Reversing a decision of the trial court, the Appellate Division, First Department, has held that the application by the Department of Taxation and Finance of a 2010 statutory amendment concerning the treatment of installment payments by nonresident shareholders of an S corporation to transactions that occurred in 2007 and 2008 violated the taxpayers’ Due Process rights. Caprio v. N.Y.S Dep’t. of Taxation & Fin., No. 651176/11, 11231, 2014 NY Slip Op 2399 (App. Div. 1st. Dep’t Apr. 8, 2014).
The plaintiffs, Mr. and Mrs. Caprio, were nonresidents of New York. They 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 to a third party 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.
For federal income tax purposes, the Caprios and the purchaser made an election under Internal Revenue Code (“IRC”) § 338(h)(10) to treat the stock sales as a sale by TMC of its assets to the purchaser in return for the installment obligations, followed by a deemed liquidation and distribution to its shareholders of the consideration received from the purchaser. In addition to the § 338(h)(10) election, the Caprios elected to report the gain from the deemed asset sale under the installment method, pursuant to IRC § 453, under which gain is generally recognized only when cash payments are actually received. The Caprios reported a capital gain on their 2007 federal income tax return of approximately $18 million, and an additional gain of approximately $1 million in 2008.
The Caprios reported these amounts on their 2007 and 2008 New York nonresident income tax returns as payments received under the installment method in exchange for stock in TMC. They took the position that the gain should be treated as having arisen from the sale of stock, and therefore was not New York-source income, since, 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.
In 2009, an Administrative Law Judge held that, under Tax Law § 632(a)(2), nonresident shareholders did not have New York-source income when they sold their stock in an S corporation under an installment agreement. Matter of Myron Mintz, DTA Nos. 821806 & 821807 (N.Y.S. Div. of Tax. App., June 4, 2009). A similar decision had been reached by the Tax Appeals Tribunal in Matter of Gabriel S. & Frances B. Baum, DTA Nos. 820837 & 820838 (N.Y.S. Tax App. Trib., Feb. 12, 2009). In August 2010, Tax Law § 632(a)(2) was amended to specifically provide that gain recognized by a nonresident shareholder of an S corporation, arising from payments received under an installment obligation, 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. The amendment was made applicable to years beginning on or after January 1, 2007, that were open for assessment or refund.
Audit and decision below. In February 2011, the Department of Taxation and Finance issued Notices of Deficiency to the Caprios for 2007 and 2008, seeking additional tax and interest of nearly $800,000. The Caprios brought suit in the Supreme Court, New York’s trial court, claiming that the application of the 2010 amendment to § 632(a)(2) to their 2007 and 2008 tax returns was unconstitutional under the Due Process Clauses of the United States and New York Constitutions. They argued that the 2010 amendments for the first time imposed a tax on gain recognized on payments received from installment obligations under IRC § 453(h)(1)(A), and that the three-and-a-half-year period of retroactivity was excessive. The trial court determined that the retroactive application was permissible and dismissed the action in November 2012.
Appellate Division decision. The Appellate Division reversed the decision below, holding that the 2010 amendments could not be retroactively applied to the years at issue. First, the court noted that while retroactive legislation is disfavored, it is “not necessarily unconstitutional” and can be valid if the period of retroactivity is short and not so “‘harsh and oppressive as to transgress the constitutional rights’” of the taxpayer. It cited the decision by the Court of Appeals in James Square Assocs. LP, et al. v. Mullen, 21 N.Y.3d 233 (2013), covered in the July 2013 issue of New York Tax Insights, as reaffirming a three-prong test to determine whether the retroactive application of a tax statute is constitutional. The three factors are: (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.
Application of these factors led the court to reject retroactivity of the 2010 amendments. With regard to forewarning of the change, which is the “‘predominant’” factor, the court found that the Caprios had no actual forewarning, and that the amendment was not even proposed until long after they had entered into the transaction, giving them no opportunity to restructure the transaction. It rejected the Department’s position that the plaintiffs could not have relied on the Mintz ALJ decision,accepting the Caprios’ argument that they reasonably relied not on Mintz but on the law as it previously existed, which prior to the 2010 amendments did not specifically address a nonresident’s receipt of payments under these circumstances. The court found that the Caprios made a “compelling argument” that under previous law the payments were not taxable, noting that under the IRC the payments would be treated as payments for stock, and New York Tax Law generally provided that a nonresident’s sale of stock was not taxable. The court also rejected the Department’s argument that the Caprios should have known it had a long-standing policy of taxing such transactions, finding the only proof for such a policy was one 2002 PowerPoint presentation made to Department auditors, and there was no evidence that taxpayers were ever informed of such a policy. The court also rejected the Department’s argument that the Caprios could not establish reasonable reliance in the absence of an explanation of how they would have structured the transaction differently, finding that the law does not require a demonstration of a specific proposed alternative but only a showing that the plaintiffs structured the transaction in “reasonable reliance” on the prior law.
The court then found that the second James Square factor, the length of the period of retroactivity, also favored the Caprios, noting that in James Square the Court of Appeals found excessive a retroactive period of 16 months, where here the period of retroactivity was even longer, three and a half years. The court rejected the Department’s argument, which had been accepted by the trial court, that longer periods of retroactivity are acceptable when a legislative change is merely curative, finding that the Department failed to demonstrate the amendment was merely curative. The court found that the Department could point to no legislative history indicating the 2010 amendment was correcting any specific error, as opposed to amending the law to adopt the Department’s “purported policy.”
Finally, although finding it was a “close question,” the court also determined that the public purpose for the retroactive application – raising tax revenues by $30 million to implement the 2010-2011 Executive Budget – was “‘not a particularly compelling justification.’” Therefore, after review of all three factors, the court determined that retroactive application of the 2010 amendment resulted in a Due Process violation and enjoined the Department from enforcing the Notice of Deficiency issued to the Caprios.
As can be seen from the cases, the treatment of gains incurred by nonresident shareholders from sales of interests in S corporations has long been a contentious issue in New York. Other taxpayers had litigated very similar issues, and in Mintz and in Baum an Administrative Law Judge and the Tax Appeals Tribunal had disagreed with the Department’s interpretation of the statute. The Department then sought and obtained a statutory amendment, by its terms retroactive, but leaving the vexing question of whether that amendment could constitutionally be applied retroactively. The Appellate Division has now decided that such retroactive treatment violates taxpayers’ Due Process rights.
One judge dissented in Caprio, agreeing with the court below that that the 2010 amendment was merely curative, and necessary to conform the statute to the Department’s policy. The dissent also opined that the plaintiffs could have requested an advisory opinion but did not do so. The majority opinion properly rejects this view, explicitly disagreeing that the Caprios had any duty to have sought an advisory opinion, finding that they had no reason to seek clarification since a reasonable reading of the Tax Law as it then existed was that the transaction was not subject to tax – the same conclusion reached by an ALJ in the Mintz case.
While no appeal had been filed as of this writing, it seems likely that the Department will seek further appeal to sustain its efforts to apply the 2010 amendments retroactively. Also, another case raising a similar issue, Burton v. New York State Dep’t of Taxation and Fin., 978 N.Y.S. 2d 653 (Sup. Ct Albany Cnty. 2014) (discussed in the February 2014 issue of New York Tax Insights), in which the taxpayer abandoned at oral argument its position on retroactivity but continued to argue that the amended statute was unconstitutional, is currently on appeal.