The New York State Tax Appeals Tribunal held that a taxpayer’s due process rights were violated when the New York State Department of Taxation and Finance retroactively applied a change in law after the taxpayer had relied on a final tribunal decision in structuring a stock sale. Matter of Franklin C. Lewis, DTA No. 827791 (N.Y.S. Tax App. Trib. May 21, 2020). The tribunal’s holding should provide comfort to taxpayers that rely on tribunal or judicial decisions when structuring transactions.
Franklin C. Lewis, a nonresident of New York, owned 50% of the shares of Energy Service Providers, Inc. (ESPI), an S corporation engaged in business in New York. On July 31, 2009, ESPI was sold to U.S. Gas & Electric, Inc. (the buyer). Under the sale agreement, the ESPI shareholders and the buyer agreed to make an Internal Revenue Code Section 338(h)(10) election, which had the effect of treating the sale of stock as the sale of ESPI’s assets (and giving the buyer a step-up in the basis of ESPI’s assets).
Before closing on the sale, Mr. Lewis was advised by his tax accountant that the Section 338(h)(10) election did not change the nature of the transaction for New York tax purposes. The tax accountant’s advice was based on a tribunal decision, Matter of Gabriel & Frances Baum. In Baum, the tribunal concluded that regardless of an Section 338(h)(10) election, a sale of S corporation stock would be treated as the sale of stock (an intangible) and not the sale of the business’s assets. Based on this advice, Mr. Lewis did not seek an increased purchase price or an indemnity from the buyer for any additional taxes that may arise due to the Section 338(h)(10) election.
After Mr. Lewis’s sale of stock, and in response to Baum, the New York State Legislature passed legislation that reversed New York’s position and characterized the sale of stock in an S corporation with a Section 338(h)(10) election as an asset sale, with the shareholders’ proceeds apportioned to New York in accordance with the S corporation’s business allocation percentage. The 2010 legislation was made retroactive to tax periods beginning on or after Jan. 1, 2007, on the basis that the legislation was “correcting” the erroneous decision in Baum and confirming the “longstanding policies” of the department. The governor signed the legislation into law on Aug. 11, 2010.
On Oct. 14, 2010, Mr. Lewis filed his 2009 New York state nonresident income tax return, characterizing the gain consistent with the old law. Therefore, Mr. Lewis did not report or pay any New York personal income tax on the proceeds from the sale of ESPI. After auditing Mr. Lewis, the department issued an assessment on the basis that the stock sale should be treated as an asset sale for New York tax purposes, consistent with the new legislation, and therefore concluded that Mr. Lewis had income apportionable to New York.
The ALJ’s Determination
In New York state, taxpayers generally must appeal audit assessments to the DTA, where an Administrative Law Judge (ALJ) will establish the record in the case and issue a decision. In Mr. Lewis’s case, an ALJ held that the retroactive application of the 2010 legislation to Mr. Lewis did not violate the due process clauses of the U.S. or New York constitutions. The ALJ reviewed prior decisions by the New York Court of Appeals (Caprio v. Dep’t of Taxation & Fin.) and the tribunal (Matter of Jeffrey & Melissa Luizza), which concluded that the same 2010 legislation could be applied retroactively to taxpayers who completed transactions prior to the issuance of the tribunal’s decision in Baum, and concluded that it was “settled law” that the 2010 legislation may be applied retroactivity.
Mr. Lewis sought to distinguish his position from prior retroactivity decisions on the basis that he relied on the tribunal’s Baum decision, which was issued shortly before the sale of ESPI in 2009. The ALJ concluded that the timing of Mr. Lewis’s transaction was not sufficiently distinguishable, in part because Mr. Lewis filed his New York income tax return in October of 2010, two months after the 2010 retroactive legislation went into effect.
The Tribunal’s Reversal
The tribunal reversed the ALJ’s decision, finding that “public policy considerations against retroactivity” dictate a finding that the application of retroactive legislation to a taxpayer who relied on a final tribunal decision interpreting New York tax laws when structuring a stock sale transaction violates a taxpayer’s right to due process.
Like the ALJ, the tribunal concluded that, when determining whether the retroactive application of a taxing statute violates due process, it must consider three factors: (1) “the taxpayer’s forewarning of a change in the legislation and the reasonableness of … reliance on the old law”; (2) “the length of the retroactive period”; and (3) “the public purpose for the retroactive application.”
In analyzing the first factor, the tribunal focused on the relative reasonableness of Mr. Lewis’s reliance on pre-2010 legislation law, and agreed with the Mr. Lewis that his case was distinguishable from Caprio and Luizza, cases finding no due process violation from the retroactive application of the same 2010 legislation. The tribunal explained that Mr. Lewis “made his decision to agree to” sell his stock with an Section 338(h)(10) election “and forgo any accommodation from the seller in return for agreeing to the election” based on his reliance on the tribunal’s Baum decision, which was “final, irrevocable and precedential” under New York law. In contrast, the taxpayers in Luizza structured their transaction based on professional tax advice, which was supported by an ALJ decision in favor of the taxpayer in Baum, but contradicted “long-standing policies” of the department. Under New York law, ALJ decisions may not be cited and may not be treated as legal precedent.
The tribunal also took issue with the ALJ’s determination that the reasonableness of Mr. Lewis’s actions must be judged in part as of the date he filed his tax returns. According to the tribunal, when a taxpayer structures a transaction based on New York tax laws, “the only relevant time period” for determining whether the taxpayer reasonably relied on or had any forewarning of changes to New York law “is the period of the negotiation and completion of the transaction.” In Mr. Lewis’s case, this was especially important because the 2010 legislation went into effect after the transaction, but before he filed his New York return.
The tribunal found the second factor weighed in the department’s favor because the period of retroactivity was short—indeed, shorter than the period of retroactivity in Caprio and Luizza.
However, the tribunal concluded that the third factor also weighed in Mr. Lewis’s favor. According to the tribunal, “the integrity of the finality of Tribunal decisions … as a public policy prevails over the Legislature’s public purpose in correcting a mistake of this Tribunal.” Weighing the factors together, the tribunal concluded that applying the 2010 legislation retroactively violated Mr. Lewis’ due process rights.
Eversheds Sutherland Observations
At first glance, it may seem odd that the tribunal concluded it was unconstitutional to apply the 2010 legislation to Mr. Lewis, who completed his stock sale in July of 2009, while agreeing that it is constitutional to apply the 2010 legislation to the taxpayers in Luizza, who completed a similar transaction in March of 2008. This is especially true because Mr. Lewis, along with the taxpayers in Luizza, were faced with interpreting the same statutory language at the time they finalized their respective stock sales.
However, the test applied by the tribunal and New York courts in determining whether legislation may be applied retroactively focuses, in part, on whether a taxpayer reasonably relied on New York tax laws as they exist at the time of a transaction, and the tribunal was troubled by the implications of issuing a decision stating that a taxpayer may not reasonably rely on its own decisions when determining what New York tax laws say.
While taxpayers often are unable to anticipate retroactive law changes, there are some steps that taxpayers can take to protect their tax positions. The most important takeaway from the Lewis decision is that in order to prove reasonable reliance on the current state of the law, taxpayers should retain evidence of contemporaneous advice from tax professionals. As demonstrated in Lewis, that advice will carry the most weight if it is based upon precedential guidance, such as a tribunal or court decision.
In addition, taxpayers fighting a retroactive change in law should be prepared to demonstrate how they relied on the contemporaneous advice. In Mr. Lewis’s case, he demonstrated that he made the decision to not seek an increased purchase price based upon his reliance on the Baum decision. In another recent tribunal decision, Matter of NRG Energy, Inc., the tribunal refused to retroactively apply legislation changing the criteria for certification under New York’s Empire Zones program (which impacted a taxpayer’s ability to claim qualified empire zone enterprise credits). In that case, the tribunal was convinced that had the taxpayer known about a retroactive statutory amendment before the amendment went into effect, the taxpayer could have taken actions to avoid the revocation of its Empire Zone certified business status.
As states begin to legislate a path to recovery from the devastating impacts of Covid-19 on state budgets, taxpayers should be particularly vigilant about their tax planning, as states may be more likely to use retroactive tax legislation as a revenue raising tool.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Eversheds Sutherland (US) LLP Counsel Open Weaver Banks represents clients in state and local tax controversies at the administrative, trial and appellate levels. Her work includes income, franchise, sales and use, and property tax matters.
Eversheds Sutherland (US) LLP Counsel Ted Friedman focuses his practice on state and local tax matters. He counsels clients on a wide range of state and local tax issues involving income and franchise taxes, sales and use taxes, gross receipts taxes, property taxes and telecommunication taxes.
Eversheds Sutherland (US) LLP Associate Michael Hilkin focuses on tax controversy and transactional issues relating to state and local income, franchise, sales and use, gross receipts and other business taxes.