A New York State Administrative Law Judge has held that the individual shareholders of a New York S corporation properly calculated their credits under the State’s Qualified Empire Zone Enterprise (“QEZE”) program using a tax factor based on their personal income tax filings, and that there is no requirement in the statute that the S corporation’s New York apportionment percentage be considered. Matter of Lisa M. & Gregory E. Henson, et al., DTA Nos. 825068 & 825254-825257 (N.Y.S. Div. of Tax App., Apr. 10, 2014).

Facts. Mr. and Mrs. Henson, and all of the other petitioners (the “Individual Shareholders”) were indirect owners of Resort Funding, LLC, through their ownership of the shares of two S corporations, Hamel Capital, Inc. and Henson Capital, Inc., two members of Resort Funding. Resort Funding had elected to be taxed as a partnership, and both corporations elected to be taxed as S corporations under the Internal Revenue Code and Tax Law § 660, so that the tax attributes of all three entities flowed through to the Individual Shareholders. Resort Funding’s only office was in Syracuse, New York, all of its operations were within the Syracuse Empire Zone, and it had been certified as a QEZE. The Individual Shareholders reported and paid New York tax on all income that flowed through to them from Resort Funding, Hamel Capital and Henson Capital, and they paid no income tax to any other state. They claimed the QEZE tax reduction credit, as set forth in Tax Law § 16, on their New York personal income tax returns.

The QEZE credit was enacted as part of the Empire Zones Program Act, added in 2000 to provide new tax credits and other incentives to businesses that agreed to create employment and make investments in areas that were economically depressed. The credit is a product of four factors: the benefit period factor, the employment increase factor, the zone allocation factor and the tax factor. Only the last one, the tax factor, was in dispute.

Where the taxpayer is an S corporation shareholder, the statute provides that the tax factor is the product of the ratio of the shareholder’s income from the QEZE allocated within New York, divided by the shareholder’s New York State adjusted gross income, multiplied by the shareholder’s New York State income tax. According to the ALJ, the tax factor is “in essence, the portion of the shareholder’s New York State income tax resulting from income from the QEZE allocated to New York.” The Individual Shareholders followed this formula in claiming their credits.

On audit, the Department recalculated the tax reduction credits, maintaining that the Individual Shareholders improperly allocated all of Resort Funding’s business income to New York State, and instead should have used only Resort Funding’s income allocated within New York State, which it defined as the company’s income reported on the Individual Shareholders’ forms K-1, multiplied by Resort Funding’s business allocation percentages as reported on its State partnership tax returns and by the two Subchapter S corporations’ business allocation percentages. The Department thereby reduced each of the Individual Shareholders’ tax reduction credit by approximately 30% and issued Notices of Deficiency for additional personal income tax.

The Individual Shareholders challenged the Notices, claiming that nothing in the statute or regulations required or even referenced use of the business allocation factor of Resort Funding or the two Subchapter S corporations, and that, as residents, they had allocated all of their income from Resort Funding to New York, so that amount should be used in computing the tax factor. They argued that the intent of the legislature, which had enacted the QEZE program to create employment and encourage investments in economically depressed areas, was to provide a tax reduction credit, and that there was no intent to reduce the amount of the credit simply because the QEZE’s products, all of which were manufactured at the certified location, were shipped out of state, thereby reducing its New York sales factor.

The Department, on the other hand, claimed that the adjustment was required to properly determine the amount of income allocated to New York, and that its interpretation of the statute should be given significant weight and judicial deference.

The ALJ’s decision. In a decision that closely tracks one issued by a different ALJ a year earlier, in Matter of Harold A. and Katherine R. Batty and Matter of James E. and Tina L. Pennefeather, DTA Nos. 824061 & 824063 (N.Y.S. Div. of Tax App., Apr. 4, 2013), the ALJ agreed with the Individual Shareholders. He found that the statute, Tax Law § 16(f)(1), required the computation of the tax factor to be made pursuant to Articles 9-A or 22, “depending on the filing nature of the taxpayer claiming the credit.” Resort Funding, Henson Capital and Hamel Capital were all flow-through entities for federal and state purposes, with their tax attributes flowing through to the Individual Shareholders. The ALJ found that Tax Law § 16 “clearly requires use of the shareholder’s portion of income from the QEZE that is allocated to New York State in calculating the tax factor.” (emphasis added). As residents, the Individual Shareholders had allocated all of their income to New York, and that was the amount that the ALJ found should be used to calculate their tax factor.

While acknowledging the Department’s argument that its interpretation of tax statutes is ordinarily to be upheld if not irrational or unreasonable, the ALJ found that, when the issue is one of pure legal interpretation of clear and unambiguous statutory language, no deference to the Department is required, since there was no need to consider any special agency expertise.

The ALJ rejected the Department’s reliance on language in the instructions to Form IT-604, finding that, to the extent that language could be interpreted to support the Department’s interpretation, it improperly differs from or expands the statute, which can be done only by the legislative or regulatory process, not merely through instructions. The ALJ also noted that, while a Technical Services Bureau Memorandum issued by the Department did discuss the use of a business allocation percentage, that discussion was in the context of instructions for calculating the tax factor for corporate partners, not individual taxpayers. See Technical Memoranda, TSB-M-06[1]C and TSB-M-06[2]I (N.Y.S Dep’t of Taxation and Fin., Feb. 2, 2006).

Additional Insights

The ALJ’s decision recognizes that the legislature intended the credit to parallel the portion of the income that the taxpayer earned and reported to New York because of the QEZE’s activity, and that there was no statutory or regulatory reason to even consider the business allocation percentage of the flowthrough entities, which were paying no tax to New York State.

This is now the second ALJ decision reaching, on the same grounds and in almost identical language, the same result rejecting the Department’s interpretation of the method that should be used to calculate the tax reduction credit available to individual shareholders of S corporations on their personal income tax returns. While ALJ decisions are not precedential, Tax Law § 2010(5), it seems unfortunate that the same issue has to be litigated all over again by different individual taxpayers. If last year’s decision in Matter of Batty and Matter of Pennefeather had been appealed by the Department filing an exception to the Tax Appeals Tribunal, the result would have been a precedential Tribunal decision applicable to all taxpayers, but it does not appear that such an exception was filed by the Department, which instead seems to have continued to apply its approach to additional taxpayers.