Philip Caprio, et al., Respondents,v.New York State Department of Taxation and Finance, et al., Appellants, Andrew M. Cuomo,, Defendant.BriefN.Y.June 4, 2015APL-2014-00177 Supreme Court, New York County, Index No. 651176/2011 State of New York Court of Appeals PHILIP CAPRIO and PHYLLIS CAPRIO, Plaintiffs-Respondents, -against- NEW YORK STATE DEPARTMENT OF TAXATION AND FINANCE, et al., Defendants-Appellants. REPLY BRIEF FOR APPELLANTS BARBARA D. UNDERWOOD Solicitor General CECELIA C. CHANG Special Counsel to the Solicitor General JUDITH N. VALE Assistant Solicitor General of Counsel ERIC T. SCHNEIDERMAN Attorney General of the State of New York Attorney for Appellants 120 Broadway New York, New York 10271 (212) 416-6274 (212) 416-8962 (facsimile) Dated: January 13, 2015 TABLE OF CONTENTS Page TABLE OF AUTHORITIES ............................................................. ii PRELIMINARY STATEMENT ........................................................ 1 ARGUMENT ................................................................................... 3 RETROACTIVE APPLICATION OF THE 2010 AMENDMENTS DOES NOT VIOLATE DUE PROCESS ....... 3 A. Due Process Does Not Prohibit the Legislature from Retroactively Closing Unintended Tax Loopholes. ................................. 3 B. Retroactive Application of the 2010 Amendments Is Rational and Fair under the James Square Factors. ................................... 8 1. Plaintiffs did not and cannot disprove the declared curative purposes of the 2010 amendments. ........................................ 11 2. Plaintiffs failed to prove that the retroactivity period here is unreasonable or unfair. ........................................................ 15 3. Plaintiffs failed to prove reasonable reliance on any established policy or practice of total tax immunity. ...................... 18 C. Pre-Amendment Law Required Plaintiffs to Pay New York Taxes. ......................................... 24 CONCLUSION ............................................................................... 33 i TABLE OF AUTHORITIES Cases Page(s) Affronti v. Crosson, 95 N.Y.2d 713 (2001) ................................................................. 23 Canisius Coll. v. United States, 799 F.2d 18 (2d Cir. 1986) ......................................................... 16 DeMartino v. Comm’r of Internal Revenue, 862 F.2d 400 (2d Cir. 1988) ..................................................... 7, 9 Furlong v. Comm’r of Internal Revenue, 36 F.3d 25 (7th Cir. 1994) ............................................................ 4 Gitlitz v. Comm’r of Internal Revenue, 531 U.S. 206 (2001) .................................................................... 32 Held v. State of N.Y. Workers Comp. Bd., 85 A.D.3d 35 (3d Dep’t 2011) ..................................................... 12 In re Lambert, 179 F.3d 281 (5th Cir. 1999) ...................................................... 21 James Square Assoc. LP v. Mullen, 21 N.Y.3d 233 (2013) ................................................. 2, 11, 15, 20 Kitt v. United States, 277 F.3d 1330 (Fed. Cir. 2002) ................................................ 3, 6 Matter of Chatlos v. McGoldrick, 302 N.Y. 380 (1951) ..................................................................... 9 Matter of Epstein v. N.Y. State Tax Comm’n, 132 A.D.2d 52 (3d Dep’t 1987) ..................................................... 7 Matter of Replan Dev., Inc. v. Dep’t of Hous. Pres. & Dev. of City of N.Y., 70 N.Y.2d 451 (1987) ................................................................. 19 ii TABLE OF AUTHORITIES (cont’d) Cases Page(s) Matter of Roosevelt Raceway v. Monaghan, 9 N.Y.2d 293 (1961) ................................................................... 10 Prof’l Serv. Network, Inc. v. Am. Alliance Holding Co., 238 F.3d 897 (7th Cir. 2001) ...................................................... 25 S & R Props. v. Maricopa County, 178 Ariz. 491 (Ariz. Ct. App. 1993) ........................................... 10 United States v. Carlton, 512 U.S. 26 (1994) .............................................................. passim Valentino v. Franchise Tax Bd., 105 Cal. Rptr. 2d 304 (Cal. Ct. App. 2001) ................................ 32 Valles v. Ivy Hill Corp., 410 F.3d 1071 (9th Cir. 2005) ...................................................... 9 Wash. Nat’l Arena Ltd. P’ship v. Treasurer, Prince George’s County, 287 Md. 38 (1980) ...................................................................... 10 Welch v. Henry, 305 U.S. 134 (1938) ................................................................ 4, 16 Zaber v. City of Dubuque, 789 N.W.2d 634 (Iowa 2010)........................................................ 7 State Law Tax Law § 2010 .............................................................................. 21 iii TABLE OF AUTHORITIES (cont’d) Federal Laws Page(s) 26 U.S.C. § 453 ........................................................................................... 28 § 453B ......................................................................................... 29 § 1366 ................................................................................... 29, 31 26 C.F.R. § 1.338(h)(10)-1 ............................................ 26, 27, 28, 30 Miscellaneous Authorities 2 Sutherland Statutory Construction § 41:17 (7th ed. Westlaw 2014) ................................................................ 7 N.Y. State Dep’t of Taxation & Fin., Publication 35: New York Tax Treatment of S corporations and Their Shareholders (Mar. 2000), available at http://www.nytaxexperts.com/pdf/new-york- publications/New-York-Tax-Treatment-of-S-Corporation- and-their-sharholders.pdf .................................................... 24, 31 N.Y. State Dep’t of Taxation & Fin., Publication 88: General Tax Information for New York State Nonresidents and Part-Year Residents (Dec. 2006), available at http://www.tax.ny.gov/pdf/publications/income/2006/pub8 8.pdf ............................................................................................ 23 Office of Tax Policy Analysis Technical Services Division, Summary of Corporation Tax Legislative Changes Enacted in 2006 (Jan. 30, 2007), available at http://www.tax.ny.gov/pdf/memos/corporation/m07_3c.pdf ...... 13 iv PRELIMINARY STATEMENT Plaintiffs seek to avoid payment of any New York income tax on their multi-million dollar sale of an S corporation based on a claimed tax loophole the validity of which the Legislature rejected through curative statutory amendments in 2010. The Legislature found that settled tax practice was contrary to and barred the tax immunity plaintiffs seek, despite two erroneous administrative decisions to the contrary; and the Legislature confirmed prior practice by enacting curative amendments made applicable retroactively to still-open tax years. A majority of the Appellate Division concluded that retroactive application of the amendments to plaintiffs’ transaction violated due process. As state appellants established in their opening brief, this Court should reverse. Relying on their own personal interpretation of pre- amendment law, plaintiffs claim that by delaying payment of sale proceeds by one month they could receive the federal and state tax benefits of a corporate asset sale while avoiding the other tax consequences of asset-sale treatment. The mechanics of plaintiffs’ loophole strategy are complicated, but the result is not. Plaintiffs contend that delayed payment of sale proceeds completely immunizes their gains from state taxation—a result they do not defend as supported by any rational tax policy or intended legislative allocation of tax burdens. Because the Legislature acted to eliminate an unintended, possible tax loophole, the retroactive application of the 2010 amendments is rational and satisfies the due-process test set forth by this Court in James Square Associate LP v. Mullen, 21 N.Y.3d 233 (2013). As the Legislature expressly found, the amendments serve the public purposes of preventing ongoing legal confusion caused by the newly-issued administrative decisions, unfair tax results for S-corporation purchasers who relied on prior tax practice, and unexpected revenue losses. The only rational and fair way to avoid these harms was to apply the amendments retroactively to still-open tax years. Plaintiffs do not point to any evidence, because they submitted none, to dispute these legislative findings or to prove that the Legislature acted irrationally. 2 ARGUMENT RETROACTIVE APPLICATION OF THE 2010 AMENDMENTS DOES NOT VIOLATE DUE PROCESS A. Due Process Does Not Prohibit the Legislature from Retroactively Closing Unintended Tax Loopholes. As explained in state appellants’ opening brief (Br. for Appellants (“App. Br.”) at 26-32), courts have uniformly upheld broad legislative authority to retroactively eliminate unintended tax loopholes. See, e.g., United States v. Carlton, 512 U.S. 26, 31- 33 (1994); Kitt v. United States, 277 F.3d 1330, 1333-35 (Fed. Cir. 2002). Retroactive closing of unintended loopholes is well-accepted for good reason: giving some taxpayers the windfall benefit of an unintended loophole unfairly shifts the burden of taxation to other taxpayers. See App. Br. at 30, 35-36. Absent retroactive application of corrective legislation, there is no other way for the Legislature to fully eliminate the public harm from an unintended tax loophole. A prospective-only cure would leave parties free to exploit unintended loopholes for still-open tax years. In addition, a prospective-only cure would 3 subject other parties who did not benefit from the claimed tax loophole (such as the purchasers in this case) to ongoing confusion and protracted litigation about their past and present tax liability. Id. at 5-8, 33-39. Because of similar policy concerns, retroactivity is commonplace in tax legislation. Non-curative tax amendments, for example, are generally made retroactive at least to the year of the legislative session preceding their enactment. See Welch v. Henry, 305 U.S. 134, 149-50 (1938); Furlong v. Comm’r of Internal Revenue, 36 F.3d 25, 26 (7th Cir. 1994) (collecting cases). The policy rationales supporting retroactivity are even greater when the Legislature acts to eliminate a potential loophole. Plaintiffs provide no basis for this Court to depart from longstanding precedent upholding the Legislature’s ability to retroactively close unintended tax loopholes. Plaintiffs do not plausibly deny that the Legislature was engaged in that very task in this case, acting to foreclose a tax-immunity interpretation that would be the essence of an unintended tax loophole. Plaintiffs have identified no reason—because there is none—why the Legislature would have purposefully permitted S-corporation 4 sellers to completely immunize millions in deemed asset-sale gains from any state taxation simply by delaying payment of gains by a single day (or one month, as plaintiffs did here).1 As state appellants demonstrated in their opening brief, such a rule makes no sense, is unsupported by any rational tax policy, and would actually undermine the foundational purposes of the underlying tax statutes at issue. See App. Br. at 50-53. Plaintiffs’ entire due process argument is premised on a single claim: that the Constitution bars the Legislature from closing a loophole if an individual taxpayer’s personal reading of tax statutes and regulations possibly supports claimed tax immunity—whether or not the interpretation was intended by the 1 Plaintiffs assert that they did not purposefully use installment reporting to exploit a potential tax loophole. Br. for Pls.-Respondents (“Pls. Br.”) at 59 n.5. But they offer no reason— other than tax avoidance—for why the initial $19.4 million payment was delayed by one month. Unlike the contingent portion of the purchase price, the initial payment did not depend on future performance of the corporation requiring payment in future installments. Moreover, plaintiffs’ claim misses the broader point. Whether certain actions were taken with a loophole in mind, the public harm of allowing windfall exploitation of a tax loophole at a later date remains the same. 5 Legislature or adopted as a matter of settled tax practice. But even if plaintiffs have a technically possible statutory interpretation of pre-amendment federal and state tax law, which they do not (App. Br. at 50-57; see also infra at 24-32), retroactive application of the 2010 amendments to plaintiffs’ S-corporation sale does not violate due process. Taxpayers have no vested constitutional right in their individual interpretation of the bare words of a tax statute. See Carlton, 512 U.S. at 31-33 (upholding retroactive application of amendment to close loophole, although taxpayer’s reading of prior tax law was supported by plain statutory language); Kitt, 277 F.3d at 1333-35 (same). If the test were otherwise, the exception would swallow the rule. Loopholes exist, after all, only when there is some viable way to parse a tax statute to avoid tax liability. There would be no need for curative amendments to eliminate an unintended loophole in the first place unless taxpayers could plausibly claim that a reading of the tax code somehow exempted them from taxation. 6 Plaintiffs suggest that the Legislature’s authority to enact curative tax legislation is limited to correction of previously “void” tax statutes (i.e. statutes enacted without legal authority). Pls. Br. at 62-65. But no such restriction exists. Courts have broadly upheld retroactive application of tax-law amendments simply to cure drafting errors or to revise statutory language to eliminate unintended loopholes opened by erroneous rulings—not simply to correct the problem of void tax legislation.2 See, e.g., Carlton, 512 U.S. at 30-33; DeMartino v. Comm’r of Internal Revenue, 862 F.2d 400, 409 (2d Cir. 1988); Matter of Epstein v. N.Y. State Tax Comm’n, 132 A.D.2d 52, 55 (3d Dep’t 1987). 2 Plaintiffs’ own authorities recognize that retroactive correction of void tax legislation is only one “type of curative,” measure within the Legislature’s power. Zaber v. City of Dubuque, 789 N.W.2d 634, 640 (Iowa 2010); see also 2 Sutherland Statutory Construction § 41:17 (7th ed. Westlaw 2014) (explaining that retroactive application of corrective tax amendments is necessary “to safeguard the public treasury against erosion of revenues and [to] avoid inequitable distribution of tax burdens”). 7 B. Retroactive Application of the 2010 Amendments Is Rational and Fair under the James Square Factors. Because the 2010 amendments fall squarely within the Legislature’s authority to retroactively eliminate a potential, unintended tax loophole, this Court’s decision in James Square— which found that the legislation in James Square was not meant to cure any unintended error—is not controlling here. See App. Br. at 26-32. As plaintiffs acknowledge (Pls. Br. at 26), the Legislature enacted the amendments to overturn Baum and Mintz, administrative rulings issued two years after plaintiffs’ S- corporation sale. The Legislature expressly found that Baum and Mintz had erroneously opened vast and unintended potential tax loopholes and that retroactive application of the curative amendments was necessary to prevent application of the administrative decisions for still-open tax years. (R. 86.) The legislative findings for the 2010 amendments confirm that retroactive application of the amendments is fully consistent with the due-process factors identified in James Square. Plaintiffs demand that this Court simply ignore the Legislature’s findings in 8 applying James Square’s factors. Pls. Br. at 61-62. But nothing in this Court’s decision authorizes that result. To the contrary, this Court has held that the Legislature’s declaration of intent to clarify prior law and thus end a technical loophole is entitled to “very great weight.” Matter of Chatlos v. McGoldrick, 302 N.Y. 380, 387-88 (1951); see also Valles v. Ivy Hill Corp., 410 F.3d 1071, 1079-80 (9th Cir. 2005) (same). Even when express legislative findings are absent, courts routinely rely on legislative history to determine that retroactive tax amendments were intended to close unintended tax loopholes—suggesting that legislative findings would necessarily be accorded even more deference. See, e.g., Carlton, 512 U.S. at 31 (relying on legislative history demonstrating that Congress intended to close tax loophole); DeMartino, 862 F.2d at 408 (relying on legislative history explaining that amendment overruled erroneous judicial holding and clarified prior law). Nothing in James Square departs from 9 this precedent—let alone authorizes wholesale disregard for the Legislature’s enacted findings.3 At a minimum, the Legislature’s detailed explanations as to its own purposes should be controlling unless plaintiffs have submitted evidence to prove that the enacted findings are false. Plaintiffs utterly failed to do so here. And when the James Square factors are applied in light of the Legislature’s declaration of 3 Plaintiffs cite inapposite cases addressing tax amendments that contained only a bare conclusory statement that the amendments were clarifying. See Pls. Br. at 62. Unlike here, the record in those cases demonstrated that the legislatures had purposefully changed established tax policy. These cases thus did not involve tax loopholes at all because the legislatures had fully intended the tax results of prior law. See Matter of Roosevelt Raceway v. Monaghan, 9 N.Y.2d 293, 303-05 (1961) (legislature created reimbursement system to encourage capital-improvement projects and specifically provided credit for federal taxes already paid, but then revoked federal-tax credit in reimbursement calculation); S & R Props. v. Maricopa County, 178 Ariz. 491, 500 (Ariz. Ct. App. 1993) (legislature purposefully broadened tax- refund law by eliminating restriction of refunds to “clerical” errors, but then changed course again and reinserted limiting statutory language); Wash. Nat’l Arena Ltd. P’ship v. Treasurer, Prince George’s County, 287 Md. 38, 40-42 (1980) (legislature expressly set recordation tax rate in one specifically-named county as $1.10 and then increased rate to $1.65). 10 curative purpose, retroactive application of the 2010 amendments is not so harsh and oppressive as to violate due process. 1. Plaintiffs did not and cannot disprove the declared curative purposes of the 2010 amendments. On the public-purpose factor, the legislative findings leave “no question” that the Legislature retroactively applied the amendments for the express purposes of protecting S-corporation purchasers from legal confusion over their step-up tax benefits, and protecting other taxpayers from bearing the burden of millions of dollars in unintended tax refunds resulting from Baum and Mintz. (R. 599-600; see R. 86, 89-90.) These important public purposes—which can only be accomplished with retroactivity—are “dispositive in this case” and defeat plaintiffs’ due process claim. Cf. James Square, 21 N.Y.3d at 249. Plaintiffs argue that state appellants must prove that the negative consequences identified by the Legislature would in fact have occurred without retroactive application of the 2010 amendments. Pls. Br. at 74-78. But this contention flips the due- process standard, with its applicable burdens of proof, on its head. 11 Due process requires only that the Legislature act with rational purpose. See Carlton, 512 U.S. at 30-31. This rational-basis standard does not require appellants to prove that the Legislature’s conclusions reflected in findings and legislative history are correct. To the contrary, it is plaintiffs who must prove that retroactive application of the 2010 amendments is irrational and arbitrary. Held v. State of N.Y. Workers Comp. Bd., 85 A.D.3d 35, 44 (3d Dep’t 2011). Plaintiffs present no evidence to carry their heavy burden, and their arguments to the contrary are meritless. First, plaintiffs assert that the Legislature had no rational reason to conclude that Baum and Mintz threatened purchasers’ step-up tax benefits. See Pls. Br. at 76-77. But the threat is clear from a plain reading of both administrative rulings. Baum held that under pre-amendment law, deemed asset-sale treatment was “not applicable” to an S- corporation sale for “New York [tax] purposes” despite the transactional parties’ federal § 338(h)(10) deemed asset-sale election. (R. 173, 177.) There is nothing irrational about the Legislature concluding that nonrecognition of the federal deemed asset-sale election under New York law would eliminate state 12 deemed asset-sale treatment for the entire sale, thereby terminating the step-up tax benefits on which purchasers had relied. In addition, Mintz would have allowed S-corporation sellers to immunize their asset-sale gains from any state taxation simply by delaying receipt of payment through installment reporting. (R. 181- 183.) The Legislature rationally found that such a result threatened to upend the fundamental tax balance inherent in all asset sales and unwind asset-sale treatment for the whole transaction. Indeed, there would be no logical legislative purpose behind providing a transaction with only the tax benefits of asset-sale treatment without any of the other tax consequences of an asset sale.4 4 Plaintiffs assert that appellants did not explain the errors in Baum and Mintz. Pls. Br. at 52 n.4. But appellants fully explained, and the Legislature found, that these rulings deviated from foundational tax principles. App. Br. at 17-19. In any event, Baum mistakenly relied on a corporate-level income tax on S corporations eliminated in 2006 (R. 91), see Office of Tax Policy Analysis Technical Services Division, Summary of Corporation Tax Legislative Changes Enacted in 2006, at 4 (Jan. 30, 2007) (describing fixed-dollar corporate tax applicable to S corporations instead of old income tax), and Mintz relied on a misinterpretation of the federal pass-through rules, see infra at 31-32. Plaintiffs’ contention that DTF acknowledged that Mintz was correct by not appealing to the Tax Appeals Tribunal (Pls. Br. 13 (continued on next page) Second, plaintiffs contend that the Legislature merely speculated—without rational basis—that retroactive application of the 2010 amendments would protect against unintended tax- refunds. Pls. Br. at 76. But it was reasonable for the Legislature to conclude that if Baum and Mintz remained viable for still-open tax filings, every S-corporation seller that had engaged in covered sale transactions would follow his economic self-interest and demand a refund. The record evidence also makes clear that DTF—the agency responsible for overseeing all of the state tax filings potentially affected by Baum and Mintz—estimated that revenue losses from refund claims would be millions of dollars per year. (R. 144.) Finally, plaintiffs claim that the 2010 amendments lack rational curative purpose because they were “designed” to raise tax revenues. Pls. Br. at 75, 77-78. Plaintiffs confuse two points: at 22, 29) is likewise meritless. DTF had no ability to appeal Baum further, and sought legislative correction of both Baum and Mintz together to ensure that the loophole was fully resolved. (R. 117.) See App. Br. at 18-19. Nor did DTF “confirm[]” Mintz’s ruling by stating that the Legislature’s limitation of retroactivity to a three-year period could result in refund claims. Pls. Br. at 22. DTF explained that refunds could result because Baum would remain viable for some open tax years. (R. 102.) 14 every time a legislature acts to close an unintended tax loophole, tax revenue is implicated. If the loophole is not retroactively closed, taxpayers will exploit the loophole, thus diminishing expected tax payments to the State. Acting to preserve expected tax revenue—and the allocation of tax burdens based on preexisting expectations—is a legitimate public purpose and is not the same as retroactively raising taxes to increase the overall tax base. See, e.g., James Square, 21 N.Y.3d at 248 (protecting other taxpayers from having to bear the burden of “significant and unanticipated revenue loss[es]” is a rational and curative goal) (quotation marks omitted)). 2. Plaintiffs failed to prove that the retroactivity period here is unreasonable or unfair. The legislative findings for the 2010 amendments also satisfy the second James Square factor by establishing that the period of retroactivity chosen by the Legislature—in this case a three-year period representing still-open tax years—is both rational and reasonable. Plaintiffs assert that any length of retroactivity beyond either the sixteen-month period in James Square or an even shorter 15 one-year period is presumptively unreasonable. Pls. Br. at 60. But there is no rigid rule limiting the duration of retroactive tax laws to a particular time frame, see Canisius Coll. v. United States, 799 F.2d 18, 27 (2d Cir. 1986) (rejecting a “one-year bench mark as the constitutional limit of retroactivity”), and James Square did not suggest otherwise. The one-year timeframe cited by plaintiffs is commonly accepted for non-remedial tax statutes that impose entirely new tax rates or policies on past periods. See, e.g., Welch, 305 U.S. at 150. But as state appellants’ opening brief establishes (App. Br. at 39), far longer periods of retroactivity are permissible for tax amendments that close tax loopholes and serve curative purposes. Arbitrarily limiting retroactive application of tax amendments to one year, as plaintiffs demand, would also make no sense because the duration of retroactivity does not by itself determine reasonableness. Rather, the reasonableness of a retroactivity period’s length is necessarily tied to the public goals achieved through retroactivity (or the lack thereof) and to the degree to which taxpayers relied on a long-established prior tax policy (or did not have any such reliance interest). Arbitrarily 16 cutting off a tax amendment’s retroactive application when a longer period is needed to accomplish curative purposes would result in unfairness to other taxpayers whom the Legislature aimed to protect. Moreover, longer periods of retroactivity do not impinge on any due-process interest if reasonable reliance on prior policy or practice is lacking. Here, retroactive application of the 2010 amendments to still-open tax years is both reasonable and fair, and tailored to the harms identified by the Legislature. A shorter period of retroactivity would allow taxpayers to seek windfall refunds for S- corporation deemed asset-sale income and call into question the still-open tax liability of S-corporation purchasers. And vast confusion and protracted litigation would be necessary if retroactivity were artificially limited within the period of still- open tax claims. Plaintiffs do not argue otherwise, nor present any evidence to suggest that the Legislature’s chosen retroactivity period was irrational or arbitrary. 17 3. Plaintiffs failed to prove reasonable reliance on any established policy or practice of total tax immunity. The Legislature’s findings establish that the 2010 amendments do not upset reasonable reliance interests, the final due-process factor identified in James Square. Plaintiffs’ core argument to the contrary is premised on the same fundamental flaw as the Appellate Division’s opinion—the incorrect assumption that reasonable reliance can be established based solely on a taxpayer’s individual reading of the tax code. Plaintiffs’ alleged interpretation of pre-amendment law is wrong, see infra at 24-32. More important, plaintiffs cannot rely on the words of the tax code alone to establish a cognizable reasonable-reliance interest. See supra at 5-7. Because due process is concerned with pragmatic fairness— not the technical interpretation of complicated and dense tax-code provisions—the reasonable-reliance requirement is not an interpretative contest gauging who presents the best hypothetical interpretation of a tax statute. To establish a violation of due process, plaintiffs must demonstrate that they relied on a 18 “sufficiently certain” legal interpretation or tax practice existing before the 2010 amendments—not simply their own personal reading of federal and state tax law. See Matter of Replan Dev., Inc. v. Dep’t of Hous. Pres. & Dev. of the City of N.Y., 70 N.Y.2d 451, 456 (1987); App. Br. at 49-50. If the rule were otherwise, every newly discovered tax loophole would trigger reasonable- reliance interests and there would be no need to analyze this factor, since the loophole—to be viable—must have some plausible basis in tax statutes and regulations. Plaintiffs’ comparison of this case to James Square (Pls. Br. at 46-47), drives home the absence of reasonable reliance here. In James Square, this Court found that plaintiff taxpayers had demonstrated reasonable reliance on prior law. But the James Square plaintiffs were not relying solely on their own individual reading of applicable statutes, like plaintiffs here. Instead, each of the James Square plaintiffs had obtained legally-enforceable government-issued certificates confirming their eligibility for state tax credits under preexisting statutory criteria. Their certificates were retroactively revoked, however, when the Legislature 19 amended the tax-credit statute to impose more restrictive criteria, which were retroactively applied to plaintiffs. 21 N.Y.3d at 240-43. In James Square, reasonable reliance was not only demonstrated by the government-issued certificates of eligibility; reliance was the whole point of the tax-credit scheme. The purpose of the tax-credit program was to induce beneficial economic activity in designated areas based on the expectation of tax credits. Id. at 240-41, 244-45. No comparable reliance interest is claimed, or proven, in this case. There is no evidence suggesting that anyone, let alone the New York State government, advised plaintiffs that all of their S- corporation sale gains could be immunized from state taxation by delaying receipt of payment by one month. In fact, plaintiffs submitted no affidavits or other competent evidence to establish that they, their lawyers, or their accountants actually believed at the time of the 2007 sale that deemed asset-sale proceeds were legally exempt from New York income taxation. Nor did plaintiffs submit any evidence to show that other parties or other tax professionals 20 shared their alleged reading of pre-amendment law.5 And plaintiffs certainly do not suggest that, as in James Square, the Legislature designed pre-amendment law to induce them to sell their S corporation in a deemed asset sale with installment payments.6 The absence of proof by plaintiffs is dispositive. But appellants nonetheless submitted more than ample evidence to refute plaintiffs’ unsupported claim of reliance on pre-amendment 5 Plaintiffs suggest that the absence of proof is somehow appellants’ fault. Pls. Br. at 52. But appellants have always maintained that the 2010 amendments reaffirmed prior law— without revoking any “long standing policy.” (R. 125-131.) It is plaintiffs who had the burden of proof to establish the opposite. No particular form of evidence, such as an affidavit, is necessary. The point is that plaintiffs submitted no proof—including proof that should have been readily available based on their own transaction—to substantiate their total-immunity theory of pre- amendment law. 6 The ALJ’s decision in Mintz cannot resurrect plaintiffs’ claim of reasonable reliance. Mintz was issued two years after plaintiffs’ sale transaction, so as a matter of timing, plaintiffs could not have relied on Mintz. In any event, the tax law expressly provides that ALJ decisions lack precedential force, Tax Law § 2010(5), and Mintz did not involve the same type of deemed- asset sale at issue in this case. Plaintiffs’ reliance on In re Lambert, 179 F.3d 281 (5th Cir. 1999) (Pls. Br. at 21, 50), is likewise misplaced for the same reason—Lambert also did not involve a deemed asset-sale transaction. 21 immunity from state taxation. Contrary to plaintiffs’ assertion (Pls. Br. at 50) state appellants identified and fully explained the specific New York and federal tax provisions existing at the time of plaintiffs’ 2007 sale that required plaintiffs to pay state taxes. App. Br. at 8-16, 53-57; see infra at 24-32. The Legislature’s findings, which are entitled to great weight, see supra at 8-10, confirm that these tax provisions had always been intended and understood to require S-corporation sellers to pay state income taxes on deemed asset-sale gains. (R. 86.) And a DTF certified public accountant submitted a sworn affidavit, made under penalty of perjury, explaining that DTF had long enforced the same policy of taxation prior to the 2010 amendments (R. 139- 140), facts that plaintiffs have never disputed. Plaintiffs also misconstrue a tax-advisory opinion publicly available at the time of the TMC sale by pointing only to the opinion’s reference to the deemed liquidation that occurs as one part of a § 338(h)(10) deemed asset-sale transaction. The opinion stated expressly that nonresident S-corporation sellers must pay New York taxes on their deemed asset-sale gains, and does not 22 remotely suggest that sellers may lawfully immunize these gains by using installment reporting to delay payment.7 (R. 163-164.) App. Br. at 45-46; see infra at 24-32. In fact, refuting plaintiffs’ claim of unfair surprise, DTF specifically instructed nonresident S-corporation shareholders to report pass-through installment gains as part of their New York source income for income-tax purposes.8 See App. Br. at 46 n.10, 7 Plaintiffs likewise misconstrue a DTF presentation that relies on and repeats the advisory opinion’s reference to the deemed liquidation while stating expressly that § 338(h)(10) transactions involve both a deemed asset sale and a deemed liquidation, with deemed asset-sale gains “pass[ing] through directly to” S-corporation shareholders. (R. 146-148, 152-155.) 8 The Court may take judicial notice of the contents of Publication 88 as a matter of public record. See Affronti v. Crosson, 95 N.Y.2d 713, 720 (2001) (per curiam). Plaintiffs’ claim that the version of Publication 88 cited in state appellants’ opening brief was published after the TMC sale is irrelevant because that version sets forth the tax rules for the year of the TMC sale, and because the version published in 2006 contains the exact same instruction. N.Y. State Dep’t of Taxation & Fin., Publication 88: General Tax Information for New York State Nonresidents and Part-Year Residents, at 11-12 (Dec. 2006). Publication 35, which is referenced in Publication 88, is of no help to plaintiffs because this publication sets forth the general S- corporation pass-through rules, explaining that nonresidents must report all items of pass-through gain that the S corporation derived from New York sources. See Pls. Br. at 41-42; N.Y. State 23 (continued on next page) 57. And record evidence established that since at least 2002, DTF had an established policy that such pass-through installment income included asset-sale gains when an S corporation distributes its installment note to shareholders in a liquidation. (R. 156-157.) Taken together, the unrebutted evidence confirms beyond any doubt that New York did not have any established tax-immunity policy on which plaintiffs could have reasonably relied. C. Pre-Amendment Law Required Plaintiffs to Pay New York Taxes. Finally, as state appellants’ opening brief establishes (App. Br. at 50-57), even if plaintiffs could rely on their own personal interpretation of pre-amendment law to show reasonable reliance—which they cannot—plaintiffs’ proffered interpretation of the pre-amendment law here is wrong. When all of the applicable statutory language is properly read in context, it is Dep’t of Taxation & Fin., Publication 35: New York Tax Treatment of S Corporations and Their Shareholders, at 24-25 (Mar. 2000) (“Publication 35”). Thus, the publication explains that sellers like plaintiffs are required to pay New York tax on their gains from a sale of corporate assets used to do business in New York. Id. 24 clear that pre-amendment law always required plaintiffs to pay state taxes on their deemed asset-sale gains from their S- corporation transaction. App. Br. at 8-16, 53-57. The 2010 amendments merely reaffirmed this prior law after it was misinterpreted by Baum and Mintz. As a result, plaintiffs’ entire argument crumbles. Plaintiffs’ interpretation relies on many interlocking pieces of two tax codes, but their ultimate theory is that they can obtain all the benefits of a deemed asset sale, while avoiding payment of taxes on deemed asset-sale gains by delaying payment of sale gains and using federal installment reporting. By this magical combination of steps, plaintiffs claim they can completely immunize millions in sale gains from any state taxation. While plaintiffs delayed payment of $19.4 million by one month, their legal theory would require the same result if payment was delayed by only one day from execution of a sale agreement. Plaintiffs’ theory ignores the fundamental economic reality of their own voluntary election to “to treat [a] stock sale as a sale of assets for tax purposes.” Prof’l Serv. Network, Inc. v. Am. 25 Alliance Holding Co., 238 F.3d 897, 899 (7th Cir. 2001). And while emphasizing New York’s policy of parallel state and federal tax treatment, plaintiffs confuse parallel treatment of one preliminary step involved in accomplishing certain federal tax results with parallel treatment of the end-result of the transaction itself. Plaintiffs focus entirely on a single small piece of the deemed asset-sale transaction—the deemed distribution in liquidation—in an attempt to avoid the tax consequences of the deemed asset sale that is the heart of the transactional structure plaintiffs chose. But none of the statutes and regulations on which plaintiffs rely allow plaintiffs to make TMC’s deemed asset-sale gains vanish or to recharacterize all of their gains as stock-sale gains because of the preliminary steps involved in completing a deemed asset sale. To the contrary, the federal regulations warn that no one regulatory provision can be used to produce a federal tax treatment inconsistent with the deemed asset sale. 26 C.F.R. 1.338(h)(10)-1(d)(9). Plaintiffs’ erroneous reading is further based on the misconception that special tax immunity can arise from the form 26 of payment for a deemed asset sale—i.e. complete immunity for nonresident S-corporation sellers who delay receipt of payment, yet full taxation for sellers who receive cash up front. Plaintiffs do not dispute that in a cash-upfront transaction, a plain reading of pre- amendment law requires nonresident S-corporation shareholders to recognize and pay New York taxes on the deemed asset sale based on the steps outlined in appellants’ opening brief.9 As previously explained and briefly outlined here, in a § 1.338(h)(10) deemed asset sale, the corporation passes through its gain on the deemed sale of its assets to shareholders. 26 C.F.R. § 1.338(h)(10)-1(d)(5). Shareholders then adjust their stock basis to account for the pass-through asset-sale gain; the S corporation is deemed to liquidate and redistribute its asset-sale proceeds in exchange for stock; and shareholders usually do not recognize any further gain in this liquidation because of the stock-basis adjustment. 9 Plaintiffs vaguely assert, based solely on Baum, that New York treats all deemed asset-sale transactions as sales of stock. Pls. Br. at 51-52. But this contention has no grounding in the tax provisions at issue and conflicts with the federal-conformity principle on which plaintiffs rely. 27 App. Br. at 13-14 & n.6, 55-56; see 26 C.F.R. 1.338(h)(10)-1(d)(5) (stating that 26 U.S.C. §§ 331 or 332 applies to liquidation)). Without disputing these preliminary steps, plaintiffs claim that they achieved the opposite tax result for their 2007 TMC sale, with plaintiffs never recognizing or paying state taxes on any of TMC’s deemed asset-sale gain. Plaintiffs rely on federal installment-reporting and corporate-liquidation provisions, stating that when a corporation sells its assets in exchange for an installment note and passes that note to shareholders in exchange for their stock in a liquidation, the installment payments rather than receipt of the note “shall be treated as the receipt of payment for the stock.”10 See 26 U.S.C. § 453(h)(1)(A). But as explained in state appellants’ opening brief, § 453(h)(1)(A) only prevents the distribution of the note from being a taxable event; it does not stop 10 Plaintiffs selectively quote the federal regulations (Pls. Br. at 13) in an attempt to elide the fact that the installment notes received by plaintiffs in the deemed liquidation are the corporation’s notes, which TMC was deemed to receive in exchange for a sale of its assets. See 26 C.F.R. § 1.338(h)(10)- 1(d)(8)(ii). 28 the S corporation’s deemed asset-sale gains from passing through to shareholders. App. Br. at 55-56. Indeed, plaintiffs’ theory is based on a reading of the federal tax code that stops short before the federal tax treatment is finished, thereby omitting a key piece of the puzzle. The installment rules go on to provide that shareholders must follow the pass-through rule in reporting their gain from the sale transaction, 26 U.S.C. § 453B(h), thus reporting their gain as if it was “realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation.” 26 U.S.C. § 1366(b). The source of the S corporation’s gain is a deemed asset sale, not a stock sale, and shareholders thus also realize gain from a deemed asset sale, not a stock sale, for federal tax purposes. Section 453B(h) thus brings the federal tax treatment around full circle, preserving the asset-sale treatment that the parties elected and ensuring that the tax treatment for sellers who do or do not delay their payments is the same. This conclusion is not only supported by the federal statutes and regulations at issue; it also comports with the logic and goal of 29 the federal tax elections in question—to allow transactional parties to choose deemed asset-sale treatment and to delay (but not to avoid) payment of income taxes for deemed asset-sale gains through installment reporting.11 Once the federal treatment is properly understood, New York’s tax treatment under pre-amendment law is also clear. Plaintiffs agree that New York always followed the federal tax treatment, and do not dispute that New York always required nonresident S-corporation shareholders to pay state tax on pass- through gains from a corporate asset sale. Thus, under pre- amendment law, plaintiffs’ federal deemed asset-sale gain was also state deemed asset-sale gain, and plaintiffs were required to 11 Plaintiffs’ reliance on Example 10 in the federal regulations is misplaced. See Pls. Br. at 13-15, 18-19. This example illustrates that even when installment reporting is in effect, the S corporation is deemed to sell its assets, receive deemed asset-sale gain, and pass this gain directly to all shareholders—including shareholders who received an installment note. And the example explains that under the installment rules, although the note’s distribution is not itself a taxable disposition, all shareholders must recognize their share of the S corporation’s deemed asset-sale proceeds under the pass- through rules of § 1366. See 26 C.F.R. § 1.338(h)(10)-1(e). 30 pay New York tax. New York accords full parallel treatment to the end transaction that parties elect under federal law, not to preliminary steps used to accomplish the ultimate transaction. Plaintiffs’ only response to § 453B(h) is to misconstrue the terms “character” and “source” in the federal pass-through rules. See Pls. Br. at 57-58. Relying on Mintz, plaintiffs contend that § 1366(b) determines an income’s corporate tax “character,” but cannot change its originating “source” as being from a shareholder’s sale of stock. But this assertion gets the entire concept of pass-through income backwards, and is the fundamental flaw underlying Mintz that the Legislature corrected. The only relevant “source” for pass-through income is the source from which the S corporation, not the shareholder, received the income because the purpose of the pass-through structure is to funnel the corporation’s gains and losses to the shareholder. See 26 U.S.C. § 1366(b) (providing that tax “character” of shareholder’s gain is determined by “source” or “manner” from which gain was “realized by the corporation”); see Publication 35 at 24-25 (“The determination of the source of S 31 corporation [pass-through] items is made at the corporation level.”). Thus, under both the federal and state pass-through rules, the shareholder must “characterize” his pass-through income as coming from the same “tangible sources” or “activity” from which the S corporation received the income. Valentino v. Franchise Tax Bd., 105 Cal. Rptr. 2d 304, 308-09 (Cal. Ct. App. 2001); see, e.g., Gitlitz v. Comm’r of Internal Revenue, 531 U.S. 206, 207 (2001) (explaining that S corporation’s discharge of indebtedness retains its “character” “as an item of income” passed through to shareholders). This is a fair and logical rule, since the S corporation is exempt from state income taxes on the precise theory that its income from whatever source is passed through to shareholders from the same source and therefore taxable on the shareholder level. 32 CONCLUSION For the foregoing reasons, this Court should reverse the Appellate Division’s decision and order. Dated: New York, New York January 13, 2015 BARBARA D. UNDERWOOD Solicitor General CECELIA C. CHANG Special Counsel to the Solicitor General JUDITH VALE Assistant Solicitor General of Counsel Respectfully submitted, ERIC T. SCHNEIDERMAN Attorney General of the State of New York Attorney for Appellants By: ____________________________ JUDITH VALE Assistant Solicitor General 120 Broadway New York, NY 10271 (212) 416-6274 Reproduced on Recycled Paper 33
