In Matter of Batty and Matter of Pennefeather, DTA Nos. 824061 & 824063 (N.Y.S. Div. of Tax App., Apr. 4, 2013), a New York State Administrative Law Judge held that the petitioners, 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. The ALJ rejected the argument made by the Department of Taxation and Finance that the individual petitioners were required to use the business allocation percentage of the S corporation’s subsidiary, finding no basis for that position in the statute or regulations.

Facts Regarding the Subchapter S entities. Mssrs. Batty and Pennefeather were shareholders of Buckingham Group, Inc., a New York corporation that had properly elected to be taxed as a Subchapter S corporation pursuant to federal and state law. Buckingham Group, in turn, was the sole shareholder in three separate Subchapter S corporation subsidiaries. Buckingham Group and one of the three subsidiaries, Buckingham Manufacturing, Inc., were certified by the State as “QEZE enterprises” in 2001. During 2006 through 2008, the years in issue, Buckingham Manufacturing manufactured arborist and lineman safety equipment in its factory in Binghamton, NY, and approximately 90% of its product was exported outside New York. Buckingham Manufacturing was a successful enterprise, growing from 38 employees in 1984 to 135 in 2001, at the time of its QEZE certification, and to 208 in 2013.

The QEZE credit claimed. Mr. Batty and Mr. Pennefeather filed New York State resident personal income tax returns, and reported and paid tax to New York on all income that flowed through to them from Buckingham Manufacturing. They paid no tax to any other state on that income. They claimed the QEZE tax reduction credit, set forth in Tax Law § 16, for each of the years at issue.

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 in this case.

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 designed to represent “the portion of the shareholder’s New York State income tax resulting from income from the QEZE allocated to New York.” Based on this formula, Mr. Batty calculated QEZE tax reduction credits of approximately $108,000, $159,000, and $228,000, respectively, for each of the three years in issue. Mr. Pennefeather calculated tax reduction credits of approximately $23,000, $35,000 and $51,000, respectively.

On audit, the Department recalculated the tax reduction credits, taking the position that the calculation should have used only Buckingham Manufacturing’s income allocated within New York State, which it defined as the company’s income reported on the shareholders’ forms K-1, multiplied by Buckingham Manufacturing’s business allocation percentages. The Department’s calculations reduced Mr. Batty’s credits for each of the years by 61%, 88%, and 89%, respectively, to approximately $42,000, $18,700, and $25,000; and Mr. Pennefeather’s credits by similar percentages, to approximately $9,000, $4,000 and $5,500.

The Department claimed these adjustments were required “to fairly allow the tax reduction credits to residents and nonresidents alike.” Mr. Batty and Mr. Pennefeather, however, claimed that nothing in the statute or regulations required or permitted use of the entity’s business allocation factor, and that, as residents, they had allocated all of their income from Buckingham Manufacturing to New York, so that amount should be used in computing the tax factor. They argued that there was no discernible intent by the legislature, which had enacted the QEZE program to create employment in economically depressed areas – a goal fully met by Buckingham Manufacturing – to reduce the available credit whenever a QEZE’s products happened to be shipped largely out of state, resulting in a small New York sales factor.

The ALJ’s decision. The ALJ held for the petitioners. 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.” Since Buckingham Group was the sole shareholder in Buckingham Manufacturing, and both were Subchapter S corporations, their income and tax attributes flowed through to the individual taxpayers. As residents, they had allocated all of their income to New York, and their tax was determined under Article 22, the personal income tax law. Therefore, their tax factor was based on their personal income tax filings and had been properly calculated.

The ALJ found that the Department “went a step further than the statute provides,” since there is no mention in Tax Law § 16 or in any regulation of application of the entity’s business allocation factor when the credit is being claimed by individual resident shareholders of an S corporation. The ALJ 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. See TSB-M-06[1]C and TSB-M-06[2] I (Dep’t of Tax. and Fin., Feb. 2, 2006). No such language was included in any pronouncements or return instructions for personal income taxpayers. The ALJ also rejected the Department’s attempt, “as a matter of fairness to nonresident taxpayers,” to rely on the Privileges and Immunities Clause of the U.S. Constitution as a basis for its adjustment. The Privileges and Immunities Clause, contained in Article IV of the Constitution, provides that “Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States,” and the ALJ noted that the object of the Clause is to place “citizens of each State upon the same footing” as citizens of other States.” Lunding v. New York Tax Appeals Tribunal, 522 U.S. 287. 296 (1988) (citations omitted). The ALJ, however, found that the Division’s position would actually treat nonresident taxpayers more favorably than residents.

Finally, the ALJ rejected the Department’s argument that its interpretation of the statute was entitled to great weight, finding that, when the issue is one of pure legal interpretation, no deference to the Department is required. Since the language of the statute clearly and unambiguously required the method used by the petitioners, that method was deemed correct.

Additional Insights

The ALJ’s decision appears to recognize that the calculation of the credit should properly parallel the income that the New York taxpayer – whether a corporation or an individual – earned and reported because of the QEZE’s activity. The personal income taxpayers in this case reported and paid tax on 100% of the income generated by the QEZE, and the entity’s business allocation percentage was totally irrelevant to that determination, so there seems to be no reason to refer to such a percentage in calculating the credit.

The ALJ also made it clear that, where the issue is one of pure legal interpretation, the Department’s position is not entitled to the usual deference that is paid to its interpretation of the tax laws, since no special expertise on the agency’s part is required when the statute itself is unambiguous. When that is the case, the ALJ noted that any administrative practice inconsistent with the statute should be disregarded by the courts.

In addition, while deserving recognition for ingenuity, the Department’s argument based on the Privileges and Immunities Clause seems unsupported. That constitutional provision is generally invoked by taxpayers challenging state action, not by states as an affirmative grant of power, and the decision does not reveal whether any precedent was cited by the Department as support for such affirmative use.