The New York State Tax Appeals Tribunal, sustaining the decision of an Administrative Law Judge, rejected—as it has many times before—a challenge to the New York State system of limiting net operating loss deductions to the amounts taken for federal income tax purposes for the same year, and arising from the same source year as the federal deduction. Matter of Five Star Equipment, Inc., DTA Nos. 824861 and 825006 (N.Y.S. Tax App. Trib., Apr. 15, 2015).

Facts. For the years 2004 through 2010, including 2007, 2008 and 2010, which were the years at issue in this proceeding, Five Star filed New York State corporation franchise tax returns, and claimed NOL deductions, in large part carried forward from previous years in which those deductions were not used for New York purposes. On audit, the Department disallowed the deductions because they did not correspond to the source years and amounts of petitioner’s federal NOL deductions for the same years: in 2007, the New York NOL deduction claimed by Five Star was from a different source year than the federal NOL deduction claimed for that year; in 2008, the New York NOL deduction exceeded the amount of the federal NOL deduction because there was no federal NOL deduction at all for 2008; and in 2010, the claimed NOL deduction was from different source years and exceeded the amount of the federal NOL deduction claimed for that year.

These variations in amounts were generally attributable to the differences between the amounts of depreciation allowable as business deductions at the federal level–which permits certain accelerated and bonus depreciation– compared to the amounts allowable under New York law, which generally does not adopt the federal methods and uses straight-line calculations. This decoupling resulted, as it often does, in Five Star reporting different amounts of net income for federal and New York State purposes, and therefore in different amounts of NOL deductions available. Five Star challenged these differences as unconstitutional under the Supremacy Clause, claiming that the decoupling conflicted with the congressional purposes behind adopting accelerated and bonus deprecation, and also as violating the Commerce Clause, the Privileges and Immunities Clause and the Equal Protection Clause.

ALJ Decision. The Administrative Law Judge had upheld the assessments, finding, first, that the Tax Appeals Tribunal and the Court of Appeals have repeatedly upheld New York’s limitations on NOL deductions. See, e.g., Matter of Refco Properties, Inc., DTA No. 812292 (N.Y.S. Tax App. Trib., July 11, 1996); Matter of Royal Indem. Co. v. Tax Appeals Trib., 75 N.Y.2d 75 (1989). The ALJ noted that there are many other situations where deductions are available at the federal level but not the state level, and since the Legislature affirmatively acted to decouple New York from federal depreciation rules in 2003—after the cases dealing with various challenges to New York’s NOL provisions—it presumably knew and approved of the results. The ALJ also rejected the company’s constitutional challenges, finding that the Division of Tax Appeals has no ability to consider a claim that a statute is unconstitutional on its face, and rejecting claims that the statute was being applied unconstitutionally. The ALJ found no merit to Five Star’s argument under the Supremacy Clause that New York’s decoupling conflicted with the congressional motivations in adopting accelerated and bonus depreciation, finding no evidence that Congress had intended to bind the states to the federal rules. Finally, the ALJ also rejected the contention that the limitations violated the Commerce Clause or the Equal Protection Clause, finding that entities operating exclusively within New York and those operating within and without New York were treated the same, and that there was no showing of unequal treatment.

Tribunal Decision. The Tribunal agreed with the ALJ, finding, first, that the previous decisions upholding the amount and source limitations of the New York NOL deductions were binding, and rejecting Five Star’s argument that the interplay between the deduction rules and decoupling change the situation and require a different result.

The Tribunal also rejected all of Five Star’s constitutional arguments. The Tribunal found no preemption that would invalidate New York’s system under the Supremacy Clause because the federal and state tax systems may and often do treat items differently, particularly deductions, which have been held to “exist solely due to legislative grace.” Matter of Grace v. State Tax Comm’n, 37 N.Y.2d 193 (1975). It found no burden on interstate commerce, agreeing that businesses operating both inside and outside New York faced the same rules, and rejected challenges based on the Equal Protection and Privileges and Immunities Clauses. No discriminatory impact was demonstrated and the Tribunal found no legal support for the proposition that a state tax system unconstitutionally burdened interstate commerce by disallowing a deduction that might be allowed by other states.

Additional Insights

The earlier cases, such as Refco and Royal Indemnity, relied upon by the ALJ and the Tribunal, did indeed conclude that New York’s statute limited NOL deductions to those actually taken on the taxpayers’ federal returns for the years at issue, and rejected arguments that the statutes should be interpreted as permitting deductions up to the amounts available for those years, whether or not such amounts were actually deducted. However, those decisions were based on analyses of the statutes in question, and no constitutional arguments were addressed, leaving an avenue of argument not previously considered. However, since the Tribunal found no evidence of preemption by federal legislation—in that Congress had addressed only federal rules—and found that the impact of New York’s decoupling falls on both in-state based companies and out-of-state based companies, the challenge that the statutes were being applied unconstitutionally was rejected. Although the ALJ and the Tax Appeals Tribunal cannot declare statutes unconstitutional on their face—only a court can do that—the lack of discriminatory result may preclude such a facial unconstitutionality argument as well.