A judge in the Supreme Court, Albany County, has upheld the constitutionality of statutory changes made to Tax Law § 632(a)(2) in August 2010 treating as New York source income gain on the sale of stock where an election was made to treat the sale as an asset sale pursuant to Internal Revenue Code § 338(h)(10). Burton v. New York State Dep’t of Taxation and Finance, 2014 NY Slip Op. 24004 (Sup. Ct. Albany Cnty. Jan. 6, 2014). The judge rejected the argument that the statute violated the State constitutional provision that intangible personal property is deemed to be located at the domicile of the owner.
A group of plaintiffs, Mr. and Mrs. Burton and others, were residents of Tennessee and shareholders in an S corporation incorporated in Tennessee. In 2007 they sold their stock to a third party, and as part of the sale the S corporation and the buyer made a joint election under IRC § 338(h)(10) to treat the transaction as an asset sale. For Federal income tax purposes the S corporation reported a gain of over $88 million, but on its New York S Corporation return it did not treat the gain as New York income. The Department of Taxation and Finance determined 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 Burtons claimed that the sale of the stock was not taxable as New York source income, since Article 16, section 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 of purposes of taxation.” There was no contention here that the stock was employed in a business carried on in New York, so the only issue was whether the election under IRC § 338(h)(10) changed the nature of the transaction from a nontaxable sale of stock to a taxable sale of assets.
Background. In 2009, an Administrative Law Judge had held that, under the version of Tax Law § 632(a)(2) as it then existed, nonresident shareholders did not have New York source income when they sold their stock in an S corporation under an installment agreement. Matter of Mintz, DTA Nos. 821807 & 821806 (N.Y.S. Div. of Tax. App., June 4, 2009). A similar decision had been reached by the Tax Appeals Tribunal in Matter of Baum, DTA Nos. 820837 & 820838 (N.Y.S. Tax App. Trib. Feb. 12, 2009), which involved an election made pursuant to § 338(h)(10), and in which the Tribunal concluded that the transaction was “a simple stock sale,” and the “fictitious deemed asset sale and the deemed distribution” were not applicable for New York purposes. The Department disagreed with those interpretations, although it did not seek to appeal the Mintz decision (and it had no ability to appeal the adverse decision in Baum).
In August 2010, at the behest of the Department, Tax Law § 632(a)(2) was amended to specifically provide that gain recognized by a nonresident shareholder of an S corporation resulting from a sale where a § 338(h)(10) election was made 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 election was made. The amendment was made applicable to years beginning on or after January 1, 2007, that were open to assessment or refund. In Caprio v. New York State Dep’t of Taxation & Fin., 2012 NY Slip Op. 22273 (Sup. Ct. N.Y. Cnty. Sept. 22, 2012), app. transf. to App. Div., 20 N.Y. 3d 1030 (2013), the Supreme Court, New York County, rejected a challenge to the retroactivity of the statutory change, holding that the 2010 amendment to § 632(a)(2) could be applied to 2007 and 2008 tax returns, finding that the amendment did not create a new tax, but was simply a “‘curative or clarifying measure…’” intended to “clarify and ratify what the Department… had long believed was already clear in the existing statutes.”
Burton decision. Against that background, the trial court in Burton took only one paragraph to determine there was no conflict between the revised statute and the State Constitutional prohibition against taxing a nonresident’s intangible personal property. The court found that the plaintiffs had made an election to treat the transaction as an asset sale, and that the statutory change simply conformed “the characterization of the transaction on both the Federal and New York State returns.” Since the legislation was intended to clarify the Department’s position that Baum and Mintz had been incorrectly decided, the court determined that for the Department “to insist on conformity in the characterization of the sales event, as memorialized in the 2010 amendment…does not constitute an unconstitutional change in the law.”
This decision does not provide much analysis of why the court concluded there was no violation of the Constitutional direction against taxing the intangible income of non-New York residents, other than the reference to the plaintiffs having made an election. It may be that the court concluded that, by voluntarily electing treatment under § 338(h)(10), the plaintiffs had waived any ability to rely on the State Constitutional protection for intangible income of nonresidents. However, that election had been made at the time of the sale in 2007, so it would be difficult to conclude that a knowing waiver had been made of a statutory provision not enacted until 2010. The decision also notes that, at oral argument, plaintiff’s counsel withdrew the argument challenging the retroactive application of the 2010 amendment, presumably in light of the Caprio decision discussed above. The appeal in Caprio was argued on November 12, 2013, and as of this writing no decision has been issued.