SALT in the Wound: New York Imposes Shareholder-Level Tax on Corporate Asset Sale

Background
The shareholders owned stock in a corporation, which we’ll simply call “Target.” Two of the Target shareholders were New York nonresidents. Target conducted its business in multiple states, including New York. Its New York allocation percentage was approximately 6.5%.

Target elected to be treated as an S corporation for federal income tax purposes. It did not, however, elect to be treated as an S corporation for New York tax purposes. This hybrid status alleviated the need for the New York nonresidents to file New York income tax returns. This tax planning was thoughtful.

In 2020, Target sold its business for $57.7 million to a third party. The parties elected to treat the business sale as a disposition of assets by making an election under IRC § 338(h)(10). Target recognized $44.5 million of gain from the sale of its goodwill in the deemed asset sale. Target paid $185,352 in New York taxes on the 6.5% portion of the gain allocable to New York.

Applicable Law
Under N.Y. Tax Law § 660(i), a federal S corporation that has not elected New York S corporation status is deemed to have made that election if more than 50% of its federal gross income constitutes “investment income,” which includes gains “derived from dealings in property,” to the extent includable in federal gross income.

The Administrative Law Judge’s Determination
The sole issue before the Administrative Law Judge (ALJ) was whether the gain from the sale of Target’s self-created goodwill qualified as “investment income” under N.Y. Tax Law § 660(i)(3). The taxpayers argued that, because the transaction was treated as an IRC § 338(h)(10) deemed asset sale, the goodwill should be characterized as an IRC § 1231 business asset under federal law, and therefore the gain should be treated as business income—not investment income—for New York purposes.

The ALJ relied on the New York State Tax Appeals Tribunal’s (Tribunal) binding decision in Matter of Lepage, which held that “gains derived from dealings in property” under N.Y. Tax Law § 660(i)(3) include gains from the sale of goodwill. Although the statute does not define this phrase, federal regulations broadly interpret it to include gains from the sale or exchange of both tangible and intangible property, including goodwill. Consistent with New York’s conformity to federal tax law, the Tribunal applied this federal definition and concluded that such gains constitute investment income regardless of whether the underlying business is active or passive, rejecting arguments that the term is limited to passive income.

Once the ALJ found that the goodwill gain was investment income, the remaining question was whether that income exceeded the 50% threshold for a mandatory New York S corporation election. Taking the goodwill sale into account, Target’s investment income was approximately 81.82% of its federal gross income—well above the 50% threshold. As a result, Target was deemed to have made a New York S corporation election, causing its income to flow through to its shareholders, including the New York source income. Each shareholder was then taxed on his share of the goodwill gain allocable to New York (the 6.5% noted above).

Conclusion
Petosa highlights a significant planning risk for nonresident shareholders of federal S corporations that have not elected New York S corporation status. Under Lepage and Petosa, M&A transactions—particularly IRC § 338(h)(10) deemed asset sales—that generate substantial goodwill or other intangible asset gains can trigger a mandatory New York S corporation election if those gains exceed 50% of federal gross income, resulting in a conversion of otherwise deductible New York corporate taxes into non-deductible shareholder level taxes. This risk is especially pronounced in short tax years, where transaction-related gain may dominate federal gross income and make the threshold difficult to avoid.

Last, we note that a New York pass-through entity tax (PTET) election would not have been available in this case. New York allows a PTET election for S corporations only if all shareholders are New York residents.

^{[1] The decision involved only two of the three shareholders. The total New York tax bill was determined by extrapolation.}

^{[2] See Section 164(b)(6) of the Internal Revenue Code of 1986, as amended (IRC), prior to the enactment of the One Big Beautiful Bill Act.}