INSIGHT: Non-Resident Taxed on Electing S Corporation’s Deemed Sale Gain

Franklin C. Lewis owes tax on his share of the gain from the sale of an “electrical energy supplier.”

Lewis was a nonresident of New York during 2009, 2010, and 2011. Prior to July 31, 2009, Lewis owned 50% of the shares of Energy Service Providers Inc. (ESPI), a New York corporation that had in place a valid election to be taxed under subchapter S for both federal and New York state income tax purposes. (Matter of Lewis, DTA No. 827791 (N.Y. Div. Tax App. 6/20/19).

ESPI entered into a purchase agreement with U.S. Gas & Electric Inc. (USGI) dated July 31, 2009. Under the terms of the agreement, the sellers, including Lewis, and the buyer, negotiated and agreed to make a federal tax code Section 338(h)(10) election. Accordingly, though the transaction was a sale of stock, the effect of the election was that ESPI, as seller, was deemed to have sold all of its assets in a taxable transaction, and USGI, as buyer, was treated as having purchased those same assets, so as to receive a step-up in the basis of the assets. The purchaser, in short, got the convenience of a stock purchase with the tax benefits of an asset purchase.

Lewis was advised that at the time of the sale (i.e., in 2009), a stock sale that was a deemed sale of assets pursuant to a Section 338(h)(10) election did not change the nature of the transaction for New York state income tax purposes, i.e., that the transaction would be treated as a sale of stock for New York tax purposes.

Retroactive Amendment

On Aug. 31, 2010, N.Y. Tax Law Section 632(a)(2) was amended to specifically state that a nonresident S corporation shareholder must treat the sale of stock subject to an election under Section 338(h)(10) as the sale of assets and apportion the proceeds thereof to New York in accordance with the S corporation’s business allocation percentage (BAP). The amendments were retroactive, and specifically were effective for tax years beginning on or after Jan. 1, 2007. Lewis, however, did not pay any New York personal income tax on the proceeds arising from the ESPI to USGI sale transaction. The New York Department of Taxation and Finance issued a notice of deficiency assessing a New York personal income tax due for the years 2009, 2010, and 2011, in the aggregate amount of $810,815, plus interest and penalty.

Lewis argued that retroactively imposing liability against him under the 2010 Amendments constituted an “as applied” violation of the Due Process Clauses of the U.S. and New York constitutions. Lewis recognized that challenges by other, similarly situated, individuals have been summarily rejected. However, Lewis argued that, since his transaction occurred after the decision in Matter of Baum, DTA No. 820837 (N.Y. Tax App. Trib. 2/12/09), was issued, his reliance-based due process argument is stronger than the arguments presented in the other cases.

Secondly, Lewis argued that ESPI’s proper New York BAP should be zero. Lewis maintained that ESPI did not provide any “tangible personal property or electricity” to its customers, but rather that it “facilitated transactions and consulted with customers regarding the utility providers.” As a consequence, Lewis argued that ESPI’s receipts were realized from providing services, and that all of the functions performed in carrying out such services occurred outside of New York from a call center in Pittsfield, Mass. Lewis therefore maintained that none of ESPI’s receipts should be apportioned to New York and, therefore, ESPI’s BAP should be zero.

In July 2009, when the instant transaction occurred, Section 632(a)(2) provided:

“In determining the New York source income of a nonresident shareholder of an S corporation … there shall be included only the portion thereof derived from or connected with New York sources of such shareholder’s pro rata share of items of S corporation income, loss and deduction.”

Former Section 632(a)(2) did not specifically address how a New York nonresident’s gain from the sale of stock in a New York S corporation would be impacted where such sale transaction was treated, pursuant to a valid Section 338(h)(10) election, as a deemed sale of the assets of the S corporation to the buyer, followed by a deemed liquidation of the S corporation in exchange for its stock, the court said.

In 2010, the New York Legislature amended Section 632(a)(2) to provide: “if the shareholders of the S corporation have made an election under section 338(h)(10), … then any gain recognized on the deemed asset sale … will be treated as New York source income allocated in a manner consistent with the applicable methods and rules for allocation” under Article 9-A. The amendments were made applicable to tax years beginning on or after Jan. 1, 2007.

It is, the court said, now settled that the 2010 amendments to Section 632(a)(2) may be applied retroactively to tax years beginning on or after Jan. 1, 2007, without violating the Due Process Clauses. Lewis, however, contested the retroactive application to his particular circumstances, maintaining that such application results in an “as applied” violation of his due process rights. Lewis pointed out that his transaction took place after the decision in Baum. Accordingly, Lewis argued that “this resulting extra level of reliance exceeds the parties’ stipulated reliance” in the other decided cases and tipped the scales in his favor, and required a conclusion that the deficiency at issue represented an unconstitutional application of the 2010 amendments. The court disagreed.

The legislature enacted the 2010 amendments to: “clarify and ratify the Division’s longstanding interpretation and application” of Tax Law Section 632(a)(2) that proceeds received in circumstances involving a Section 338(h)(10) election resulted from deemed asset sales such that nonresidents were required to report their share of such proceeds as New York source income. The legislature, the court noted, drew no distinction between transactions that predated the decision in Baum or postdated such decision. “The Legislature did not limit the retroactive reach of the 2010 Amendments by any reference to the Baum decision. … Thus, the Legislature’s intended sweep of retroactivity included those who could have and … in fact did rely on Baum.” The additional factual distinction of Lewis’s reliance on Baum was insufficient to find a due process violation. Lewis’s challenge on due process grounds therefore failed.

Business Allocation Percentage

Despite Lewis’s “argument that ESPI merely facilitated transactions between suppliers, deliverers, and consumers of electricity, it remains that ESPI’s receipts resulted from its ongoing purchases of and sales of electricity.“ Lewis maintained that its receipts should be considered receipts from services or other business receipts. Under either of such circumstances, its receipts were not properly self-apportioned to New York, but should have been apportioned elsewhere, based upon where the services generating such receipts were performed.

In fact, the court said, “providing electricity to its customers is what ESPI did, via its purchases of electricity from NYISO and its subsequent sale of that electricity to its customers.” Lewis’s “position that it was merely a transaction facilitator overlooks, and is in fact belied by, the energy purchase contracts between ESPI and NYISO that are in the record, by the consistent written descriptions of ESPI and its business … by the testimony at hearing, and by ESPI’s consistent 100% self-apportionment of receipts to New York, coupled with its failure to have apportioned any of its receipts to Massachusetts or elsewhere.” ESPI, the court concluded, was an electrical energy supplier. ESPI’s receipts may not fairly be characterized as derived from services, but rather were derived from the sale of goods to customers mainly located in New York. ESPI, in short, was a principal and not merely an agent; and its BAP was 100%.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.