Defending New York Residency Audits that Target Capital Gains

By:
Jack Trachtenberg, Esq.
Published Date:
Feb 1, 2014

It is no secret that New York maintains one of the most aggressive residency audit programs in the country. By some accounts, the New York State Department of Taxation and Finance generates more than $300 million per year in personal income tax revenue to a large extent by challenging the residency status of taxpayers who claim to have made their homes in other states. The largely subjective nature of the inquiry, combined with a high burden of proof for the taxpayer and frequent lack of available records to meet that burden of proof, feeds the aggressiveness of the department’s efforts to collect revenue. CPAs should be aware of the department's history and policies in this area.

In most residency audits, the department will assert that taxpayers continue to owe New York resident tax on 100 percent of their worldwide income (including investment income) because the taxpayers have failed to prove a change of domicile to another state. This line of attack questions the taxpayers' subjective intent to make the asserted new domicile their “permanent home.” Additionally, the department frequently falls back on New York’s statutory residency provisions, which allow the department to assert resident taxation if the taxpayer: (i) maintained a permanent place of abode in the New York for substantially all of the tax year and (ii) spent more than 183 days in the jurisdiction. (See Matter of Newcomb, 192 N.Y. 238; see also N.Y. Tax Law § 605(b)).

Targeting Capital Gains

Among the department’s favorite targets are taxpayers who have claimed a change of domicile from New York to Florida, which is a popular destination for former New Yorkers due, in part, to the state’s lack of an income tax. New York also aggressively pursues taxpayers who claim a change of residence from New York City—which imposes its own income tax—to nearby surrounding areas (e.g., Long Island, Westchester or Connecticut), especially when the taxpayer maintains an apartment or condominium in the City and continues to commute to the City for employment.

Taxpayers in these categories become particularly attractive audit targets when their change of residency is followed by a transaction in which the individual recognizes large capital gains. The department pursues these individuals because nonresidents generally do not pay New York state income tax on capital gains. If the department succeeds in classifying the taxpayer as a resident in the year in which the capital gain is recognized, it may tax the entire gain. Similarly, under New York’s “accrual rule,” if the taxpayer elects to recognize the gain from a transaction on an installment basis, the department may be able to tax each installment payment if it can successfully assert residency against the taxpayer in the year in which the transaction originally occurred. This may be true even if the future installment payments were made in years in which the department agrees the taxpayer was a nonresident. (See N.Y. Tax Law § 639).

The department’s Nonresident Audit Guidelines (the “Guidelines”), which were amended in June 2012, direct the department’s auditors to pay special attention to taxpayers who recognize large capital gains “immediately” after a reported change of domicile:

Past audit experience has identified many taxpayers who have claimed a change in domicile immediately prior to the occurrence of a large capital gain. As a nonresident, a taxpayer generally avoids paying New York State income tax on capital gains. Large capital gains are uncommon, and often the only change in lifestyle demonstrated by the individual is the fact that a substantial gain was realized in the year of, or immediately after, the alleged change of domicile.

(New York State Department of Taxation and Finance, Nonresident Audit Guidelines (June 2012) page 80, (emphasis added)).

The language of the Guidelines raises a couple of interesting points. First, it is not clear what the department will consider to be “immediate” when deciding whether an asserted change of domicile was motivated solely by a pending capital gain transaction. In some cases, the department has sought to challenge a taxpayer’s change of domicile where the capital gain was recognized only days, weeks or months after the change of domicile. However, in my experience, the department’s auditor will question the taxpayer’s intent and motivations, and aggressively pursue residency, whenever a large capital gain is recognized during the traditional three-year audit cycle. Indeed, since a taxpayer’s New York domicile continues under the law until the taxpayer has proven otherwise, auditors will frequently pursue residency during an audit cycle in which there are no capital gains so that they can try and capture any income arising in a later audit cycle.

The Guidelines also suggest the department does not think highly of any taxpayer’s ability to prevail in defending an asserted change of domicile that it believes is motivated by a desire to avoid tax on capital gains. The courts, however, have long recognized the right of a taxpayer to “change his or her domicile for the purpose of avoiding taxation.” (Andrews v. Graves, State Tax Comm’n, 32 N.Y.S.2d 352 (1942), aff’d by 288 N.Y. 660 (1942)). Moreover, in my experience, these cases are readily defendable precisely because the lifestyle of the taxpayer often changes significantly in connection with the event that gives rise to the capital gain (e.g., the sale of a business).

Keys to Success

The likelihood of a taxpayer prevailing in any residency audit, but particularly one in which large capital gains are at stake, is enhanced if the taxpayer undertakes suitable planning in advance of the transaction that will produce the capital gain. Moreover, for taxpayers who are under audit, success depends heavily on a proper handling of the substantive and procedural aspects of the audit and any administrative appeals.

To establish a change of domicile, taxpayers must demonstrate a change of lifestyle such that their subjective intent to make a new location their permanent home is shown by objective evidence. Toward this end, New York now looks to five primary factors:

1. Home Factor – Where does the taxpayer maintain his or her bigger, nicer, more expensive home?

2. Business Factor – Where does the taxpayer’s active business involvement take place?

3. Time Factor – Where does the taxpayer spend the majority of his or her time?

4. Near and Dear Factor – Where does the taxpayer keep his or her sentimental or valuable belongings?

5. Family Factor – Where does the taxpayer’s spouse or partner live? Where do their minor children live and attend school?

The law does not require that a taxpayer sever all connections with New York in order to effectuate a change of domicile. (See Matter of Charlotte Gemmel, Division of Tax Appeals, DTA No. 819222 (Nov. 2004) (holding that “while petitioner unquestionably retained ties to New York during the years at issue, such ties did not preclude her from changing her domicile to California”)). Nonetheless, the fewer ties that a taxpayer retains in New York (and the more ties he or she establishes in the new domicile), the stronger the case will be. Depending on particular circumstances, a taxpayer intending to establish a domicile outside of New York should consider a variety of steps in connection with the five primary factors set forth above:

  • The taxpayer should consider selling his or her historical New York home and at least downsizing to something more suitable for occasional visits to the state. Renting the historical New York home may also be an option. If possible, any new home acquired in New York should be rented as opposed to purchased.
  • Active business involvement in New York should cease or be reduced. Work should be done outside of the state as much as possible. Executives should reduce their day-to-day involvement and take on a more limited role as a consultant or independent contractor if feasible.
  • The taxpayer should reduce the amount of time spent in New York and spend as much time in the new domicile as possible. This is especially true for weekends, holidays, and special occasions (e.g., birthdays and weddings).
  • Personal items, especially those with monetary or sentimental value, should be moved to the new domicile.
  • Spouses or partners and minor children should relocate to the new domicile or spend as much time in the location of the new home as possible.

Equally important to successfully defending against a residency audit is maintaining records to substantiate the taxpayer’s affirmative actions in connection with the domicile factors above. By way of example, taxpayers should retain closing documents related to the sale of their New York residence, purchase or lease agreements for the downsized New York home, employment agreements documenting a reduction in active business involvement in New York, moving records and insurance documents showing the relocation of personal items, as well as records documenting the taxpayer’s presence in and out of New York (e.g., credit card statements, travel records, and business diaries). Records establishing physical presence within and without New York are also crucial to establishing that the taxpayer was not present in New York for more than 183 days in connection with the statutory residency test described above.

In addition to taking affirmative actions with respect to the five primary domicile factors, taxpayers wishing to establish a domicile outside of New York should attend to other formalities that reflect their new domicile. This includes filing tax returns using the address of the new domicile, executing new wills that recite the location of the new domicile, filing declarations of domicile in the new home state, notifying social and religious organizations of the change of domicile and changing membership records to reflect nonresident status, obtaining a driver’s license and registering vehicles in the new state of domicile, opening personal checking and savings accounts, changing voter registration to the new home state, and moving professional relationships (e.g., doctors, lawyers and accountants) to the new state of domicile.

While these formalities are not viewed by New York as being dispositive of a domicile change, the failure to undertake them can be fatal. (See Matter of Kartiganer v. Koenig, 194 A.D.2d 879 (App. Div. 1993) (holding, “although petitioners make much of the fact that they registered to vote, obtained driver's licenses and filed tax returns in Florida, these factors are not dispositive.”) seealso Matter of Gray v. Tax Appeals Tribunal, 235 A.D.2d 641 (App. Div. 1997) (holding taxpayer’s declaration of domicile, driver’s licenses, voter’s registrations, social organization memberships, medical care, and charitable contributions to Florida insufficient to overcome New York business ties)).

Taxpayers who are under audit can enhance their chances of success by coupling the ability to produce documentation with a strategic handling of the audit and appeal process. The goal is to discourage auditors from going on fishing expeditions designed to uncover any shred of evidence that supports what may seem to be a preconceived determination of the taxpayer’s residency status. The taxpayer should be responsive to the auditor’s inquiries, but must control the flow of documentation so that the individual items of information are given context and a meaning that is consistent with the taxpayer’s change of lifestyle, motivations and intention to establish a new domicile.

Taxpayers must also be prepared to provide credible testimony, especially if the matter proceeds to an administrative appeal or litigation. Because domicile centers on the taxpayer’s intent, a failure to provide credible testimony supported by documentation can lead to adverse results. In a recent case—involving a taxpayer that recognized a $2 million capital gain shortly after claiming a change of domicile from New York to Tennessee—the taxpayer lost in large part because of a lack of credible testimony supported by adequate documentation. According to the court:

[The taxpayer’s] overall credibility was undermined by the lack of evidence to corroborate much of her testimony, her vague and evasive testimony regarding certain key facts, as well as some conflicting testimony given by her boyfriend. [Consequently, the taxpayer] did not meet her burden to demonstrate by clear and convincing evidence ‘an absolute and fixed intention to abandon [her New York domicile] and acquire another.’ (Matter of Ingle v. Tax Appeals Tribunal, 110 A.D.3d 1392 (App. Div. 2013))

While testimony can be crucial to establishing a change of domicile, taxpayers must be cautious, providing written or oral testimony only at the appropriate stage of the audit or appeal, and only under circumstances that are appropriately protective of the taxpayer. (Testimony may also be crucial to establishing the taxpayer’s pattern of travel and physical presence in various locations so as to avoid taxation as a statutory resident of the state.) If taxpayer testimony is contemplated as part of an audit or appeal, it may be in the taxpayer’s best interest to engage legal counsel (if counsel has not already been engaged), to ensure the taxpayer is advised of their legal rights and any privileges that may bar certain lines of inquiry.

New York is aggressive when it comes to challenging the residency of taxpayers who have claimed to move to other states. This is especially true where the taxpayer has changed domiciles before the recognition of large capital gain income. Taxpayers anticipating such a situation should consult with their tax advisor in advance to ensure that appropriate residency planning is undertaken. Taxpayers who are under audit should ensure that they are properly represented to protect their interests and help navigate the sometimes difficult substantive and procedural aspects of a residency audit.



Jack Trachtenberg, JD, is Counsel in the State Tax Group at Reed Smith LLP in NewJack Trachtenberg, Esq.
 York City. Previously, Mr. Trachtenberg served as New York State’s first Deputy Commissioner and Taxpayer Rights Advocate at the New York State Department of Taxation and Finance. He can be reached at 212-521-5414 or jtrachtenberg@reedsmith.com.

 
Views expressed in articles published in Tax Stringer are the authors' only and are not to be attributed to the publication, its editors, the NYSSCPA or FAE, or their directors, officers, or employees, unless expressly so stated. Articles contain information believed by the authors to be accurate, but the publisher, editors and authors are not engaged in redering legal, accounting or other professional services. If specific professional advice or assistance is required, the services of a competent professional should be sought.