On May 17, 2021, the New York Tax Appeals Tribunal (“Tribunal”) held that when determining whether a New York C corporation must mandatorily elect to be treated as an S corporation as a result of the investment ratio test provided by New York Tax Law § 660(i), such test requires that “federal gross income” adopt the same definition as is provided under the Internal Revenue Code (“IRC”) and as is reported on federal returns for the corporation.

In 2012, a third-party acquirer purchased from taxpayers all of the outstanding shares of Lepage, Inc. and Bakeast, Inc. Both Lepage and Bakeast had elected to be treated for federal income tax purposes as subchapter S corporations.  However, neither entity filed New York S corporation elections. In connection with the sales, valid elections under IRC § 338(h)(10) were made and thus the sales were treated as deemed asset sales by Lepage and Bakeast followed by a liquidating distribution of the consideration to the taxpayers.

After audit, the Division of Taxation (“Division”) concluded that under NY Tax Law § 660(i), both Lepage and Bakeast should be treated as New York S corporations for tax year 2012. NY Tax Law § 660(i) includes an investment ratio test whereby a New York S corporation election is mandatory if a federal S corporation’s investment income in a taxable year exceeds 50% of its “federal gross income” for that year.  Because the sales of Lepage and Bakeast were treated as asset sales under IRC § 338(h)(10), the Division concluded that portions of the gain from such sales that met the definition of investment income were included in the determination of federal gross income of Lepage and Bakeast. As a result of including these amounts in federal gross income, both Lepage and Bakeast exceeded the investment ratio for 2012 and thus the Division asserted they should be treated as New York S corporations.

Taxpayers argued that Lepage and Bakeast did not exceed the investment ratio and therefore the criteria for the mandatory New York S corporation election had not been met.  As part of their argument, the taxpayers asserted that the term “federal gross income” should not include income that would not have been included in federal gross income if the corporations were treated as C corporations for federal income tax purposes.  Although both Lepage and Bakeast reported gains from the asset sales when reporting federal gross income at the federal level for purposes of reporting income apportioned to New York, both Lepage and Bakeast reported amounts for federal taxable income that had been reduced by the gain from the deemed asset sales. Taxpayers justified the reduction, arguing that, because Lepage and Bakeast were C corporations within New York, for purposes of the calculation under NY Tax Law § 660(i) their “federal gross income” should be limited to items that would be counted as “federal gross income” as if the corporations were treated for federal income tax purposes as C corporations as well.  Taxpayers further argued that NY Tax Law § 660(i) should follow a similar standard and the meaning of federal gross income should be limited to only amounts that would be treated as federal gross income if the corporation were treated as a C corporation for federal income tax purposes.

The Tribunal rejected the taxpayers’ arguments, stating that nothing in NY Tax Law § 660(i) indicated that “federal gross income” should be so limited.  The Tribunal upheld the determination that New York S corporation status was mandatorily elected for both Lepage and Bakeast and thus taxpayers were subject to liability as S corporation shareholders on the gains from the sales.