A New York State Administrative Law Judge has held that a gain on the sale of real property owned by a limited liability company, that was in turn 99% owned by an Employee Stock Ownership Plan ("ESOP"), was taxable income to the sole participants and beneficiaries of the ESOP. Matter of Patrick Murphy and Kathleen Murphy, DTA No. 825277 (N.Y.S. Div. of Tax App., Feb. 9, 2017). The ALJ rejected the argument that the Division of Tax Appeals' jurisdiction to hear the case was preempted by the Employee Retirement Income Security Act of 1974 ("ERISA") and found that the gain should be attributed to the petitioners because the ESOP was a "sham trust."

Facts. The gain in question arose from the 2006 sale of real property located at 948 Second Avenue in Manhattan for $5.5 million. At the time of the sale, the property was owned by JJF Associates LLC ("JJF Associates"), a limited liability company treated as a partnership for tax purposes. JJF Associates was owned 99% by JJF Realty Employees Stock Ownership and Plan Trust ("JJF ESOP") and 1% by Triune Foundation, Inc. Triune had been incorporated in 1994 as a not-for-profit corporation and was tax exempt under Internal Revenue Code 501(c)(3). Petitioner Patrick Murphy was its president. Mr. Murphy was also the sole trustee of JJF ESOP at the time of sale, having succeeded Triune in that position, and Mr. and Mrs. Murphy were the only participants and beneficiaries of JJF ESOP.

The petitioners, Patrick and Kathleen Murphy, described JJF ESOP as a tax-exempt pension trust established for the benefit of the employees of JJF Realty Management, Inc. ("JJF Realty"), an entity wholly owned by JJF ESOP, and claimed they were employees of JJF Realty during the 2006 year in issue. They were also JJF Realty's president and secretary, respectively. JJF Realty's certificate of incorporation stated that its purpose was to own and operate the property. JJF Realty was dissolved by proclamation of the New York Secretary of State on June 25, 2003. Nonetheless, JJF Realty filed a New York State Corporation Franchise Tax Return for 2007, although not for 2006 or any previous year, signed by Mr. Murphy as its president. It reported $900 in assets as of the beginning of the year and $2,852,009 at the end, which were the same amounts shown on its 2006 federal income tax return. It reported no payroll.

In 1996, Triune contributed the real property to JJF Associates, which was done, according to testimony from Mr. Murphy, to allow for the property's management and generation of income for Triune, which was established to create educational programs such as funding scholarships. When the property was sold in 2006, JJF Associates recognized a gain of approximately $2.2 million on the sale and reported it on its New York State partnership return.

Federal Filings. Sometime prior to 2006, Triune stopped operating, and its tax-exempt status was revoked in 2011 for failure to file tax returns for the previous three years. The date of the creation of JJF ESOP was unclear, since the petitioners asserted it was created in 1999, but JJF ESOP's federal forms 5500-EZ indicated JJF ESOP first became effective on May 31, 2005. Both the 2006 and 2008 returns stated that the plan had no assets at the beginning of each year, but had $2,000,500 at the end of the year. However, JJF Associates' 2006 federal tax return showed JJF ESOP as having $3 million in assets. JJF ESOP's 2006 federal return reported a gain of $2,268.774 on the property and stated that, other than the petitioners, JJF Realty had no employees.

ESOP Documentation. During the audit, JJF ESOP provided a document entitled "JJF Realty, Inc. Employee Stock Ownership Trust" ("ESOP Trust Agreement") between JJF Realty, as the employer, and Triune, as the trustee. The ESOP Trust Agreement provides that JJF Realty established an employee stock ownership plan for the benefit of eligible employees of JJF Realty, to be administered by a committee appointed by the board of directors of JJF Realty. The trustee was required to report to the committee and furnish annual written reports. The ESOP Trust Agreement was signed by Mr. Murphy both on behalf of JJF Realty, in his capacity as president, and as trustee of Triune. No evidence supporting the existence of a committee or any written annual reports were submitted into the record. After issuance of a subpoena by the Division of Tax Appeals, which was upheld by the courts against challenge by the petitioners (including a challenge based on the argument that ERISA preempted the action), the Murphys also submitted a document entitled "JJF Realty Management Inc. Employees Stock Option Plan & Trust" ("JJF ESOP Plan"), which states that eligible JJF Realty employees included full-time employees, as well as those with at least 1,000 hours of service each year. JJF Realty made no contributions to JJF ESOP in 2006, there were no annual valuations of plan assets for JJF ESOP, and petitioners did not maintain separate individual pension accounts within JJF ESOP.

[T]he ALJ rejected the Murphys' argument that the Division of Tax Appeals' jurisdiction, and the personal income tax imposition statute, Tax Law 601, were preempted by ERISA.

Issues and ALJ Hearing. After an audit of both JJF Associates and JJF ESOP, the Department of Taxation and Finance concluded that the gain on the sale of the property was taxable to petitioners because they were "ineligible participants" of JJF ESOP, since they were not employees of JJF Realty. A Notice of Deficiency was issued in November 2010. At the ALJ hearing, the Department added a new argument, contending that JJF ESOP should be disregarded as a "sham entity" with no economic substance.

The evidence at the hearing, in addition to that summarized above, included testimony from Mr. Murphy that title to the property was transferred from JJF Associates to JJF ESOP prior to its sale in 2006, although there was no record of any deed or contract, and that the property was transferred to JJF Realty and then back to JJF Associates as part of a "practical merger," done "in a very simplified way through corporate resolutions and other agreements..." although no resolutions or agreement were presented. There was also no favorable determination letter from the IRS confirming the qualification and tax exempt status of JJF ESOP. In affirmations, Mr. Murphy described his responsibilities as president of JJF Realty as including negotiating and contracting leases and filing tax returns; Mrs. Murphy's responsibilities as including billings for monthly rentals, maintaining rent rolls, and dealing with local agencies; and the responsibilities of both as including arranging for building maintenance, repairs, garbage and snow removal, and responding to tenant complaints.

ALJ Determination. First, the ALJ rejected the Murphys' argument that the Division of Tax Appeals' jurisdiction, and the personal income tax imposition statute, Tax Law 601, were preempted by ERISA. While acknowledging that ERISA contains a broadly worded preemption provision, the ALJ found that preemption applies only to statutes "that directly regulate[] the heart of ERISA plan administration," and not to state laws that only touch peripherally on retirement plans. The ALJ reviewed recent decisions, including U.S. Supreme Court decisions in De Buona v. NYSAILA Medical & Clinical Services Fund, 520 U.S. 806 (1997) and New York State Conference of Blue Cross & Blue Shield Plans v. Travelers Insurance Co., 514 U.S. 645 (1995), and found that Tax Law 601 does not attempt to regulate ERISA plans or interfere with federal regulation of such plans. He also found "particularly compelling" the Department's reliance on Hattem v. Schwarzenegger, 449 F.3d 423 (2nd Cir. 2006), in which the Second Circuit Court of Appeals found that California's unrelated business taxable income statutes were not preempted from application to an ERISA plan, since the laws were of general applicability, did not force plan trustees to act in any particular matter, and did not have a "reference to" ERISA but instead "functioned irrespective of the existence of ERISA plans."

Next, on the merits, the ALJ agreed with the Department that JJF ESOP was a sham trust without economic substance. The ALJ relied on federal authority that set out a four-part test to determine whether a trust lacked economic substance, Sparkman v. Commissioner of Internal Revenue, 509 F.3d 1149, 1155 (9th Cir. 2007), citing Markosian v. Commissioner of Internal Revenue, 73 T.C. 1235, 1243-44 (1980): (1) whether the taxpayer's relationship to the transferred property differed materially before and after the trust's creation; (2) whether there was an independent trustee; (3) whether an economic interest passed to other trust beneficiaries; and (4) whether the taxpayer respected the restrictions set forth in the trust documents. The ALJ found that JJS ESOP failed all four parts. First, the Murphys' relationship to the property did not change materially when the trust was created, since there was at all times an identity in ownership and control of the property and the gain from its sale. Mr. Murphy, as president of Triune and the trustee of JJF ESOP, controlled the two members of JJF Associates, and he and Mrs. Murphy were the sole beneficiaries of JJF ESOP, as well as the sole owners and officers of JJF Realty. Second, JJF ESOP did not have an independent trustee, there was no evidence of an independent committee having been created as contemplated by the trust documents, and therefore there was no "meaningful restriction" on the Murphys' use of trust property. Third, no economic interest passed to other beneficiaries of the trust, since none existed. Finally, the evidence showed that the Murphys had unrestricted use of the property, and the records lacked any explanation of numerous inconsistencies, such as the fact that for both 2006 and 2008, JJF ESOP had no assets at the beginning of each year but had over $2 million at the ends of the years, the absence of any accounting for the difference between the $2 million reported and the rest of the $2.268 million gain, and the absence of a bank account for JJF ESOP.

The ALJ also found the record to be "laden with contradictions," and described Mr. Murphy's testimony as "confusing, evasive, and contradictory," further supporting the finding of the sham trust, and noting such items as the different identifications of the effective date of JJF ESOP; the listing on JJF Associates' 2006 federal tax return of JJF ESOP having $3 million in assets while JJF ESOP's own return listed only $2 million; the fact that JJF Realty had no payroll; and the signature on the ESOP Trust Agreement only by Mr. Murphy both as president of JJF Realty and as trustee of Triune. The ALJ concluded that "petitioners seek the benefit of organizational formalities yet fail to establish that they observed them," finding such disregard "one of the hallmarks of a sham trust," and upheld the assessment of personal income tax.

Additional Insights.

The concept of federal preemption is certainly valid, and there does exist a broad preemption by ERISA of state regulation of pension plans subject to the federal statute. However, the cases in which preemption has been found generally involve statutes or state action directly applicable to federally regulated retirement plans, such as Morgan Guaranty Trust Company of New York v. Tax Appeals Tribunal, 80 N.Y.2d 44 (1992), or imposing tax on a plan asset itself, rather than on the income derived from the sale of an asset by another entity, as was the case in Murphy.

The facts seem to show numerous overlapping relationships between several commonly owned entities, including the ESOP, without any clear demarcation of different responsibilities requiring different duties. In any such small businesses, and particularly when seeking to claim the tax benefits that accrue to an ESOP, it is critical to maintain strict adherence to all details of record-keeping, and to ensure that formalities are followed. Here, the trail of documents was so unclear and contradictory that what may have been a valid attempt to set up a proper ESOP was derailed by numerous record-keeping failures.