In Burton v. New York State Dep’t of Taxation and Fin. et al., N.Y. Decision No. 115, and Caprio v. New York State Dep’t of Taxation and Fin. et al., N.Y. Decision No. 116 (N.Y. July 1, 2015), the Court of Appeals rejected two separate challenges to the validity of a 2010 statutory amendment to Tax Law § 632(a)(2), which provided that gains recognized by a nonresident on the sale of S corporation stock may be treated as New York-source income when a transaction is treated as an asset sale under IRC § 338(h)(10) or payments are received from installment obligations under IRC § 453(h)(1)(A).
Background to the 2010 statutory amendment. In a 2009 decision, an Administrative Law Judge held that, under the Tax Law as it then existed, nonresident shareholders of an S corporation did not have New York-source income when they received payments pursuant to an installment obligation that had previously been received by the S corporation in exchange for its assets and subsequently distributed to such shareholders in exchange for their stock upon the corporation’s liquidation. Matter of Mintz, DTA Nos. 821806 & 821807 (N.Y.S. Div. of Tax. App., June 4, 2009). Further, in Matter of Baum, DTA Nos. 820837 & 820838 (N.Y.S. Tax App. Trib. Feb. 12, 2009), the Tax Appeals Tribunal concluded that nonresident individuals who sold S corporation stock treated as a sale of assets for Federal income tax purposes pursuant to IRC § 338(h)(10) did not have New York-source income on their gain. It reasoned that the transaction was “a simple stock sale” and that the “fictitious deemed asset sale and the deemed distribution” under IRC § 338(h)(10) was not applicable in determining whether the nonresident shareholders were subject to New York income tax on the gain.
In August 2010, at the behest of the Department of Taxation and Finance, Tax Law § 632(a)(2) was amended (the “2010 Amendment”) to specifically provide that gain recognized by a nonresident shareholder of an S corporation will be treated as New York-source income based on the S corporation’s New York business allocation percentage for the year in which the assets were sold if such gain is related to a distribution of an installment obligation under IRC § 453(h)(1)(A) or a stock sale for which an IRC §338(h) (10) election had been made. The 2010 Amendment was made applicable to tax years beginning on or after January 1, 2007, representing the years that at the time were open for assessment or refund. The New York legislature characterized the 2010 Amendment as a “clarification,” stating that the Baum and Mintz decisions “erroneously overturned the longstanding policies” of the Department. L. 2010, ch. 57, Part C, § 1 (“Legislative findings”).
The Burton decision. A group of plaintiffs, including Mr. and Mrs. Burton, were Tennessee residents and shareholders in an S corporation incorporated in Tennessee that was doing business in New York. In 2007, the plaintiffs sold their stock, and the S corporation and the buyer made a joint election under IRC § 338(h)(10) to treat the transaction as an asset sale. While the S corporation reported a gain of over $88 million for Federal income tax purposes, the plaintiffs did not report or pay any New York State income taxes associated with the sale. The Department, relying on the 2010 Amendment, determined on audit that the gain constituted New York-source income, and the plaintiffs paid the tax, claimed a refund, and then brought a declaratory judgment action in court when the refund claim was denied.
The basis of the plaintiffs’ action was that the sale of the stock was not taxable as New York-source income because Article 16, § 3 of the New York State Constitution provides that “intangible personal property within the state not employed in carrying on any business therein by the owner shall be deemed to be located at the domicile of the owner for purposes of taxation.” The plaintiffs argued that this provision precluded taxation of gains from the sale of a nonresident’s intangible personal property, including stock.
Upholding the trial court's decision (discussed in the February 2014 issue of New York Tax Insights), the Court of Appeals held that the 2010 Amendment did not violate the New York State Constitution because Article 16, section 3 did not bar the taxation of a nonresident’s New York-source income earned from a stock sale. The Court of Appeals reasoned that, even if the plaintiffs’ sale was treated as a stock sale rather than a deemed sale of assets consistent with IRC § 338(h)(10), Article 16, section 3 proscribed ad valorem and ownership/property-based taxes on nonresidents’ intangible personal property but contained no language constraining the imposition of any other non-location based taxes, such as income taxes.
The Caprio decision. The plaintiffs, Mr. and Mrs. Caprio, were nonresidents of New York and were the sole shareholders of an S corporation doing business as TMC Services, Inc. (“TMC”), which derived a portion of its income from activities in New York. In 2007, the Caprios sold all of their shares in TMC for a base price of approximately $20 million, plus an additional payment of $500,000 in 2008, and received promissory notes from the buyer for the installment obligations. Just like the plaintiffs in Burton, the S corporation and the buyer made an IRC § 338(h)(10) election, but the Caprios also elected to report the gain from the deemed asset sale under the installment method, pursuant to IRC § 453(h)(1)(A), under which gain is generally recognized only when cash payments are actually received.
While the Caprios reported approximately $19 million in capital gains on their Federal income tax returns for 2007 and 2008, they took the position on their New York nonresident income tax returns that the payments were not taxable in New York because, under Tax Law §631(b)(2), gain from the sale of an intangible asset such as stock is not included in the taxable income of a nonresident unless the asset was employed in a trade or business in New York, and IRC § 453(h)(1)(A) classified the installment payments as payments for stock. Positions similar to that taken by the Caprios were subsequently upheld in the Baum and Mintz decisions, but after the 2010 Amendment became law, the Department issued Notices of Deficiency to the Caprios. The Caprios brought suit in the Supreme Court, New York’s trial court, claiming that the retroactive application of the 2010 Amendment to the 2007 and 2008 years was unconstitutional under the Due Process Clauses of the United States and New York Constitutions.
Agreeing with the trial court and overturning the Appellate Division decision (discussed in the May 2014 issue of New York Tax Insights), the Court of Appeals concluded that the retroactive application of the 2010 Amendment was constitutional. As had the Appellate Division, the Court of Appeals applied a three-prong “balancing-of-equities” test for determining the constitutionality of retroactive tax laws, as outlined in James Square Assocs. LP, et al. v. Mullen, 21 N.Y.3d 233 (2013), which considers: (1) the taxpayer’s forewarning of a change and the reasonableness of reliance on the old law; (2) the length of the period of retroactivity; and (3) the public purpose for retroactive application. While the Appellate Division found that all three of these factors indicated that the retroactive application of the 2010 Amendment was unconstitutional, the Court of Appeals reached the opposite conclusion. The Court of Appeals reasoned that the Caprios could not have reasonably relied on the law prior to the 2010 Amendment, because, as stated in the Legislative findings included with the 2010 Amendment, the Department had a long-standing policy at the time of the Caprios’ transaction that was contrary to their position, and the Baum and Mintz decisions only subsequently—and temporarily—altered that policy. The Court of Appeals further concluded that the retroactive period for which the 2010 Amendment applied was not unfairly long and had a “compelling” public purpose because the 2010 Amendment was “curative” in nature and only applied to open tax years.7326
Subsequent to the Baum and Mintz decisions, it had appeared that nonresident individuals could avoid New York income tax on gain from the sale of stock of an S corporation that was part of an installment sale or IRC § 338(h)(10) election. The 2010 Amendment, and now the Burton and Caprio decisions, eliminated such opportunities.
The Caprio decision at the Court of Appeals relied on the same three-prong “balancing-of-equities” test as the Appellate Division for determining the constitutionality of retroactive tax laws under the Due Process Clauses of the United States and New York Constitutions but undid the Appellate Division’s taxpayer-friendly application of that test. While the Appellate Division had noted that there was no evidence of the Department’s long-standing policy, other than a 2002 PowerPoint presentation made to Department auditors that had not been publicly distributed, the Court of Appeals found that the PowerPoint presentation and a 2006 Department publication (former Publication 88, unmentioned in the Appellate Division decision, but of which the Court of Appeals took judicial notice as a matter of public record), were sufficient evidence of a long-standing policy that was reinstated by a curative retroactive amendment to the Tax Law.