim. To succeed, the taxpayer must provide sufficient documentation to the Department to prove his or her days worked inside and outside New York for the relevant period. Similarly, on a going forward basis, taxpayers should ensure that they retain the proper records to document their working days within and without New York during the period from grant to vesting for the options or rights. Since the allocation period set forth in the new regulations spans a lesser period of time than the 1995 Memorandum Allocation Methodology, most nonresident employees who have already received their compensatory options and rights should not be significantly affected by the recordkeeping, given that they already had a duty under New York law to keep track of their working days within and without New York for this period and for general wage allocation purposes. Residents, however, persistently suffer from a lack of knowledge of their recordkeeping obligations. If the Stuckless saga does no other good, perhaps it serves as a wake up call to employees who are granted options while residents of New York, but might eventually exercise them while resident elsewhere. Specifically, residents of New York who have been compensated with options in exchange for services rendered in New York should obtain and retain diaries, expense reports, and other records necessary to document their working days within and without New York during the period from grant to vesting if there is any chance they might change their state of residence prior to the exercise of their options. There are tax consequences to the employer, as well as the employee, as a result of these developments. The employer’s primary tax concern is whether it has withheld the proper amount of tax due. Under New York law, an employer is required to withhold an amount that is “substantially equivalent” to the amount of tax due. An amount calculated under the old rules (which as noted are not themselves all that clear) may not sufficiently satisfy the employer’s New York withholding tax duties under the new rules. Employers should therefore review and revise their practices to capture the specific period mandated in the final regulations: grant-to-vesting. In addition, employers may wish to inform their employees of the new rules, to alert them to the recordkeeping necessary to comply with New York’s tax laws. A different problem lies with other states that currently employ an allocation approach different from grant-to-vesting. If these states do not revise their rules, (based, for example, on the justifications articulated by New York, the Service and the OECD) then there is a potential for mismatch. Specifically, if the source state (New York) and the state of residence (Connecticut) use different fractions for determining the amount of the New York source income, then (rate differences aside) the credit allowed by the state of residence could be more or less than the tax imposed by a source state. For example, if an employee has 300 New York workdays out of a total 600 work days from grant to vesting, New York will tax one-half of the option income. But if that same employee works 400 days in New York out of a total 1,000 days between grant and exercise, Connecticut would consider only 40% of the income as New York sourced. In that case, 10% of the income might be double taxed. Given the vast amounts of income generated by stock options these days, this is a potentially very real problem. States that do not currently have option income allocation rules may wish to promulgate regulations, and hope to avoid the Stuckless mess. Similarly, it may be prudent for taxing authorities in other states to formalize their policies currently set forth in technical memoranda or opinions, through formally promulgated regulations. This would allow courts and other administrative tribunals the opportunity to defer to such policies, provided they are reasonable and within the scope of the relevant statute under which they are promulgated. It would also, very importantly, allow taxpayers the opportunity to comply with the law, since taxpayers would understand the taxing authority’s interpretation and approach to enforcement of the law. VI. CONCLUSION There are several relevant time periods when a state may impose tax on the benefits resulting from stock options, stock appreciation rights and restricted stock. These include taxing the employee on the date of grant, the date of vesting, the date of exercise, or the date of the sale of the underlying stock acquired under the options. There also are legitimate questions regarding the portion of the employee’s income that should be considered compensation income, versus investment income. While interesting, these questions are not the primary focus of this Article, but are considered in a limited fashion inasmuch as they were addressed in Michaelson and Stuckless, and involve the same theoretical issues that states and taxpayers must consider in determining the proper amount of income that should be allocated to a particular state, when the taxpayer has performed servi