Questioning the constitutionality of state personal income tax provisions seems to be all the rage these days. On the heels of the Supreme Court’s decision in Comptroller v. Wynne discussed in our recent blog post, New York’s highest court heard oral arguments on Thursday, June 4, for two related cases to determine whether the taxation of nonresident shareholders of S corporations is constitutional.

To understand these two cases, we have to get into the weeds a bit of New York Tax Law §632(a)(2) and some federal tax provisions. When shareholders of a Subchapter S corporation sell their company, the purchaser often prefers to treat the transaction as a deemed sale of assets under IRC § 338(h)(10) of the Internal Revenue Code, rather than a sale of stock. This permits the purchaser to get a “step up” in basis for the assets. From a technical standpoint, the sale is treated as a deemed sale of assets followed by a deemed liquidation of the company. The selling shareholders still get favorable capital gains treatment on the proceeds. Since a 338(h)(10) election is typically most beneficial to the purchaser, the purchase price of the company will take into consideration any negative tax implications for the seller.

In 2009, the New York Tax Appeals Tribunal looked at how the sale proceeds of a corporation sold pursuant to a IRC §338(h)(10) election would be taxed to a New York nonresident shareholder. In Matter of Baum, the taxpayer (represented by Hodgson Russ) successfully argued that, for New York purposes, he had really just sold stock in his S corporation—an intangible not taxable to a nonresident. A few months after the Baum decision, an Administrative Law Judge in Matter of Mintz came to the same conclusion for purposes of installment payments pursuant to IRC §453(h).

Not surprisingly, the New York Department of Taxation and Finance (DTF) did not like these results and convinced the legislature to pass Tax Law §632(a)(2). Under this amendment, passed as part of the 2010-11 budget legislation, a 338(h)(10) election for federal purposes is also treated as an asset sale for New York purposes and is thus taxable to a nonresident based on the company’s New York apportionment factors. In addition, if the proceeds from the sale are paid out in installments, pursuant to IRC §453(h), those proceeds are similarly taxable to a nonresident. The kicker was that the statute was retroactive to all open tax years, thus covering transactions that had been negotiated under the Baum decision and long before the law change. New York nonresident shareholders subsequently received tax bills for sale proceeds that they had been advised were nontaxable.

Enter Burton and Caprio (case summaries and oral argument available here). The cases address different parts of Tax Law 632(a)(2). Caprio, which the taxpayer won on appeal from an adverse supreme court decision, looked at whether two installment payments from a deemed asset sale in 2007 were taxable to the nonresident shareholders. The Caprios argued that the retroactive application of §632(a)(2) was unconstitutional. The DTF argued that this amendment was not a new tax but simply a curative amendment reflecting previous policy and thus retroactivity was permissible. To support that position, they offered a non-binding advisory opinion, a DTF PowerPoint, and the DTF’s memo in support of the legislation. Like at the Appellate Division, the judges seemed unconvinced that the amendment was only curative, asking repeatedly for evidence beyond the limited documentation in the record that the 2010 amendment represented “longstanding policy” and that nonresident taxpayers had paid the tax on such transactions prior to Baum. 

Burton faced a more skeptical court. There, the taxpayers had also sold their corporation in a deemed asset sale in 2007, and it was the constitutionality of taxing a nonresident on the proceeds from a deemed asset sale at issue. But rather than argue that the retroactive application of the law was unconstitutional, the taxpayers argued (unsuccessfully at the supreme court level) that the application of §632(a)(2) violated article XVI §3 of the New York Constitution, which limits taxation of intangibles to the state of the owner’s domicile. The judges seemed to doubt that the constitution prohibited taxing a nonresident on the gain from the sale of an intangible in addition to the intangible itself.

So, stay tuned. Clearly, the judges were trying to understand what are complicated transactions even for tax practitioners. They appeared to be looking for any room to differentiate between the taxation of a 338(h)(10) deemed asset sale from a 453(h) installment sale—something even the state’s attorney argued was not possible. The question is whether that will lead them to declare the retroactive application of the entirety of § 632(a)(2) unconstitutional or somehow limit that holding to an installment obligation.