Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
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*
* Counsel, Roberts & Holland LLP, New York, State and Local Tax Practice Group.
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 interpretations of the relevant statutes and regulations. Other states may be stuck with results far worse than New York’s Stuckless scenario.