Rejecting a claim by taxpayers that retroactive application violated their due process rights, a judge in the Supreme Court, New York County, has upheld the application of statutory changes made in August 2010 to the treatment of the distribution of installment obligations to the nonresident shareholders of an S corporation for the 2007 and 2008 tax years. Caprio v. New York State Dep’t of Taxation & Fin., 2012 NY Slip Op. 22273 (Sup. Ct. N.Y. Cty. Sept. 22, 2012).
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 purchase price” of approximately $19.9 million, plus a contingent purchase price based on TMC’s financial performance for 2007, 2008, and 2009. The agreement required the purchaser to pay approximately $19.4 million plus interest in 2007, and the remaining $500,000 plus interest in 2008, under promissory notes referred to as “Installment Obligations.”
For federal income tax purposes, the Caprios and the purchaser made an election under Internal Revenue Code § 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 recognized only when cash payments are actually received. The Caprios reported a capital gain on their 2007 federal income tax returns of approximately $18.2 million, and an additional gain of approximately $1.1 million in 2008.
They 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. The Caprios took the position that the gain should be treated as income from the sale of stock, and therefore not New Yorksource 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 gain is from property employed in a trade or business in New York.
Previous Litigation and Statutory Amendment. 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 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). 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 to assessment or refund.
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 more than $700,000. The Caprios brought suit in New York Supreme Court, a 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 court found initially that the Caprios were not required to exhaust administrative remedies before the Division of Tax Appeals, since they were challenging the statute’s constitutionality. However, it then determined that the retroactive application was appropriate.
First, it reviewed the general standard, finding that retroactive application of tax statutes did not necessarily infringe upon due process rights, and that courts were required to consider the nature of the tax and circumstances at issue. The Caprios claimed that the new statutory language enacted a “wholly new tax,” which the court noted might run afoul of due process requirements if not limited to a short period of retroactivity. Here, the court agreed with the Department that the 2010 amendments did not create a new tax but were simply “‘curative or clarifying measures’” intended to correct erroneous determinations by an ALJ in Mintz and by the Tax Appeals Tribunal in Baum, and were merely intended to “clarify and ratify what the Department… had long believed was already clear in the existing statutes.” The court further determined that the legislative findings accompanying the amendment indicated that it was intended to clarify the existing statute and correct what were viewed as erroneous determinations in Mintz and Baum. Since the statute itself provided for retroactivity back to 2007, taxpayers “would reasonably expect that so long as the statute of limitations period remained open…the Department…could impose an additional assessment.”
While the Caprios argued that any retroactivity period should extend no further back than the year of the legislative session preceding the enactment, the court rejected that argument, finding that both federal and New York courts have approved retroactivity periods longer than one year.
The Caprios also argued that they structured the 2007 stock sale in reliance on the previous interpretation, which was upheld in Mintz, and that the Department, by failing to appeal the decision in Mintz and instead seeking a legislative remedy, knew that the existing law did not impose a tax in these circumstances. The court rejected this argument, noting that ALJ determinations have no precedential value, so a taxpayer cannot reasonably rely on them, and that, since the Mintz decision was issued in 2009, the Caprios could hardly have relied on it in structuring their transaction in 2007. The court found persuasive the evidence offered by the Department about its longstanding interpretation of § 632(a)(2), and found that the Mintz and Baum decisions in 2009 were “aberrational.”
Additional Insights. This decision illustrates some of the difficulties inherent in litigating state tax disputes. Here, other taxpayers had litigated very similar issues, and both an Administrative Law Judge, whose decisions are not precedential, and the Tax Appeals Tribunal, whose decisions are precedential, had disagreed with the Department’s interpretation of the statute. Since the taxpayer was successful before the Tribunal in Baum, the Department had no right to appeal the decision, and decided against appealing Mintz. Instead, the Department took the alternative course of seeking and obtaining a statutory amendment. Nonetheless, both an ALJ and the Tax Appeals Tribunal had found that the original statute did not provide for the interpretation urged by the Department. When taxpayers who lose before the Tax Appeals Tribunal appeal those decisions to the Appellate Division, the Department customarily argues that the decisions of the Tribunal are entitled to great deference. Here, the Department seemed to be saying just the opposite: that the Tax Appeals Tribunal was wrong, had always been wrong, and no reliance at all can be placed on its decisions, so that taxpayers and their advisors who similarly believed they understood the statute remain at risk. To the extent the Department finds a need to amend a statute to enforce its interpretation—even if it had always believed its interpretation was correct—the better policy might perhaps be to acknowledge that taxpayers who took the opposite position had been joined in their thinking by an ALJ and the Tribunal, and to apply the new statute prospectively only.