Reversing the decision of an Administrative Law Judge, the New York State Tax Appeals Tribunal has upheld the constitutionality of retroactively applying to the 2008 tax year a 2010 statutory amendment to Tax Law § 632(a)(2) concerning the treatment of installment payments by nonresident shareholders of an S corporation. Matter of Jeffrey M. and Melissa Luizza, DTA No. 824932 (N.Y.S. Tax App. Trib., Mar. 29, 2016). Despite the fact that the taxpayers had reasonably relied on the then-current state of the law in structuring their 2008 transaction, the Tribunal found that the recent decision of the Court of Appeals in Caprio v. New York State Dep’t of Taxation and Fin. et al., 25 N.Y.3d 744 (2015), reh’g denied, 26 N.Y.3d 955 (2015), required it to apply the statutory amendment retroactively.
Facts. The petitioners, Mr. and Mrs. Luizza, were nonresidents of New York. Mr. Luizza owned 100% of the stock of an S corporation that did business in New York and other states, and in December 2007 he agreed to sell the company to an unrelated purchaser. At the purchaser’s request, Mr. Luizza agreed to an election to treat the sale as a deemed sale of the company’s assets pursuant to Internal Revenue Code (“IRC”) § 338(h)(10), but only to the extent that there would be “no negative federal or state tax implications for the S corporation or himself individually,” and requested that he be reimbursed for any such tax consequences. The purchaser requested instead that the tax consequences of the election be addressed up front, so Mr. Luizza and his accountants researched the federal and New York State tax implications, including the effects of Tax Law § 632(a)(2) and other New York State authority available in late 2007 and early 2008. Mr. Luizza was advised by his tax advisors that there would be no tax consequences in New York as a result of the election, and he therefore agreed not to require the purchaser to increase the purchase price or to provide indemnity when the sale closed in March 2008. The Department of Taxation and Finance stipulated that “Mr. Luizza reasonably relied on the New York law applicable at the time of the sale when he agreed not to require the [b]uyer to increase the purchase price nor to provide indemnity for any additional taxes arising as a result of the election.”
Mr. Luizza reported a capital gain of approximately $8 million on his 2008 New York nonresident income tax return, but did not include the gain as income attributable to New York sources.
Background to the 2010 Statutory Amendment.
Mr. Luizza’s research correctly stated the law at the time of the transaction. Furthermore, in 2009, the Tax Appeals Tribunal expressly 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 where an election had been made under IRC § 338(h)(10). Matter of Gabriel S. & Frances B. Baum, DTA Nos. 820837 & 820838 (N.Y.S. Tax App. Trib. Feb. 12, 2009). A few months after Baum, an ALJ reached a similar conclusion in Matter of Myron Mintz, DTA Nos. 821806 & 821807 (N.Y.S. Div. of Tax App., June 4, 2009).
Having lost in litigation, the Department sought to change the statute. In August 2010, Tax Law § 632(a)(2) was amended to specifically provide that gain recognized by a nonresident shareholder of an S corporation 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 retroactive to years beginning on or after January 1, 2007, that were open for assessment or refund, and was accompanied by legislative findings stating that the change was “necessary to correct a decision of the tax appeals tribunal and a determination of the division of tax appeals that erroneously overturned the longstanding policies of [the] department of taxation and finance . . . .”
In reliance on the statutory amendment, the Department took the position that the Luizzas had to allocate a portion of the capital gain to New York and issued a Notice of Deficiency for nearly $200,000, including tax and interest, but without penalty. The Luizzas argued that the retroactive application of the amended Tax Law § 632(a)(2), under the circumstances, violated their right to due process.
ALJ Decision. The ALJ agreed with the Luizzas. In deciding whether to apply the statute retroactively, he relied on an analysis that was set out by the Court of Appeals in James Square Assocs. LP, et al. v. Mullen, 21 N.Y.3d 233 (2013), which reviewed three factors: (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.
With regard to the first factor, which has been held to be the “predominant” factor, the ALJ found that neither Mr. Luizza nor his advisers had any knowledge or reason to believe in 2008 that there would be a statutory change two years later, that Mr. Luizza reasonably relied on the law applicable at the time of the sale, and that Mr. Luizza was harmed by his reliance, since he did not have the opportunity to seek a higher purchase price or require an indemnity from the purchaser as he originally intended. With regard to the period of retroactivity, the ALJ relied on the “guidance” of the Appellate Division in an earlier level of the Caprio litigation, in a case involving the same set of statutory amendments but concerning the tax treatment of installment obligations rather than deemed asset sales, and found that the period of retroactivity was excessive. Caprio v. New York State Dep’t of Taxation and Fin. et al., 117 A.D.3d 168, 177 (1st Dep’t 2014). The ALJ also noted the Appellate Division’s conclusions in Caprio that there was no legislative history to support the Department’s position that the amendment was correcting any specific defect, rather than changing the statute to adopt the position requested by the Department, and that there was no valid public purpose in correcting the “mistakes” of the Tribunal in Baum and an ALJ in Mintz, since the Appellate Division had clearly found that the purpose of the amendment was not corrective but to raise tax revenues by $30 million.
In 2015, after the ALJ’s decision in Luizza, the Court of Appeals reversed the Appellate Division in Caprio, and, as discussed in the January issue of New York Tax Insights, held that the retroactive application of the portion of the 2010 statutory amendments applicable to the tax treatment of installment obligations did not violate the taxpayers’ Due Process rights.
Tribunal Decision. In light of the reversal in Caprio by the Court of Appeals, the Tribunal found that it needed to decide, first, whether it was bound by the decision in Caprio to uphold the constitutionality of the 2010 amendments as they applied to the Luizzas’ facts. While noting that it was “not without serious concerns as to the ramifications of this decision,” the Tribunal held that Caprio must control.
Although the retroactivity of the deemed asset sale amendments was not directly before the Court of Appeals in Caprio, where the plaintiffs had limited their challenge to the retroactive application of the amendments concerning the tax treatment of installment obligations, the Tribunal found that the clear intention of the Court of Appeals in Caprio was to uphold the retroactivity of all of the 2010 amendments.
Next, the Tribunal considered whether fact differences distinguished the case from Caprio, since the Luizzas, unlike the plaintiffs in Caprio, had sought and relied upon professional advice and demonstrated that they would have adjusted the purchase price if they had any forewarning of the change in law, and the Department stipulated their reliance was reasonable. However, the Tribunal found that Caprio required it to conclude that “petitioner’s reliance on the law cannot be held to be reasonable despite the stipulation signed by both parties and the additional facts that petitioners have proven . . . because, according to Caprio, petitioner should have been aware . . . of the long standing policies” of the Department. In reaching this conclusion, the Court of Appeals in Caprio had relied on the legislative findings, as well as an affidavit of an auditor concerning that policy. The Tribunal rejected the Luizzas’ argument that the Department had submitted no evidence of any such long-standing policy in their case, stating that Caprio required the conclusion that the Department’s policy made their reliance on their interpretation unreasonable and defeated their argument that they had no way of foreseeing the 2010 changes.
With regard to the period of retroactivity, the Tribunal found that, since Caprio had concluded the purpose of the 2010 amendments was curative or corrective, the two-and-a-half to three-year period of retroactivity was not unreasonable.
Finally, the Tribunal also rejected the Luizzas’ attempt to distinguish their case from Caprio on the grounds that the actual issue in Caprio was the retroactive application of the installment obligation amendments, which had been ruled on only in the non-precedential Mintz ALJ decision, rather than the deemed asset sale amendments, which had been ruled on by the Tribunal in the precedential Baum decision. While noting that the legislature “cannot cure or correct a decision of this Tribunal that is final and irrevocable,” the Tribunal found that the decision in Caprio about the “curative, rational public purposes” in the legislative findings overcame any arguments about the finality and continued effect of Tribunal decisions such as Baum.
Given the decision in Caprio, the result in Luizza may not be surprising, but these two decisions taken together raise troubling questions about the administration of tax policy in New York State. The only evidence of the “curative” and “corrective” nature of the 2010 arguments found by the Court of Appeals was the legislative findings and an affidavit submitted by a Department auditor concerning the Department’s internal policy— but no evidence that there had been any external statements of this policy that would have put taxpayers on actual notice. Indeed, the Department itself stipulated that the Luizzas had “reasonably relied” on the state of the law at the time they made a decision on whether or not to seek indemnity from the buyer. Both an ALJ and the Tribunal, in a precedential decision, had disagreed with the Department’s interpretation of the original statute, regardless of the internal policy followed or arguments made by the Department in litigation. The combination of the Caprio decision and the Luizza Tribunal decision, if it is the last word on this case, seem to indicate that taxpayers rely on contemporaneous research and Tribunal decisions at their own peril. While the precise issue involved in these cases—the retroactive application of the 2010 statutory amendments—probably does not apply to many more cases by now, the underlying principles could end up having broader application whenever the Department seeks to reverse an unfavorable Tribunal decision via retroactive legislation.
As of this writing, it is not known whether further appeal will be sought in Luizza.