The New York State Tax Appeals Tribunal reversed the decision of an Administrative Law Judge and held that the Qualified Empire Zone Enterprise ("QEZE") tax reduction credit allowed to a New York resident may be reduced by applying the business allocation percentage of the Subchapter S corporation giving rise to the income. Matter of Mark S. and Maria F. Purcell, DTA No. 825436 (N.Y.S. Tax App. Trib., Nov. 14, 2016).

Facts Regarding the Petitioners

Petitioner Mark Purcell was the sole shareholder of Purcell Construction Corporation ("PCC"), a business that had properly elected to be taxed as a Subchapter S corporation pursuant to federal and state law. PCC was certified by the State as a QEZE in 2003. During 2008 through 2010, the years in issue, PCC provided building design and construction activities, designing and creating large structures such as dormitories, barracks, and college residence halls, performing its design work and manufacture at two facilities within the Empire Zone. Some of its construction projects were performed inside New York, and others were outside New York, primarily in Virginia.

The QEZE Credit Claimed

Mr. Purcell filed New York State resident personal income tax returns, and reported and paid tax to New York on the income that flowed through to him from PCC. He also paid tax to Virginia, and claimed a credit for such tax, which was not challenged by the Department of Taxation and Finance and was not the basis of any adjustment. Mr. Purcell claimed a 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 a shareholder in an S corporation, 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. Based on this formula, Mr. Purcell claimed credits ranging between approximately $14 million and $22 million during the years in issue.

On audit, the Department recalculated the tax reduction credits, taking the position that the calculation should have used only PCC's income allocated within New York State, which it defined as the company's income reported on the shareholder's forms K1, multiplied by PCC's business allocation percentages. The Department's calculations reduced Mr. Purcell's credits for each of the years, and sought additional tax and interest totaling nearly $3 million for all three years in issue.

ALJ Decision

The ALJ had interpreted the phrase "shareholder's income from the S corporation allocated within the state" in Tax Law 16(f)(2)(C) to mean income that is subject to tax under Article 22, and that where an S Corporation shareholder is a New York resident, all

the shareholder's income from the S corporation is subject to tax under Article 22, and no allocation based on the Subchapter S corporation's allocation percentage is warranted. The ALJ found no authority in any statute or regulation for the application of the S Corporation's business allocation percentage where the QEZE tax reduction credit is claimed by a resident shareholder of an S corporation.

Tribunal Decision

The Tribunal reversed the ALJ. It found, first, that tax credit statutes are similar to and should be interpreted similarly to statues creating tax exemptions, meaning they must be strictly construed against taxpayers. While noting that it did not defer to the Department's proposed interpretation, since the question was one of pure statutory construction, the Tribunal found the Department's proposed interpretation reasonable, and that petitioners had not met their burden to show that theirs is the only reasonable construction.

The Tribunal determined that the use of the term "allocate" generally means to apportion into separate parts, and by using the term "allocated within the state" to describe the income to which the credit is applied under Tax Law 16(f)(2)(C), the intent must have been to allocate the Subchapter S corporation's income at the level of the Subchapter S corporation, because the phrase would otherwise be "superfluous" as applied to resident shareholders, since all of a resident shareholder's income is New York income. Despite finding that the Department's "interpretation might appear, at first, to be a less obvious or natural interpretation of the statutory language," the Tribunal adopted that interpretation and found that the Department "reasonably" used PCC's business allocation percentage despite the absence of any language in the statute or regulations applying such an allocation, as there is in the statute for corporate shareholders of S corporations.

The Tribunal also rejected arguments that the statute as applied unconstitutionally differentiated between resident and nonresident shareholders, since nonresident shareholders will receive a credit reflecting the full amount of New York tax attributable to the nonresident shareholder's income from the S corporation, finding that the tax factor for both the resident and nonresident shareholders includes all S corporation income allocated within New York. It also found that the economic development purpose behind the Enterprise Zone program was a significant public interest outweighing any "incidental impact on interstate commerce."

Additional Insights

Two other Administrative Law Judges had also disagreed with the Department's construction of the QEZE tax credit statute, in Matter of Harold A. & Katherine Batty and Matter of Pennefeather, DTA Nos. 824061 & 824063 (N.Y.S. Div. of Tax. App., Apr. 4, 2013), and Matter of Lisa M. & Gregory E. Henson, et al., DTA Nos. 825068 & 825254825257 (N.Y.S. Div. of Tax App., Apr. 10, 2014). Neither of those cases appears to have been appealed to the Tax Appeals Tribunal, and ALJ decisions are not precedential, although the fact that three different ALJs reached the same result might be interpreted as supporting the Tribunal's observation that the Department's position was "a less obvious or natural" one, and maybe was not as reasonable as the Tribunal concluded.

In addition, while the Tribunal has no authority to declare a statute unconstitutional, but only to consider its constitutionality as applied in a specific situation, the Tribunal relied on its conclusion that any impact on interstate commerce is "incidental," but considered only the one petitioner before it without any investigation into how many other similarly situated taxpayers may be affected. The Tribunal also found that the public purpose of increasing economic development in Enterprise Zones outweighed any impact on interstate commerce, but it did not explain how that public interest is furthered by limiting the amount of credit that can be claimed. To the contrary, reducing the amount of available credit would seem to discourage New York residents from forming businesses in Enterprise Zones.