Earlier this month, I was invited to present on the topics of domicile and stock options to the New Jersey Society of CPAs. More than 100 representatives of small businesses, accounting firms, and law firms were in attendance. Stock options are increasingly used as a means of compensation. When income is realized by an individual related to past services, it may be taxable to a state whether or not the individual is currently a resident. For the individual, minimizing state income taxes, and properly reporting to the state where income was earned is important. Equally, from the standpoint of the company, state income tax withholding issues should be addressed.

1. NJCPA Society
Annual Tax Seminar
November 4, 2017
Residence and Domicile – Principles and Practice
State Taxation of Stock Options
Stephen J. Bercovitch, J.D.

2. Agenda
1. Domicile
2. Equity based compensation
3. Case study
4. Q & A

3. Domicile
Changing domicile and residences

4. Where is home to you?
 States tax their residents on all of their income regardless of its
source.
 Generally income recognized by an optionee upon exercise of an
option and sale of the stock acquired will be taxed by the state of
residence at the time of the exercise and sale.
 You can have more than ONE residence, yet ONLY ONE domicile.
 Your domicile remains the same until you affirmatively abandon it and
acquire a new one with the intention of making the new location your
permanent home
 See, New York State Nonresident Audit Guidelines, June 2014:
 https://www.tax.ny.gov/pdf/2014/misc/nonresident_audit_guidelines_2014.pdf

5. Domicile & Equity
Compensation
 When the optionee performed services in New York, the State has
asserted its jurisdiction to tax the compensation income of a non-
resident.
 With a change of domicile out-bound, taxability (income recognition) may
occur during non-residence whereas the compensation was earned during
the period of residence.
 Issues are two-fold:
 Was there a bona fide change of domicile; and
 If yes, then what is the method applicable to the type of equity compensation
for New York State or New Jersey sourcing of the income
 Also:
 What type of record keeping is advisable

6. Spouses and Separate Residence Status
 One spouse (i.e. the optionee spouse) may be a bona fide non-resident, and have
income that can be treated under non-resident sourcing rules, whereas the other spouse,
who may not have received a large amount of income, may be a statutory resident in-
State for more than 183 days.
 Under Common Law: When a woman married she automatically lost her old domicile and acquired the
domicile of her husband.
 New York State: Domestic partner was able to prove change of domicile to California, spouse remaining in
New York State (Petition of Charlotte Gemmel, Docket 819222, New York Division of Tax Appeals, ALJ
Determination, 1/10/2004
 New York Reg. Section 111.2(d) “Husband and wife with different resident status.”
Yes! Spouses can file joint federal, separate NYS tax returns.

7. Spouses and Separate Residence Status
 New Jersey – Allows joint federal, separate state returns when spouses
have different filing status (see, New Jersey Division of Taxation,
Bulletin GIT-4, Filing Status, Rev. 12/16)
 Married couples filing a joint return must file a joint NJ return in most
cases.
 If during the entire tax year one spouse was a resident of New Jersey
and the other a nonresident, the resident may file a separate New
Jersey return, if required.
 The nonresident spouse may also have to file a nonresident return if
income was received from a New Jersey source.

8. What you need to know…
 What to do and not do in order to help prove that a bona fide change of
domicile has occurred.
 Determining factors for tax purposes:
 What is the use pattern in terms of “lifestyle?”
 Items “near and dear”.
 Family ties, holidays, hobbies
 Taxpayer’s intent?
 Where the historical domicile is not sold, the State will compare size and value
to the Florida home.
 Business ties to the legacy state.
 Number of days spent in each state is a prominent consideration.
 Retention of a residence in NY/NJ is not, by itself sufficient
evidence to negate change in domicile to (for example) Florida.

9. Equity based
compensation
Taxation of a non-resident when the
compensation was earned at the time of
residence

10. Stock Option Compensation
 Compensatory stock options typically take the form of incentive stock options
(“ISOs”) issued to employees, which must meet the criteria set forth in
Section 422 of the Internal Revenue Code, or nonqualified stock options
(“NSOs”) issued to employees and other service providers, which are not
required to meet such criteria. The tax treatment to both the granting
employer and the option holder varies depending on whether the options are
ISOs or NSOs.
 Income inclusion:
 With some exceptions, neither type of option is taxable at the time of
grant
 Thus taxability (income recognition) may occur during non-residence,
whereas the compensation was earned during residence.
 Issue: non-resident state sourcing of stock option compensation

11. Stock Option Compensation - ISOs
 With respect to an ISO, neither the grant nor exercise of an ISO generally
gives rise to a taxable event.
 But there is an alternative minimum tax (“AMT”) adjustment when an ISO is
exercised, assuming the stock received on exercise is vested. In addition, if
the stock received on exercise of an ISO is held until the later of (1) one year
from the date the ISO was exercised and (2) two years from the date the ISO
was granted, then the employee is generally taxed at capital gain rates on
the future disposition of the stock.
 If there is a disposition of the stock before these holding period requirements
are met (i.e., a “disqualifying disposition”), the stock transfer causes a
taxable event in the calendar year of the disqualifying disposition and the
employee may recognize a portion of the spread as ordinary income.
 The employer must report the exercise of an ISO by filing Form 3921, Exercise
of an Incentive Stock Option Under Section 422(b), with the IRS and furnishing
the form to the employee for the year the ISO is exercised.

12. Stock Option Compensation - NSOs
 The tax treatment of NSOs is generally governed by Section 83 of the IRC,
unless Section 409A applies. Under Section 83, the timing of income inclusion
depends on whether the option has a readily ascertainable fair market value
(“FMV”) when the option is granted.
 If the option does have a readily ascertainable FMV, the option is taxable at
grant. However, U.S. stock options issued to employees seldom have a FMV
that meets the definition of “readily ascertainable.” If an option fails to
meet this definition (that is, the option is deemed not to have a readily
ascertainable FMV at the time of grant); of if the option is issued “under
water”, the option becomes taxable at exercise.
 In our case study, Mr. Lucky’s NSOs were exempt from Section 409A.

13. New York State Sourcing Rules – Non-
Residents
 In comprehensive guidance, New York State established the sourcing rules
for allocation of stock options, see New York State Tax Treatment of Stock
Options, Restricted Stock, and Stock Appreciation Rights Received by
Nonresidents and Part-Year Residents, TSB-M-07-7(I), October 4, 2007
 New York adopts the federal treatment of stock options, since federal
adjusted gross income is the starting point for computing a taxpayer's New
York net income, and terms used in the New York and U.S. tax laws are
construed to mean the same thing when used in a comparable context
[N.Y.Tax Law §607]
 Section 601(e) of the New York Tax Law imposes a personal income tax on
the portion of a nonresident individual's taxable income that is derived from
New York sources.

14. New York State – Workday fraction
 In the case of a nonresident individual who works in New York State
• The portion of the individual's compensation related to stock options, restricted
stock, and stock appreciation rights that is New York source income is determined
by multiplying such compensation by the New York workday fraction.
 The allocation period may span multiple years and may include periods in which the
nonresident was formerly a New York State resident.
 The allocation period for a statutory and non-statutory stock option = period of time
beginning with the date the option was granted and ending with the date the option
vested.
 For a nonresident, calculate the workday fraction from grant to vesting.
 “if the option vested at the time it was granted, the allocation period is the same
period of time that applies to regular, non-stock-based remuneration from the grantor
during the taxable year the option was granted.”
 Employee may change domicile: Residents may or may not track their workdays during
the period of resistance

15. New Jersey Rules
 Much less elaborate guidance compared with New York. No “audit
guideline”, little no litigation or policy bulletins.
 The taxability of incentive stock options is simply based on the federal
treatment. Incentive stock options may be received and exercised by an
employee without recognizing any gain. If the requisite holding period is
met, the taxable event is the sale of the stock, and gain or loss will be
realized to the extent of the difference between the option price and the
sale price of the stock. [New Jersey State Tax News No. 3, 11/01/2007]
 Based on the above guidance on incentive stock options and employee
stock purchase plans, compensation from a non-statutory stock option
plan should be reported as compensation in the same manner and in the
same period as prescribed for federal purposes.
 See, Deferred Compensation Received by Nonresident Hedge Fund
Managers Under IRC §457A, October 12, 2017:
 Income earned in New Jersey is subject to Gross Income Tax, regardless of the
residency of the taxpayer when the income is reported. This includes deferred
income that is earned in one period, then reported and taxed in a later one. New
Jersey considers nonresident hedge fund managers receiving such deferred income
as subject to the Gross Income Tax in accordance with N.J.S.A. 54A:5-8a(2). In
addition, N.J.S.A. 54A:8-3(c) requires that income must be reported to New Jersey
at the same time that it is reportable for federal income tax purposes.

16. What you need to know…
 When calculating the tax treatment of NSOs, you need to know
 Fair market value at the time of grant.
 If the option does have a readily ascertainable FMV, the option is taxable at
grant. Compensation is equivalent to the bargain element.
 Strike price
 Sale price if stock is sold
+ In addition, for New York State income tax purposes, you
need to know:
 Grant date
 Vesting date
 The workday fraction for the grant-to-vesting period

17. Case Study
Inclusion of option income of a non-resident

18. Case Study – Inclusion of option
income of a non-resident
 Mr. Lucky is a CFO of a closely held New York company which is ripe for sale to
a private equity firm.
 Mr. Lucky desires to minimize state taxes and will change his domicile to
Florida.
 Mrs. Lucky remains in New York City through the school year with the high
school age children.
 The Luckys purchase a new home and move to Florida on June 30, 2013 where
Mr. Lucky works from the company’s Florida office.
 Under the employer’s stock option plan and the Incentive Equity Grant
Agreement, on January 1, 2013, Mr. Lucky is granted a Non-Qualified Stock
option to buy 18,000 shares in 2013. Of this amount, 12,000 shares vest
immediately. The vested shares were “out of the money”. The remaining
shares vest in 2014 and 2015, but immediately vest if there is a change in
control (i.e. a buyer for the company)

19. Case Study – Inclusion of option
income of a non-resident
 Mr. Lucky exercises his rights under the option plan in 2015 when the
company is sold. Thus Mr. Lucky’s W-2 in 2015 shows the income attributable
to the difference between the strike price and the FMV of the shares upon
sale of the company.
 The pay stub shows the income attributable to the option plan, namely
18,000 shares at the difference between the strike price ($65) and the FMV
on acquisition ($165), or $1,800,000.
 Mr. Lucky travels widely on business and has worked in-State 50 percent of
the time during 2013; with fewer days in-State during 2014 and 2015.
 Is New York entitled to tax Mr. Lucky in 2013? 2014? 2015? If yes, at what
allocation/sourcing ratio?

20. Domicile versus residence – state
taxation of “source income”
 The State’s position: change of domicile was never fully effectuated.
 Mrs. Lucky remains in New York
 Thus, Mr. Lucky would be taxable as if he were a resident of the State, on 100% of
his equity compensation.
 The taxpayer’s position is that the equity compensation is sourced to the State
according to non-resident sourcing rules.
 Mr. Lucky worked 50% of his days in New York in 2013 and fewer days in 2014
(10%) and 2015 (5%). Thus the grant-to-vesting workday fraction is lower in
both non-resident years. With 220 working days, equates to 110 + 22 + 11
(143) over 660 total, or blended 22%.
 The bona fide marital domicile is Florida
 Even if Mrs. Lucky is a statutory resident of New York, the Luckys are both
domiciled in Florida and spouses can file separate New York State returns.

21. Case study -- Conclusion
 In 2015, New York source income is recognized on exercise. The pay stub shows the income
attributable to the option plan, namely 18,000 shares at the difference between the strike
price ($65) and the FMV on acquisition ($165), or $1,800,000.
 A portion of Mr. Lucky’s NSOs (12,000 shares) were granted and vested in the same year, 2013,
prior to the Luckys move from New York State to Florida on June 30, 2013
 Income is sourced using the workday fraction that applies to regular remuneration in the
same taxable year, i.e. the 2013 New York State wage allocation factor, or 50% (2/3 x $1.8MM
x 50% = $600,000 source income)
 Since the FMV at grant date was the same as FMV at vesting date, there was no compensation
to report in 2013.
 Mr. Lucky’s position: no income in 2013 when the shares were “under water”. The shares
appreciated thereafter. Tax based on 2015 valuation using a 2013 workday fraction appears
inequitable, given that 18,000 shares had little or no value in 2013.
 State’s position: At a minimum, New York State income tax is based upon the 2015 valuation,
using the 2013 workday fraction (for 12,000 shares); and, the 2014 and 2015 workday
fractions for the 6,000 share balance that vested in those years ($300,000 x 10% plus
$300,000 x 5% equals $45,000 total New York source income for 2014-2015).
 New York TSB-M-07(7)I, October 4, 2011 contemplates situations whereby prescribed formulas
don’t reach a fair and equitable result, and allows for alternative allocations.

22. Questions?

23. Thank you!
Stephen J. Bercovitch, J.D
STATE AND LOCAL TAXES
232 Madison Ave., Suite 700
New York, NY 10016
stephen@bercovitchtax.com
8550 Boulevard East #3H
North Bergen, NJ 07047
T: 212-651-4382
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http://bercovitchtax.com/
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