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Challenges Raised to the Convenience/Necessity Test

A recent State Administrative Law Judge determination concluded that the "convenience of the employer test" (Reg. Sec. 132.18(a)) was not unconstitutional as applied to a Connecticut resident who worked for a New York employer both at the employer's facility and at his home on other days. The ALJ indicated that the fact that Connecticut did not, under its physical sourcing rules, allow a credit for New York income taxes attributable to days the taxpayer worked at home did not cause the regulation to be invalid or require New York to disavow a portion of his income as New York source income.

While the taxpayer was taxed by two jurisdictions on the same income, the ALJ said that this did not result from New York's use of an allocation rule that violates either the Commerce Clause or the Due Process Clause. The ALJ said that sourcing based on physical presence is not the only acceptable apportionment method and that sourcing under the convenience test is not prohibited even where, in conjunction with the tax system of Connecticut, some level of double tax resulted. The taxpayer confined his arguments to the constitutional issues. He did not argue that the convenience/necessity test was inconsistent with the statute. (Edward A. and Doris Zelinsky, DTA No. 817065, November 2, 2000)

Despite this determination, it is clear that there is a significant problem with New York State's approach to taxing earned income of nonresidents.

A state can tax income of nonresidents only to the extent that that income is derived from sources within the state. This is mandated by the U.S. Constitution. As the U.S. Supreme Court has pointed out, a state may tax its own residents on their income from all sources, whether within or outside the state, but it can constitutionally tax nonresidents only on income from property owned within the state or from a business, trade, or profession carried on in the state "and the tax is only on such income as is derived from those sources." (See Shaffer v. Carter, 252 U.S. 37, 57 (1920).) The New York State statute, in accordance with this restriction, provides that a nonresident employee is taxed only on income "attributable to... a business, trade, profession or occupation carried on in this state." (See Tax Law Sec. 631(b).)

The problem in New York has arisen from the Department's administration of this simple standard. Unfortunately, the Department has extended an approach that was originally developed to address abuses by commuters to situations for which it is wholly inappropriate. The Department's regulations provide an allocation method based on days worked within and outside the State. They provide that the earned income of a nonresident employee who performs services for his employer both within and outside New York State is allocated between New York State and non-New York State sources based on "that proportion of his total compensation for services rendered as an employee which the total number of working days employed within New York State bears to the total number of working days employed both within and without New York State." (See Reg. Sec. 132.18(a).) This approach is unexceptionable. The problem has been in its implementation.

The same regulation also provides that "any allowance claimed for days worked outside New York State must be based upon the performance of services which of necessity, as distinguished from convenience, obligate the employee to out-of-state duties in the service of his employer." This test has come to be known as the convenience/necessity test, and the Department and, unfortunately, the courts have held that it means that work that is undisputedly done outside New York by a nonresident will nevertheless be treated as work done within New York unless the employer's necessity requires it to be done outside the State.

Almost all of the rulings and cases have involved nonresidents who live in the New Jersey or Connecticut suburbs of New York City and whose regular places of business are in New York City. It seems likely that the convenience/necessity test was developed to prevent manipulation of the days-worked test by commuters. The prototypical situation with which the Department and the courts have been concerned is that of the individual who has a full-time job in New York City at which he works five days a week, who lives, for example, in Hoboken, New Jersey (just across the Hudson River from New York), who spends an hour every Saturday and Sunday working from his home, and who attempts to avoid New York taxes by claiming that, because Saturday and Sunday are non-New York working days, two-sevenths of his compensation income should be treated as non-New York income. In the typical abusive case, only a minimal amount of the taxpayer's actual working time is spent outside of New York State because the non-New York weekend days are partial days at best, whereas he works a full day on each of the New York days. Moreover, the nature of the situation raises the question of whether work has in fact been performed in New Jersey on the weekend days that the taxpayer purports to treat as "working" days. This is a clear abuse of the system, and the Department and the courts have been right not to tolerate it. One way to deal with this type of attempted manipulation would be to provide that only full days would be counted as working days. The convenience/ necessity test is another way of addressing the problem.

The convenience/necessity test has been upheld in litigation. The New York Court of Appeals has said that the rationale for the convenience/necessity test is that New York State residents do not gain any "tax benefits" from working at home and neither, therefore, should nonresidents. (See Speno v. Gallman, 35 NY2d 256, 259 (1974).)

Unfortunately, the Department has elevated what may well be an appropriate audit technique to an inappropriate rule of law. It has applied it to cases involving people who do not live within easy commuting range of New York State and who do not have a choice on any given day as to whether to work that day at their nearby New York office or in their home. This has resulted in attempts to tax income that has no conceivable connection to New York State in a manner that is clearly contrary to both the New York statute and the U.S. Constitution.

One recent determination involved an employee of a New York-based company who worked at his home in Portland, Maine. It was stipulated that only 12 percent of his working days were in New York. The State ALJ found that days on which the employee worked at home, he did so for his own convenience rather than for his employer's necessity. The employee spent a considerable amount of time at industry trade shows and conventions, and then followed up with visits, correspondence and phone calls. According to the ALJ, there was no showing why the correspondence or phone calls could not have originated from his employer's office in New York. Applying the convenience/necessity test, the ALJ held that New York could tax the employee on all his income, even though it was not disputed that only 12 percent of his income was earned in the State. (George and Joan Wallace, DTA No. 817182, December 21, 2000)

The problem can also be illustrated by an example that is drawn from a case now pending before the Division of Tax Appeals of the New York State Tax Appeals Tribunal. (In the interest of full disclosure, McDermott, Will & Emery represents the taxpayer.) The taxpayer is an individual who the Department concedes is a nonresident of New York State for purposes of the personal income tax. He lives in Nashville, Tennessee, and works for a company that is based in New York City. He had previously worked for a software development company of which his present employer was a client, and when that company's relationship with the employer ended the employer hired the taxpayer as an employee. The parties agreed that the taxpayer, who had served the company efficiently from Nashville in the past, would continue to be based in Nashville. He set up an office in his home and arranged with the telephone company to install a long-distance data line from his home to the employer in New York. He also had a dedicated voice telephone line that he used solely for business purposes. He traveled to New York from time to time for the sole purpose of instructing the employer's New York personnel in the use of new or revised computer programs that he developed from his home office in Nashville. In the taxable years at issue in the case, the Department has conceded that Nashville was the taxpayer's principal place of business, that he worked for no other company either as an employee or as an independent contractor, and that 75 percent of his working days were spent in Nashville while only 25 percent of his working days were spent in New York. The taxpayer has conceded that the arrangement was implemented for his convenience. His employer would have been perfectly happy to have him do his work in New York. The Department, applying the convenience/necessity test, has taken the position that all of his income must be treated as New York income that is taxable by New York, even though it admits that only 25 percent of his income was in fact earned in New York.

This is clearly a situation in which it is inappropriate to apply the convenience/necessity test. The individual in this case in fact did most of his work in Tennessee. His work in Tennessee was done on a full-time basis, and his Nashville office was his principal place of business. The fact that it was also in his home is immaterial. There is no basis in the statute for saying that work that is clearly done outside the State must be treated as New York State work if it was done there for the employee's convenience and not because of employer necessity.

The facts of this case illustrate the manifest unlawfulness of the Department's position, but it does not represent the outer limits. The Department acknowledges, as it must, that a nonresident employee who spends no time working in New York State cannot be taxed on any of his income. Nevertheless, Department representatives have indicated informally that the Department's position is that if an employee spends only one day in a year working in New York State and the rest of his working days are spent outside New York State for reasons of his convenience and not employer necessity, the Department will treat all of his income as New York income. The absurdity of such a result is obvious, yet it is the Department's position.

A 1996 Advisory Opinion (Mark F. Annito, TSB-A-96(10)I) presents another application of the convenience/necessity test in a manner that contravenes both the statute and common sense. In this instance, Citibank decided that it did not have adequate space for a number of its employees and required a group of its employees to work outside the New York office. Nevertheless, the Department held that the work done by a Connecticut resident employee from his home office had to be treated as New York work because the nature of the services was such that they could have been performed at the employer's New York office, even though the employer did not allow him to do so.

The convenience/necessity test, as applied by the Department to nonresidents who live well beyond commuting range, is clearly contrary to the statute, which provides that only income derived from business conducted in New York State by a nonresident is taxable by the State. The convenience/necessity standard might be an appropriate audit tool for examining the returns of commuters. It would seem perfectly appropriate for the Department to provide as an audit methodology that a taxpayer who works at home for his own convenience should have an added burden of proof in establishing that work was in fact done on particular days outside New York. It would also be appropriate to provide that only full-time days will be counted under the days-worked formula. Indeed, the Department's own guidelines for its auditors set forth a reasonable approach to the test. They provide that "[w]hen an individual has his or her principal place of business in New York, regular working days spent at home for employee convenience rather than the necessity of the employer are generally considered New York State work days." The guidelines limit the application of the convenience/necessity test to situations in which the employer's principal place of business is in New York. Moreover, they indicate that in such circumstances days worked outside of New York will "generally" be considered New York work days, suggesting that the convenience/ necessity standard is not an ironclad rule of law, but rather an audit tool that should be used only in appropriate cases. Such an application of the test would be consistent with the New York State statute which allows the Department to tax only income earned within the State.

A literal application of the convenience/necessity test in all cases will be unconstitutional in many situations because it will result in taxation of income out of all proportion to the person's contacts with the state. In discussing the New York rule, state tax authorities Professors Jerome and Walter Hellerstein have observed:

The U.S. Supreme Court and the New York Court of Appeals have clearly established that under the Due Process Clause a state cannot tax income that is out of all proportion to the taxpayer's contacts with the state. (See Hans Rees' Sons Inc. v. North Carolina, 283 U.S. 123 (1931); British Land (Maryland) Inc. v. Tax Appeals Tribunal, 85 NY2d 139 (1995).) When a nonresident employee does most of his work outside the State, it would seem hard to maintain that New York's attempt to tax all of his income, regardless of where earned, meets this constitutional standard.

The rationale for the convenience/necessity test as stated by the Court of Appeals in Speno v. Gallman  --- that New York State residents do not gain "tax benefits" from working at home and that neither, therefore, should nonresidents  --totally misapprehends the constitutional and policy difference between a state's taxation of residents and a state's taxation of nonresidents. As the Supreme Court pointed out in Shaffer v. Carter, a state can tax a resident on all of his or her income, regardless of whether it is derived from sources within the state. The taxpayer's residence provides an adequate constitutional base for justifying such taxation. In the case of a nonresident, however, a state can only tax income from in-state sources. A nonresident cannot constitutionally be taxed on income that is earned out of state, whether at a home office or at some other location, and without regard to whether the work is done out of state because of the employee's convenience, the employer's convenience, or either's necessity. If that is a "tax benefit," it is one that is conferred and, indeed, required, by the U.S. Constitution. New York State does not have the power to override that result by taxing a nonresident's out-of-state income.

The New York Tax Department's position in applying the convenience/necessity test in all cases and, in particular, to cases involving people whose principal place of business is not in New York, is clearly inconsistent with the statute and in many cases will be unconstitutional. While it may be an appropriate audit methodology to use in auditing commuters from adjacent states whose principal places of business are in New York, it should not be applied as a rule of law to all nonresidents.

Department representatives have expressed concern with the "telecommuting problem." But if a nonresident in fact works from his or her home, that work is not done in New York and New York has no fair claim to tax the resulting income. When a nonresident employee's services are performed outside New York, the State has no legitimate basis for taxing the income derived from those services. (Contributed by Peter L. Faber, McDermott, Will & Emery)