New York Court Upholds Retroactive Income Tax Provision for 338(h)(10) Elections
The Supreme Court of New York County upheld the retroactive income tax amendment treating an election under Internal Revenue Code section 338(h)(10) as an asset sale for New York State income tax purposes.
Retroactivity Upheld for 338(h)(10) Election and Non-Resident S Corporation Shareholders
Non-residents of New York are taxed only on New York source income. The sale by a non-resident of an intangible which is not used in a business conducted in New York is not New York source income and therefore not subject to tax. This means that a non-resident of New York can sell the stock of an S corporation which conducts business in New York, and not pay New York income tax on the sale of the stock.1
Internal Revenue Code section 338(h)(10) permits the buyer and seller to elect to treat the sale of the stock as a deemed sale of the assets, followed by a deemed liquidation of the S corporation. In 2009, the New York State Tax Appeals Tribunal held that the deemed treatment under Internal Revenue Code section 338(h)(10) was a fiction which did not change the fundamental fact that the non-resident shareholder sold stock — an intangible not subject to tax — and therefore no tax was owed to the State of New York.2
The following year, 2010, the Department of Taxation and Finance (“Department”) had legislation enacted to reverse the Baum and Mintz decisions.3 The amended statute provides that where an S corporation has made the section 338(h)(10) election “any gain recognized on the deemed asset sale for federal income tax purposes will be treated as New York source income allocated . . . in the year that the shareholder made the section 338(h)(10) election . . . .” It also specifies that any gain or loss recognized “on the exchange of the stock as part of the deemed liquidation shall be treated as the disposition of an intangible asset and will not increase or offset any gain recognized on the deemed assets sale . . . .” In other words, if you have a gain on the deemed sale of the assets and a loss on the exchange of the stock, you pay New York tax on the deemed gain, without any reduction for the loss.4
To make it worse, the legislation, enacted in 2010, was made retroactive to January 1, 2007. So if a non-resident sold stock in an S corporation and decided to make the section 338(h)(10) election based on the Baum decision, the New York tax consequences were changed after the transaction was closed. The Department justified retroactivity by noting in the legislative history that the amendment was intended to “clarify” the existing statute and to correct the “erroneous” decisions of Baum and Mintz.
Many discussed whether the retroactive reach of the new law would be upheld. That question was answered, at least preliminarily, in September, 2012, when the Supreme Court of New York County ruled that the amended statute was not unconstitutional as applied to the plaintiffs and granted the State’s motion for summary judgment dismissing the complaint.5 The Court determined that the amendment did not enact “a wholly new tax” (as opposed to “amendments that bring about certain changes to the operation of the tax laws”) and reflected the “longstanding policies of the Department of Taxation and Finance.” The Court also held that the plaintiffs could not have relied on Baum or Mintz, because their transaction was in 2007, before these cases were decided in 2009. We understand that the ruling will be appealed.
One wonders how the Department’s interpretation of a statute, however long-standing, which does not appear to be supported by the language of the statute before amendment, could have been the law. Or how an amended statute which imposes tax where the Tax Appeals Tribunal held there was none could be said not to impose a new tax. Or how retroactively changing the rules years after transactions are closed can be justified. These questions may be resolved by the decision of a higher court.
Until then, taxpayers who are under audit for these transactions and are subject to the retroactive reach of the amendment would be wise to resolve the audit in a way that permits a refund claim to be filed, and then file a protective claim for refund. Without doing so, the issue may be resolved by the courts long after the statute of limitations for a refund has run, forever barring the claim for refund.
1 The non-resident shareholder would pay New York income tax on her share of the S corporation’s income allocated to New York.
2 Matter of Baum, DTA Nos. 820837 and 820838 (Tax Appeals Tribunal, 2009). The Tribunal also held that because the New York statute computed the income of the S corporation as if no S election had occurred, the section 338(h)(10) election was unavailable and had to be disregarded. In Matter of Mintz, DTA Nos. 821806 and 821807 (2009), an administrative law judge held that the installment sale contract distributed out to the shareholders of an S corporation following the sale of the corporation’s assets was not subject to New York income tax because it was treated by federal income tax provisions as payment received in exchange for the stock.
3 Tax Law section 632(a)(2).
4 This was the Department’s litigation position in the Baum case.
5 Caprio v. New York State Department of Taxation and Finance, Index No. 651176/2011E (New York Supreme Court, New York County, September 22, 2012). The Supreme Court is a trial court.