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SALT TALK: May the Source Be with You – NY Nonresident Subject to Tax on Litigation Settlement

Posted by Wayne Berkowitz CPA, J.D., LL.M. on Jan 3, 2017 1:00:00 PM
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Having already surpassed $600 million at the box office, it’s no surprise that the New York State Tax Appeals Tribunal is looking to Rogue One and the Star Wars franchise for guidance. Case-in-point, the Tribunal’s recent decision[1] confirming a New York nonresident individual’s source income will always be with them. The unpleasant experience of one couple plainly points to the absolute necessity of planning for the state tax consequences when settling a lawsuit. 

Meet the Murphys.

As nonresidents of New York, these husband and wife taxpayers were subject to tax on only their New York source income. Mr. Murphy was a member in an LLC that conducted a portion of its business in New York and, accordingly, had New York source income during its years of operation. Mr. Murphy assigned his LLC interest to Mrs. Murphy during 1999. Various issues arose with the LLC and Mrs. Murphy started legal action against the LLC.

As a result of the litigation, Mrs. Murphy was awarded over $1 million as profit distributions for the years 2000 through 2004; as well as other amounts of approximately $2 million representing compensation for her equitable interest in the LLC. The Court also made provisions for Mrs. Murphy to receive pre- and post-judgment interest on these amounts.

As often happens in litigations, Mrs. Murphy ultimately agreed to settle with the LLC for a total amount of $2.1 million of which $0.6 million was allocated as payment for the LLC interest and the remainder as unspecified. Accordingly on their 2007 federal income tax return, the Murphy’s treated the $0.6 million as capital gain and the remainder as ordinary income. However, on their New York State nonresident income tax return, none of the $2.1 million was treated as New York source.

The Murphy’s had several creative arguments, among them:

  • Intangible income is generally not sourced to a nonresident state;
  • Murphy was “assigned” the LLC interest, and not being a member, could not receive a profits interest,
  • Much of the $2.1 million was interest income which had no New York source

Nevertheless, the Tribunal rejected them all.

Ultimately, the Tribunal held that the proper analysis in determining the source of payments in litigation is to look at “in lieu of what” the payment was made. The settlement made it clear that all but the $0.6 million allocated to compensation for the LLC interest was to compensate Mrs. Murphy for profits (“in lieu of”) earned by the LLC during periods it was conducting business in New York and as such must be treated as New York source income.

So while “the source” clearly remains with Mr. and Mrs. Murphy, what could they have done differently to minimize the overall state tax burden? First and foremost, before taking any apportionment position, any credit received in the resident state must be analyzed.  Second, when settling any litigation, state tax considerations must not be forgotten. Clearly a greater, but still reasonable, allocation to the LLC interest rather than to past earnings would have reduced the New York tax liability. Also, the court decision provided for interest income, which would not have been New York source, yet the settlement agreement ignored this fact and no provision was made for interest. 

Questions on approaches to sourcing income? Contact me at WBerkowitz@BerdonLLP.com or your Berdon advisor.

Wayne Berkowitz, a tax partner and head of the State and Local Tax Group at Berdon LLP, advises on the unique requirements of governments and municipalities across the nation.

[1] In the Matter of James B. and Jane S. Murphy (NYS TAT DTA 825459, December 16, 2016).

Topics: SALT TALK

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