The New York State Tax Appeals Tribunal has reversed the decision of an Administrative Law Judge and held that New York personal income tax cannot be imposed on a gain on the sale of real property owned by a limited liability company that was in turn owned by an Employee Stock Ownership Plan (“ESOP”). Matters of Patrick Murphy & Kathleen Murphy, DTA No. 825277 (N.Y.S. Tax App. Trib., Mar. 6, 2018). The Tribunal found that the federal Employee Retirement Income Security Act of 1974 (“ERISA”) supersedes state laws that relate to employee benefit plans, leaving the Tribunal without authority to rule on whether the trust qualified under ERISA, and therefore canceled the deficiency. 

Facts. The gain in question arose from the 2006 sale of real property located in Manhattan (the “Property”) to an unrelated party for $5.5 million, generating a gain of approximately $2.2 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 reported the gain on its 2006 New York State partnership return.  

At the time of the sale, 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). Mr. Murphy was its president, and was also the sole trustee of JJF ESOP at the time of sale, and Mr. and Mrs. Murphy were the only participants and beneficiaries of JJF ESOP.

In 1996, Triune had contributed the 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.  

The petitioners 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, and JJF Realty had no other officers or employees as of 2006. 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.

Federal Filings. JJF ESOP’s federal forms 5500-EZ for 2006 and 2008 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 each 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 “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 Murphys also submitted a “JJF Realty Management Inc. Employee 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. 

The deed evidencing the August 2006 sale of the Property, the Real Estate Transfer Tax (“RETT”) filing summary associated with the sale of the Property, and the New York City real property transfer tax form all listed JJF Associates as the seller. However, an “Amendment to Agreement” dated February 28, 2006 between JJF ESOP and the purchaser of the Property identified JJF ESOP as the seller. Mr. Murphy testified that title to the Property was transferred from JJF Associates to JJF ESOP prior to its sale in 2006.

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. The Murphys provided a waiver of the statute of limitations, extending the time to assess until December 15, 2010, but refused requests for further waivers. On November 8, 2010, after sending a proposed audit adjustment, the Department advised the Murphys that an additional waiver would be needed to give it time to review any additional materials, and that if no waiver was received, a notice of deficiency would be issued. On November 12, 2010, petitioner Patrick Murphy sent a letter stating that the original waiver was revoked “eo instanti,” that it had been obtained in violation of petitioners’ rights under the Due Process clause and the New York State taxpayer bill of rights, and that it was contrary to the Department’s audit guidelines. 

A notice of deficiency was issued on November 22, 2010. The petitioners requested a conciliation conference, which resulted in a conciliation order sustaining the assessment. Petitioners later became aware that the auditors and the conciliation conferee had substantive discussions regarding the matter without petitioners’ involvement.

ALJ Hearing and Determination. The ALJ had decided, first, that the notice of deficiency was not preempted by ERISA as the petitioners claimed, and rejected the petitioners’ arguments that the notice was issued untimely and lacked a rational basis, despite claims that the Department changed its theory at the hearing and did not proceed on its original theory. The ALJ then dealt with the argument that JJF ESOP should be disregarded as a “sham entity” with no economic substance. The ALJ agreed that JJF ESOP was a sham trust, and that the gain from the sale should be attributed directly to Mr. and Mrs. Murphy, noting, among other facts, that they alone beneficially owned and controlled the Property, both before and after the creation of JJF ESOP, that they were the only ones to benefit from the sale, and that Mr. Murphy was not an independent trustee since he controlled JJF Realty, the creator of the trust, and was also a primary beneficiary. The ALJ further found Mr. Murphy’s testimony at the hearing to be “confusing, evasive and contradictory,” rejected the arguments that petitioners were denied due process by the audit or by the ex parte communications between the conciliation conferee and the auditors during the conciliation process, and found that Mr. Murphy’s attempt to unilaterally revoke the waiver extending the limitations period “was of no consequence.”

Tribunal Decision. First, the Tribunal agreed with the ALJ that the notice of deficiency issued on November 22, 2010 was timely, and that Mr. Murphy’s attempt to unilaterally revoke the waiver by letter on November 12, 2012 was not effective.

However, on the preemption issue, the Tribunal reversed the ALJ. It found, first, that the gain from the sale of the Property resulted in long term capital gain that was reported as such on JJF Associates’ 2006 partnership return, and that the full amount of the gain was reported on its 99%-member JJF ESOP’s K-1 and thus was passed through to JJF ESOP. An ESOP qualified under IRC § 401(a) is exempt from tax, and responsibility for tax ultimately falls to the trust’s beneficiaries when distributions from the trust are taxable to the distributee in the year of distribution under IRC § 402(a). An ESOP qualified under IRC § 401(a) is an employee benefit plan as defined in ERISA, and falls within the scope of the ERISA preemption provision, which states that ERISA’s provisions “supersede any and all State laws insofar as they . . . relate to any employee benefit plan.” 29 U.S.C.A. § 1144(a).  

To determine the scope of the federal preemption, the Tribunal reviewed federal cases and, while noting the presumption that Congress generally does not intend to preempt state law, particularly in an area of “traditional state regulation” such as tax, pointed out that the ERISA statute expressly provides that state tax laws are not exempt from preemption.

The Tribunal found that the term “relates to” in the preemption statute is interpreted in its “normal sense,” and that an ERISA plan preempts state law if the law has a “connection with or reference to such a plan.” It noted that, under Ingersoll-Rand Co. v. McClendon, 498 U.S. 133 (1990), preemption would apply, because here, as in IngersollRand, the existence of a plan subject to ERISA regulation is a “critical factor” in determining liability. The petitioners seek to prove that JJF ESOP exists and is qualified under IRC § 401(a), and the Tribunal found that the administrative proceeding relates to the “‘essence’ of JJF ESOP, the putative ERISA plan, and therefore relates to ERISA.” The Tribunal held that it would be “plainly contrary to the preemption clause’s ‘goal of uniformity’ for the Division of Tax Appeals to determine whether a trust is qualified under” IRC § 401(a). 

The Tribunal acknowledged that there might be a potential for abuse if the mere claim of the existence of an ERISA plan were to create a shield of preemption, but found that not to be the case here, since the record contained the JJF ESOP Trust Agreement, JJF ESOP Plan, JJF ESOP’s forms 5500-EZ for the years 2006 and 2008 through 2012, and JJF ESOP’s 2006 Form K-1, and that the authenticity of those documents was not in question. The Tribunal found that the record creates prima facie evidence of the existence of JJF ESOP, and that it was therefore preempted from making a determination regarding the qualification of a trust under IRC § 401(a). It granted the petition and canceled the notice of deficiency.

ADDITIONAL INSIGHTS

The ALJ’s decision concentrated primarily on the rather complicated facts, potentially inconsistent documents, numerous overlapping relationships among several commonly owned entities, including the ESOP, and testimony by Mr. Murphy that the ALJ found lacked credibility. The Tribunal focused instead on the broader issues presented by the Department’s audit, and the documentation produced by the petitioners which was not contested by the Department. The Department’s theory was based on its position that the ESOP was a sham and should be disregarded, and that was exactly the argument accepted by the ALJ and used as the basis for his decision. However, that question — the validity of an ESOP — is explicitly preempted from state review by federal law, and the Tribunal found that it could not address that issue at all.