Philip Caprio, et al., Respondents,v.New York State Department of Taxation and Finance, et al., Appellants, Andrew M. Cuomo,, Defendant.

Brief

N.Y.Jun 4, 2015

APL-2014-00177 To be argued by: JUDITH N. VALE 15 minutes requested 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. 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: October 20, 2014 i TABLE OF CONTENTS Page TABLE OF AUTHORITIES ............................................................ iv PRELIMINARY STATEMENT ........................................................ 1 ISSUE PRESENTED ....................................................................... 4 STATEMENT OF THE CASE ......................................................... 5 A. The Importance of Retroactivity to Curative Tax Legislation ...................................................................... 5 B. Taxation of S-Corporation Income ................................. 8 Parallel treatment of S-corporation 1. transactions under state law ................................ 10 Federal elections for S-corporation sales ............. 11 2. C. The 2010 Amendments ................................................ 17 The Baum and Mintz decisions ............................ 17 1. The Legislature’s express findings of curative 2. purpose .................................................................. 19 D. Facts and Procedural History ...................................... 21 The 2007 S-corporation sale ................................. 21 1. Plaintiffs’ due process challenge .......................... 23 2. ii TABLE OF CONTENTS (cont'd) Page ARGUMENT ................................................................................. 26 RETROACTIVE APPLICATION OF THE CURATIVE 2010 AMENDMENTS DOES NOT VIOLATE DUE PROCESS ................................................................................ 26 A. James Square Did Not Alter the Legislature’s Established Ability to Achieve Curative Goals through Retroactive Tax Amendments. ...................................................... 26 B. Plaintiffs Failed to Establish a Due Process Violation in Light of the 2010 Amendments’ Unrebutted Legislative Findings. ...................... 33 Retroactive application of the curative 1. 2010 amendments is needed to resolve confusion, protect taxpayer expectations, and preserve fairness. ................................... 33 Retroactive application of the 2. amendments to open tax years is rational and fair. ........................................... 39 The unrebutted legislative findings that 3. the 2010 amendments reinstated prior law defeats plaintiffs’ claimed reliance on an existing policy of tax immunity. .......... 41 C. Plaintiffs’ Reading of Prior Law Was Neither Well-Established Nor Reasonable. ....... 47 Due process requires reliance on settled 1. understandings rather than potential interpretations of prior law. .......................... 48 iii TABLE OF CONTENTS (cont'd) Page Plaintiffs’ interpretation of prior law is 2. unreasonable. ................................................ 50 a. Pre-amendment tax immunity would serve no discernable purpose. .................. 50 b. Pre-amendment tax immunity is not supported by prior law. ............................ 53 CONCLUSION ............................................................................... 58 iv TABLE OF AUTHORITIES Cases Page(s) Canisius Coll. v. United States, 799 F.2d 18 (2d Cir. 1986) ......................................... 6, 28, 31, 37 DeMartino v. Comm’r of Internal Revenue, 862 F.2d 400 (2d Cir. 1988) ....................................................... 28 Gen. Accessory Mfg. v. Okla. Tax Comm’n, 122 P.3d 476 (Okla. Civ. App. 2005) ......................................... 16 Gen. Mills Inc. v. Comm’r of Revenue, 440 Mass. 154 (2003) ................................................................. 16 James Square Assoc. LP v. Mullen, 21 N.Y.3d 233 (2013) ......................................................... passim Kitt v. United States, 277 F.3d 1330 (Fed. Cir. 2002) .................................................. 49 Mandell v. Auditing Div. of the Utah State Tax Comm’n, 186 P.3d 335 (Utah 2008) .......................................................... 16 Matter of Epstein v. N.Y. State Tax Comm’n, 132 A.D.2d 52 (3d Dep’t 1987) ............................................... 6, 34 Matter of Replan Dev., Inc. v. Dep’t of Hous. Pres. & Dev. of City of N.Y., 70 N.Y.2d 451 (1987) ..................................................... 27, 48, 49 Matter of Varrington Corp. v. City of N.Y. Dep’t of Fin., 85 N.Y.2d 28 (1995) ........................................................... passim Montana Rail Link, Inc. v. United States, 76 F.3d 991 (9th Cir. 1996) ........................................................ 34 Prince v. State Dep’t of Revenue, 55 So. 3d 273, 284 (Ala. Civ. App. 2010) ............................. 12, 16 v TABLE OF AUTHORITIES (cont’d) Cases Page(s) United States v. Carlton, 512 U.S. 26 (1994) .............................................................. passim Untermyer v. Anderson, 276 U.S. 440 (1928) .................................................................... 49 Welch v. Henry, 305 U.S. 134 (1938) .............................................................. 27, 36 Wiggins v. Comm’r of Internal Revenue, 904 F.2d 311 (5th Cir. 1990) ...................................................... 53 State Laws Ch. 57, 2009 N.Y. Laws 2657 ......................................................... 30 Ch. 563, 1960 N.Y. Laws 1746 ................................................. 10, 42 Tax Law § 617 ................................................................................. 9, 10, 42 § 631 ..................................................................................... 11, 17 § 632 ................................................................................. 9, 10, 42 § 660 ............................................................................. 1, 9, 10, 42 § 683 ............................................................................................. 8 § 687 ............................................................................................. 8 § 2006 ........................................................................................... 7 § 2016 ........................................................................................... 7 20 N.Y.C.R.R. 4-2.2 .......................................................................... 9 vi TABLE OF AUTHORITIES (cont’d) Federal Laws Page(s) 26 U.S.C. § 338 ........................................................................................... 13 § 453 ........................................................................................... 56 § 453B ................................................................................... 15, 56 §§ 1361-1379 ............................................................................ 1, 9 § 1366 ............................................................................. 14, 15, 56 § 1367 ......................................................................................... 14 26 C.F.R. § 1.338(h)(10)-1 .................................................. 13, 14, 15 Miscellaneous Authorities Byron F. Egan, Asset Acquisitions: Assuming and Avoiding Liabilities, 116 Penn. St. L. Rev. 913 (2012) ........... 12, 13, 14, 52 Gregg D. Polsky, Installment Reporting for Sales of S Corporation Stock with a § 338(H)(10) Election, 74-Aug. Fla B. J. 44 (2000) ...................................................................... 54 Joseph R. Gomez, Tax Aspects of Mergers and Acquisitions for the Corporate Lawyer, 5 J. Small & Emerging Bus. L. 321 (2001) ....................................................................... 11, 12, 13 Sydney E. Unger, New York City Bar Reports on Installment Method Reporting for Stock Sale Elections, 97 Tax Notes Today 108-38 (June 5, 1997) ...................................................... 54 N.Y. State Dep’t of Taxation & Fin., Publication 88: General Tax Information for New York State Nonresidents and Part-Year Residents (Dec. 2007), available at http://www.tax.ny.gov/pdf/publications/income/2007/pub8 8.pdf ...................................................................................... 46, 57 PRELIMINARY STATEMENT This case concerns curative amendments to Tax Law § 632, enacted in 2010, to correct two administrative rulings that disrupted long-settled New York policy regarding taxation of income from the sale of S corporations.1 The legislation expressly applies retroactively to still-open tax years. The court below held that the retroactive application of the amendments violated due process, but that ruling was incorrect. This legislation satisfies all of the well-accepted criteria for retroactive application of curative tax amendments: it serves the important public purposes of preventing confusion, preserving taxpayers’ expectations, and protecting against unexpected revenue losses by cutting off unintended tax loopholes; utilizes a rational and fair retroactivity period to accomplish these curative goals; and reaffirms long- 1 An S corporation is a special form of corporation that is permitted to avoid paying corporate-level income tax by passing income, gains, and losses directly to shareholders, who are then responsible for paying personal federal and state income taxes on the corporation’s flow-through earnings. See 26 U.S.C. §§ 1361- 1379; Tax Law § 660(a). 2 settled prior law rather than changing prior tax policy on which plaintiffs could have relied. The administrative rulings that led to this curative legislation would have opened up an unintended and significant tax loophole by allowing nonresident shareholders to avoid payment of any New York income taxes on the profits from selling an S corporation’s assets used to earn New York income. The underlying rationale of the administrative decisions is technical and dense, but the basic result they authorized is easy to understand. Nonresident shareholders—by taking advantage of certain federal tax elections—would be able to claim that an S- corporation sale was a sale of corporate assets for federal tax purposes while simultaneously reporting the same transaction as a sale of stock for state tax purposes. The result would be to immunize their sale gains from any New York taxation, because nonresidents are taxed by New York on the sale of corporate assets used to do business in New York, but not on the sale of intangible property such as shares of stock. 3 The Legislature responded by amending Tax Law § 632 in 2010 to confirm that the unintended loophole was not the law. The Legislature specifically found that the administrative rulings sharply departed from established New York law requiring parallel state and federal treatment of shareholder income. The Legislature further explained in express statutory findings that retroactive application of the curative 2010 amendments to open tax years (i.e., years for which tax returns remain subject to tax assessment and refund claims) was necessary to prevent ensuing legal chaos and unintended tax consequences for hundreds of already completed S-corporation transactions. Plaintiffs-respondents brought this declaratory judgment action to prevent the 2010 amendments from being applied to require them to pay any state income tax on their S-corporation sale. The Appellate Division First Department held, with one Justice dissenting, that retroactive application of the 2010 amendments to plaintiffs’ 2007 sale violated due process as a matter of law. This Court should reverse. The Appellate Division improperly ignored the Legislature’s uncontroverted findings that 4 retroactive application advances the 2010 amendments’ corrective public purposes. The Appellate Division relied on this Court’s decision in James Square Assoc. LP v. Mullen, 21 N.Y.3d 233 (2013). But James Square is inapposite because it addressed a unique tax-credit scheme and did not involve an express legislative finding that retroactivity was needed to fulfill curative public goals. In contrast to James Square, when there is legitimate public purpose, the Legislature has broad authority to apply tax legislation retroactively. Longstanding precedent by this Court and the Supreme Court affirms the unique importance of retroactivity for curative tax legislation, and the contested 2010 amendments fall squarely within the type of legislation upheld by prior precedent. ISSUE PRESENTED Does application of the 2010 amendments to plaintiffs’ 2007 S-corporation sale satisfy due process where the Legislature rationally applied the amendments to open tax years to accomplish curative goals? The First Department answered in the negative. 5 STATEMENT OF THE CASE A. The Importance of Retroactivity to Curative Tax Legislation While retroactivity may be rare and unusual for other types of legislation, retroactive application of corrective tax legislation is both common and routine. Several factors make retroactivity especially important in the field of taxation. First, tax laws are complex, with many interlocking and overlapping state and federal provisions. Second, parties naturally have an incentive to exploit potential ambiguities or technical conflicts in the law to avoid tax liability. Finally, because the fundamental purpose of tax legislation is to equitably apportion the costs of government among those who benefit from government services and protections, permitting parties to claim the benefit of unintended tax loopholes distorts fair funding principles—shifting the burden of taxation to other individuals. For all these reasons, courts have recognized that legislatures have broad authority to apply curative tax legislation retroactively to close unintended tax loopholes. Retroactive application has been upheld to correct a statutory omission caused 6 by legislative oversight, see, e.g., United States v. Carlton, 512 U.S. 26, 29-32 (1994), or, as in this case, to correct and overturn a legal interpretation of tax laws by administrative bodies or courts, see, e.g., Matter of Varrington Corp. v. City of N.Y. Dep’t of Fin., 85 N.Y.2d 28, 31-32 (1995). In either case, the legislature is not limited to closing a tax loophole prospectively, but may also make a statutory amendment retroactively applicable to past tax years and transactions. See, e.g., Matter of Varrington Corp., 85 N.Y.2d at 33-35 (retroactive amendment to corporate tax rules to reinstate policy of taxing limited partners disrupted by administrative ruling); Carlton, 512 U.S. at 31-32 (retroactive amendment to estate-tax statute to correct unintended loophole); Canisius Coll. v. United States, 799 F.2d 18, 26-27 (2d Cir. 1986) (retroactive amendment to FICA tax statute to reinstate collection of certain FICA taxes disrupted by Supreme Court decision); Matter of Epstein v. N.Y. State Tax Comm’n, 132 A.D.2d 52, 55 (3d Dep’t 1987) (retroactive amendment to sales and use tax statute to clarify definitional ambiguity). 7 In New York, such curative legislation is often required to close tax loopholes because there is no further appellate process when the Tax Appeals Tribunal rules in favor of a taxpayer. See Tax Law § 2016. Although both the taxpayer and the Department of Taxation and Finance (DTF) may appeal to the Tax Appeals Tribunal from an administrative law judge’s ruling resolving a tax dispute, see id. § 2006(7), only the taxpayer can obtain judicial review of an unfavorable ruling by the Tribunal, id. § 2016 (providing judicial review process only for the “petitioner”—i.e., the taxpayer petitioning to overturn DTF’s tax determination). The taxpayer may do so by bringing an Article 78 proceeding in the Appellate Division, Third Department, but DTF has no similar appellate right. Id. As a result, DTF’s only recourse for curing erroneous administrative determinations by the Tribunal is to seek clarifying legislation. Moreover, a single administrative ruling will have widespread consequences if not corrected for open tax years. For example, income-tax filings in New York remain open for three years and are subject to further tax assessments or taxpayer 8 refund claims throughout this time even if a taxpayer has already paid taxes for a given tax year. Id. §§ 683, 687. As a result, retroactive application of a curative amendment is often necessary to avoid ongoing and forward-looking negative tax consequences, such as refund claims by taxpayers who want to rely on pre- amendment administrative rulings that the Legislature intended to overrule or modify. B. Taxation of S-Corporation Income The 2010 amendments at issue in this appeal concern the taxation of income for nonresident S-corporation shareholders. Some background principles are necessary to understand the underlying tax scheme. For ordinary corporations (known as C corporations), New York taxes the income of both domestic and foreign corporations, with foreign corporations taxed to the extent they conduct business connected to New York. An S corporation, however, is a special type of corporation that passes through corporate gains and losses to shareholders. S corporations thus do not pay federal or state corporate income tax, but their shareholders 9 pay personal income taxes on the pass-through income received from the S corporation. 26 U.S.C. §§ 1361-1379; Tax Law § 660(a). Resident New York shareholders owe state income tax on all pass-through S-corporation income. Tax Law § 617(a)-(b). Nonresident shareholders are assessed proportional New York income taxes based on the underlying percentage of pass-through gains “derived from or connected with New York sources . . . of S corporation income” as reported on the shareholders’ federal income tax returns.2 Id. § 632(a)(2); see also 20 N.Y.C.R.R. § 4-2.2. 2 If an S corporation conducts business activities in New York, such as collecting business receipts, holding real property, or paying salaries, the percentage of these activities attributable to New York out of the corporation’s overall business activities is used to calculate the New York source income for which a nonresident shareholder would owe New York income tax based on his or her proportion of share ownership. See 20 N.Y.C.R.R. 4- 2.2. (See R. 140.) 10 Parallel treatment of S-corporation 1. transactions under state law New York conforms its tax treatment of S-corporation pass- through earnings to federal tax law. This foundational parallel- treatment principle is reflected in the Tax Law, which provides that S-corporation shareholders may elect to report for state income-tax purposes the same “S corporation items of income, loss, deduction and reductions . . . which are taken into account for federal income tax purposes.”3 Tax Law § 660(a). (See R. 140.) As a result, the amount of S-corporation pass-through income taxed by the State is calculated based on the amount of flow-through income taxed under federal law. Tax Law §§ 617(b), 632(e)(2). Moreover, to ensure parallel state and federal treatment, “[e]ach item” of pass-through gain retains “the same character” for state income tax purposes as “for federal income tax purposes.” Id. §§ 617(b), 632(e)(2). (See R. 140.) 3 New York restructured the entire personal income-tax system in 1960 for the specific purpose of conforming state income tax practice to that of the federal government. See Ch. 563, §§ 1-2, 1960 N.Y. Laws 1746, 1746-76. 11 Federal elections for S-corporation sales 2. Parallel treatment is an important principle because of the different ways that a sale of an S corporation can be structured under federal law. Such a transaction can be structured as a sale of the shareholders’ ownership interests in the S corporation, i.e., as a sale of the shareholders’ stock to new owners. Alternatively, the transaction can be structured as a sale of the S corporation’s assets—such as its real property, machinery, goodwill, customer lists, etc.—to a new corporation. These two distinct methods of selling an S corporation have significantly different legal and tax consequences. A straight stock sale, for example, often benefits selling shareholders because a stock sale provides sellers with certain legal advantages, such as the ability to pass all corporate liabilities to the buyer. See Joseph R. Gomez, Tax Aspects of Mergers and Acquisitions for the Corporate Lawyer, 5 J. Small & Emerging Bus. L. 321, 329 (2001). Moreover, gains treated as income from a sale of stock are in many States, like New York, generally not subject to taxation unless the selling shareholders are residents. See Tax Law 12 § 631(b)(2); see also, e.g., Prince v. State Dep’t of Revenue, 55 So. 3d 273, 284 (Ala. Civ. App. 2010). An asset sale, by contrast, generally subjects selling shareholders to additional tax liability because sale proceeds are passed through as gains are earned from the sale of corporate assets—resulting in greater state income-tax exposure for nonresident shareholders and potentially higher federal income tax rates for all shareholders. See Byron F. Egan, Asset Acquisitions: Assuming and Avoiding Liabilities, 116 Penn. St. L. Rev. 913, 928-29 (2012). But unlike selling shareholders, S- corporation purchasers generally prefer an asset sale because an asset sale allows the purchaser to “step up” to fair market value the taxable basis of the target S corporation’s assets, which results in future reduced tax liabilities.4 See Gomez, supra, at 324. The federal tax code also permits another sale option, which allows an S-corporation purchaser to receive the legal benefits of a 4 The step-up adjustment can provide the purchaser with future enhanced tax deductions for asset depreciation and lower taxable gains on subsequent asset sales. See Egan, supra, at 926. 13 stock sale while also obtaining the federal tax treatment of an asset sale. This option is known as a “deemed asset sale” or § 338(h)(10) election—named for the section of the Internal Revenue Code (IRC) that authorizes the option. A deemed asset- sale election is voluntary and binding: because of its future tax consequences (potentially negative for selling shareholders), the election must be jointly made and agreed to by the purchaser and all S-corporation shareholders.5 26 C.F.R. § 1.338(h)(10)-1(c)(3); see Gomez, supra, at 331-32. The parties’ choice to make a deemed asset-sale election is controlling. The gains from the underlying transaction are treated as corporate asset-sale gains once the election is made, and these gains are passed through to shareholders and taxable as asset- sale income. 26 U.S.C. § 338(h)(10)(A)(ii); 26 C.F.R. § 1.338(h)(10)- 1(d)(3), (d)(5); Egan, supra, at 928-29. To complete the transaction, 5 Shareholders will often agree to the election because they receive the legal advantages of a stock sale, see, supra, at 11, and because purchasers may compensate the seller for any negative tax consequences of asset-sale treatment by paying a higher sale price. See Egan, supra, at 928. 14 the purchased S corporation is then deemed to liquidate and to distribute its sale proceeds to shareholders. 26 C.F.R. § 1.338(h)(10)-1(d)(4)-(5). Because shareholders are already responsible for paying taxes on the pass-through deemed asset- sale gains, they usually do not recognize any further taxable gains or losses in this liquidation.6 See Egan, supra, at 928-29. This deemed asset-sale treatment chosen by all of the transactional parties does not change if payment of the S- corporation sale gains is delayed. When an S corporation is sold with payments to be made in future installments rather than in 6 Selling shareholders usually do not recognize further taxable gains or losses on the liquidation because of a tax mechanism called stock-basis adjustment. Whenever an S corporation passes its gains or losses to shareholders, including from a deemed asset sale, shareholders adjust their stock basis— which represents their investment in the company—up or down to match the flow-through income on which they already must pay taxes. 26 U.S.C. §§ 1366(d), 1367(a)(1)(A). For example, if an S corporation earns $100 of income and has one shareholder with a stock basis of $500, the shareholder pays income tax on $100 of pass-through gain and also raises his stock basis by $100, from $500 to $600. If the shareholder later sells his stock for $600, he recognizes no further taxable gain on the sale because he sold $600 worth of stock for $600. He thus pays taxes only once on the $100. 15 cash up front, federal tax law (IRC §§ 453, 453B) permits the gains from the installment sale to be reported, and thus subject to income tax, only as installment payments are received by shareholders rather than at the time of the initial sale for the full purchase price. If the parties to an S-corporation sale have made a deemed asset-sale election, their separate choice to structure the transaction using delayed payments does not undo or unwind their threshold choice to apply deemed asset-sale treatment to the transaction as a whole. The deemed asset-sale election proceeds in the same way, the only difference being that the corporation receives an installment note instead of cash in the deemed asset sale, and passes this note to shareholders in the liquidation. 26 C.F.R. § 1.338(h)(10)-1(d)(8)(i)-(ii). As a result, shareholders are permitted to report and pay taxes on the deemed asset-sale gains as installment payments on the S corporation’s note are received and passed through. But these delayed payments for the deemed sale of assets remain subject to the tax rules that apply to asset- sale gains. 26 U.S.C. § 453B(h); id. § 1366(b). 16 Because state tax treatment of S-corporation pass-through earnings conforms to that of federal law, supra, at 8-16, New York holds S-corporation shareholders to their own federal elections. (R. 86, 89-90, 93-94, 140-142.) Thus, when shareholders make a federal deemed asset-sale election and choose installment reporting, New York has traditionally taxed the transaction in precisely the same fashion as the federal government—as an asset sale by the S corporation with shareholders liable for income taxes for pass-through asset-sale gains when installment payments are received. As under federal law, the parties’ choice to structure the sale transaction as an installment sale does not grant any additional tax immunity, nor can it undo the consequences of their initial deemed asset-sale election.7 (R. 140-143.). 7 New York’s parallel treatment of § 338(h)(10) gains as asset-sale income for state tax purposes accords with the law of many other States. See Mandell v. Auditing Div. of the Utah State Tax Comm’n, 186 P.3d 335, 343-35 (Utah 2008) (treating deemed asset-sale gains as from corporate asset sale rather than from stock sale); Gen. Mills Inc. v. Comm’r of Revenue, 440 Mass. 154, 168-71 (2003) (same); Prince, 55 So. 3d at 281 & n.3 (same); Gen. Accessory Mfg. v. Okla. Tax Comm’n, 122 P.3d 476, 480 (Okla. Civ. App. 2005) (same). 17 C. The 2010 Amendments In 2010, the Legislature acted to correct two administrative decisions that threatened to undermine longstanding New York tax practice with respect to parallel treatment of S-corporation pass-through gains. The administrative rulings opened up a vast, unintended tax loophole by allowing parties to claim the benefits of federal deemed asset-sale treatment while simultaneously immunizing their gains from state income taxation applicable to gains from an asset sale. The Baum and Mintz decisions 1. In Matter of Baum, issued in February 2009, the Tax Appeals Tribunal treated an S-corporation transaction as a stock sale for state tax purposes despite the shareholders having made a binding deemed asset-sale election under federal law. (R. 172- 177.) This stock-sale treatment resulted in nonresident shareholders avoiding payment of any state taxes because income from a stock sale is usually not considered to be derived from New York sources. (R. 176-177.) Tax Law § 631(b)(2). And by holding that New York does not follow federal deemed asset-sale 18 treatment, Baum threatened to undo the state tax benefits provided to purchasers in deemed asset-sale transactions. In Matter of Mintz, issued in June 2009, a New York S corporation sold its assets in an actual (not deemed) asset sale in return for an installment-payment obligation, and distributed this installment note to its shareholders in exchange for stock as part of a liquidation. An Administrative Law Judge ruled that income received by the shareholders through the installment note should be treated as stock-sale income rather than as asset-sale gains flowing from the corporation—effectively allowing S-corporation shareholders to immunize themselves from taxes on asset-sale gains through the simple expedient of agreeing to delay receipt of their gains. (R. 179-184.) In both cases, in accordance with established law and policy, DTF argued that the S-corporation shareholders should be liable for state income taxes and that their gains should be treated as asset-sale gains in parallel with federal tax rules. Under the applicable procedural rules, however, DTF could not obtain judicial review of the Tribunal’s Baum decision. See, supra, at 7. Although 19 DTF could have appealed the Mintz ruling to the Tribunal, an appeal would not have resolved Baum’s errors or addressed the use of installment reporting in deemed asset-sale transactions. The Legislature’s express findings 2. of curative purpose To remedy the confusion and tax loopholes caused by Baum and Mintz, DTF sought and obtained clarifying amendments from the Legislature, enacted in August 2010. In specific statutory findings, the Legislature found that it was “necessary to correct” Baum and Mintz, which had: erroneously overturned the longstanding policies of [DTF] that nonresident subchapter S shareholders who sell their interest in an S corporation pursuant to [a federal] election under section 338(h)(10) or section 453(h)(1)(A) of the Internal Revenue Code . . . are taxed in accordance with the election and the transaction is treated as an asset sale producing [taxable] New York source income. (R. 86.) The Legislature corrected Baum and Mintz by amending Tax Law § 632. The amendments reconfirmed New York’s preexisting treatment of deemed asset-sale transactions, providing that “any gain recognized on the deemed asset sale for federal income tax 20 purposes will be treated as New York source income” from an asset sale subject to state income tax. (R. 86.) The amendments further clarified that a voluntary asset-sale election cannot be undone through federal installment reporting. (R. 86.) Rather, “any gain recognized on the receipt of payments from [an] installment obligation for federal income tax purposes will be treated as New York source income.” (R. 86.) The Legislature made these clarifying amendments retroactive to all “taxable years beginning on or after January 1, 2007 for which the statute of limitations for seeking a refund or assessing additional tax is still open.” (R. 87.) The legislative findings and history explain that retroactivity was required to confirm asset-sale treatment for completed deemed-asset sale transactions, resolve legal confusion, ensure that purchasers would retain the state step-up tax benefits they had expected, and protect against unwarranted refunds and unexpected tax losses. (R. 86, 89-90, 102.) As the Legislature found, the amendments were needed “to prevent confusion in the preparation of returns, 21 unintended refunds, and protracted litigation of issues that” had already been properly administered. (R. 86.) D. Facts and Procedural History The 2007 S-corporation sale 1. Plaintiffs are the prior owners and sole shareholders of Tri- Maintenance & Contractors, Inc. (TMC), an S corporation that provides janitorial services. (R. 48-50.) While plaintiffs owned TMC, the corporation earned nearly fifty percent of its total income from New York sales. (R. 16, 400.) In February 2007, two years before Baum and Mintz, plaintiffs sold TMC to Sanitors Services, Inc. through a stock purchase agreement for a base price of over $19.9 million plus additional contingent payments based on TMC’s performance. (R. 50.) Sanitors agreed to pay the base price in two installments with interest: (1) an initial payment of $19.4 million in March 2007, only one month after execution of the agreement; and (2) the remaining $500,000 eleven months later. (R. 50-51.) Plaintiffs and Sanitors jointly made a federal § 338(h)(10) deemed asset-sale election. (R. 364-366.) TMC also elected to delay reporting its asset-sale gains using installment reporting. (R. 52, 22 393.) Accordingly, TMC filed an installment sale income form as part of its 2007 federal tax return, stating that it had engaged in a “[d]eemed sale of assets under [§] 338h(10)” with a contract price of over $19 million plus future contingent payments. (R. 385, 393.) On their individual federal income tax returns, plaintiffs reported gains from the sale as they received payments on the installment notes, thus reporting: (1) over $18 million in gains on their 2007 returns, representing the first installment payment; and (2) $1 million on their 2008 returns representing the second installment payment and further contingent payments. (R. 53-54.) While plaintiffs paid full federal income taxes on their gains from the TMC sale, they took the position that no New York income taxes were owed for the multi-million sale at all. Plaintiffs claimed tax immunity by self-reporting their gains as unconnected to the deemed asset sale or the installment notes passed to them by TMC. Plaintiffs took the position that by using installment reporting to delay recognition of TMC’s more than $18 million deemed asset-sale gains by one month, they could unwind the § 338(h)(10) deemed asset-sale treatment they had chosen and 23 transform all of the corporate asset-sale earnings passed through to them into nontaxable stock-sale gains. Both plaintiffs and Sanitors were represented by large law firms and professional accountants in negotiating and structuring the TMC sale. (R. 284, 288, 305-306, 337-338.) Plaintiffs did not allege that they were advised by counsel or any tax professional that their reporting of the TMC sale gains followed established practice in New York in 2007, was likely to result in complete immunity from state taxation, or even complied with New York law. Nor did plaintiffs point to any other evidence—such as a tax treatise or practitioners’ guide—indicating that S-corporation shareholders could structure transactions to qualify for the federal and state step-up benefits of asset-sale treatment, yet avoid entirely the state tax consequences of an asset sale by delaying their reporting of gains by one month. Plaintiffs’ due process challenge 2. Within the statute of limitations period and prior to enactment of the 2010 clarifying amendments, DTF commenced an audit of plaintiffs’ 2007 and 2008 state tax returns. (R. 145.) 24 DTF ultimately concluded that plaintiffs’ owed approximately $775,000 in additional state taxes and interest from TMC’s deemed asset sale. (R. 234-244.) Rather than pay the taxes, plaintiffs filed this declaratory judgment action, seeking a declaration that retroactive application of the 2010 amendments to the TMC sale violates federal and state due process. (R. 47-61.) Supreme Court, New York County (Feinman, J.) granted defendants’ motion for summary judgment and dismissed plaintiffs’ complaint. (R. 14-43.) Supreme Court concluded that the 2010 amendments fell into the heartland of curative legislation that rationally and constitutionally uses retroactivity to further important public purposes. (R. 29-34.) In particular, Supreme Court emphasized the express legislative finding that retroactive application of the curative amendments was needed to remedy the confusion and other negative consequences of the Baum and Mintz decisions. (R. 29-34.) And Supreme Court concluded that plaintiffs had failed to present any evidence to rebut the Legislature’s specific findings, or to prove instead that the amendments had eliminated a “long-standing tax policy” of complete tax immunity. (R. 37-39.) 25 The First Department reversed on the law and held that plaintiffs were entitled to a declaration that application of the 2010 amendments to plaintiffs violated due process.8 (R. 577-603.) Despite stating that the amendments’ public purposes presented a “close question” (R. 592), the Appellate Division held that the 2010 amendments were not curative and did not further sufficiently compelling public goals to support their retroactive application to the TMC sale (R. 579, 590-592). To reach this conclusion, the court below relied heavily on this Court’s decision in James Square. (R. 585, 590-592.) The court also ignored the Legislature’s specific factual findings with respect to the 2010 amendments’ important curative goals. Justice Andrias dissented. (R. 594-603.) He noted that, unlike in James Square, in this case, the Legislature made explicit legislative findings—leaving “no question” that the 2010 amendments were “a curative measure.” (R. 599-600, 602-603.) 8 Plaintiffs initially appealed Supreme Court’s order directly to this Court. This Court declined jurisdiction and transferred the appeal to the First Department. Caprio v. N.Y. State Dep’t of Tax. & Fin., 20 N.Y.3d 1030 (2013). 26 Further, Justice Andrias emphasized that plaintiffs had presented no evidence to rebut the Legislature’s findings or otherwise demonstrate that the 2010 amendments altered New York practice with respect to taxation of deemed asset sales. Instead, plaintiffs relied solely on their personal interpretation of preexisting law, which did not suffice to prove a due process violation. (R. 600-602.) The First Department granted appellants’ motion for leave to appeal to this Court. (R. 575.) ARGUMENT RETROACTIVE APPLICATION OF THE CURATIVE 2010 AMENDMENTS DOES NOT VIOLATE DUE PROCESS A. James Square Did Not Alter the Legislature’s Established Ability to Achieve Curative Goals through Retroactive Tax Amendments. Unlike in other legal fields, retroactive legislation is generally accepted in tax law because “[t]axation is neither a penalty imposed on the taxpayer nor a liability” assumed by contract.” Matter of Varrington, 85 N.Y.2d at 33 (quotation marks omitted). Rather, taxes are the means through which the 27 Legislature “apportion[s] the cost of government among those who” enjoy its benefits. Id. (quotation marks omitted); Carlton, 512 U.S. at 33. Equitably distributing the costs of government “is a delicate and difficult task,” Welch v. Henry, 305 U.S. 134, 149 (1938), and it is well established that “[t]ax legislation is not a promise” and that taxpayers have no “vested right” to prior versions of the tax laws, Carlton, 512 U.S. at 33. Because retroactivity is an accepted and important part of tax law, relatively short retroactivity periods are routine even in noncurative amendments that implement wholly new tax policies. See, e.g., Carlton, 512 U.S. at 32-33 (noting that “Congress almost without exception [gives] general revenue statutes effective dates prior to the dates of actual enactment” (quotation marks omitted)); Matter of Replan Dev., Inc. v. Dep’t of Hous. Pres. & Dev. of City of N.Y., 70 N.Y.2d 451, 455, 456 (1987) (collecting cases). But far longer periods of retroactivity are appropriate and often necessary in curative and clarifying legislation to prevent legal errors from plaguing open tax years with future and ongoing confusion, negative tax consequences, and sudden revenue losses that the 28 Legislature never intended. See, e.g., Matter of Varrington, 85 N.Y.2d at 35 (upholding six-year retroactivity period where tax rules reinstated longstanding policies disrupted by administrative ruling); Canisius Coll., 799 F.2d at 26-27 (upholding four-year retroactivity period where amendment ratified prior practice questioned by judicial decision). For this reason, courts have for decades “liberally construed” curative tax amendments and upheld their retroactive application. Canisius Coll., 799 F.2d at 26-27; see, e.g., Matter of Varrington, 85 N.Y.2d at 33; DeMartino v. Comm’r of Internal Revenue, 862 F.2d 400, 408-09 (2d Cir. 1988). James Square did not disturb this long-established precedent upholding retroactive application of clarifying amendments to achieve important curative goals. In James Square, the Legislature created a program to induce economic development in designated geographic areas in return for businesses receiving a state tax credit. 21 N.Y.3d at 240-241. More than a decade later, the Legislature passed amendments requiring businesses to meet new eligibility criteria to qualify for the tax credits. Id. at 241-42. The amendments were made retroactive to 29 tax years beginning on or after January 1, 2008, resulting in the retroactive revocation of tax-credit eligibility certifications of businesses that had not complied with the new standards in prior years. Id. at 241-43. In concluding that retroactivity was not supported under these circumstances, this Court noted that the amendments in James Square had not been “meant to cure an unintended error,” and took pains to distinguish its ruling from the well-settled precedents upholding retroactive application of curative tax amendments designed to correct mistakes and to remedy unintended tax results. Id. at 248. In James Square, this Court found that the Legislature retroactively imposed the new tax-credit criteria despite having anticipated and intended the costs of the prior tax-incentive program. 21 N.Y.3d at 250. By contrast, the undisputed evidence here shows that the Legislature never expected that purchasers’ step-up benefits would be called into question, or that nonresident shareholders would be allowed to forego tax payments or to collect refunds by transforming deemed asset-sale gains into stock-sale income. And the goals of the statute and its amendment in James 30 Square were quite different from the goals of the statute and amendments at issue here. This Court emphasized that the goals of the statute in James Square were to spur investment, bring employment opportunities, and prevent tax abuses, and that retroactive application of an amendment could not change the past behavior of the affected businesses. Id. In contrast, here retroactive application of the 2010 amendments is the only way for the Legislature to correct fully many of the future negative impacts of Baum and Mintz, namely, continuing confusion about purchasers’ ongoing ability to claim step-up tax benefits from past deemed asset sales and unexpected tax losses from sellers’ refund claims. Most important, unlike the 2010 amendments, the tax legislation in James Square did not contain any express legislative findings that retroactive application of the amendments was needed to resolve future confusion, unfair tax results for other taxpayers, or unwarranted refund claims for still-open tax years. Id. Compare Ch. 57, pt. S-1, § 3, 2009 N.Y. Laws 2657, 2748-52 (amendments to Empire Zone Program at issue in James Square), with (R. 86). The Legislature’s express finding that retroactive application of the 2010 31 amendments was required to achieve important curative goals thus sets this case far apart from James Square. The Appellate Division’s mistaken application of James Square to this case led to an incorrect analysis of each of the three overlapping factors relevant to due process, distorting the balancing test for retroactivity. When a tax amendment is curative or clarifying, all of the due-process factors must be liberally viewed through the lens of the crucial role that retroactivity plays in accomplishing unique public purposes. See Canisius Coll., 799 F.2d at 26-27. But the court below failed to apply this curative lens at all because it simply ignored the 2010 amendments’ uncontroverted curative goals, as expressly found by the Legislature. This failure was a fundamental error—James Square did not invite courts to disregard express legislative findings regarding the curative purposes and effects of tax amendments, particularly when no evidence contradicts the Legislature’s considered judgments. Here, the legislative findings erroneously disregarded by the Appellate Division establish that all three of the due-process 32 factors fully support retroactivity. Specifically, the findings demonstrate that (1) retroactivity was needed to achieve the curative 2010 amendments’ important public purposes of preventing legal chaos and unfair tax results from two erroneous administrative rulings; (2) application of the 2010 amendments to open tax years for which the statute of limitations has not expired is rational and fair; and (3) plaintiffs did not reasonably rely on any settled interpretation of prior law but instead used their own unsupported theory of tax immunity contradicted by longstanding New York law. Plaintiffs, who carried the heavy burden of demonstrating that retroactive application of the 2010 amendments would be “so harsh and oppressive” as to lack any rational legislative purpose, James Square, 21 N.Y.3d at 246 (quotation marks omitted); see also Carlton, 512 U.S. at 30-31, failed to present any evidence at all to contradict the Legislature’s findings. 33 B. Plaintiffs Failed to Establish a Due Process Violation in Light of the 2010 Amendments’ Unrebutted Legislative Findings. Retroactive application of the curative 1. 2010 amendments is needed to resolve confusion, protect taxpayer expectations, and preserve fairness. Although the Appellate Division recognized that the 2010 amendments’ public goals present a “close question” here (R. 592), the court concluded that the amendments are not curative and do not promote any compelling public purposes (R. 590-592). But the court below reached this incorrect conclusion only by ignoring the Legislature’s express findings—unrebutted by plaintiffs—that retroactive application of the 2010 amendments is required to achieve the legislation’s crucial curative goals. As Justice Andrias explained in dissent, the “legislative findings leave no question that the 2010 amendments were a curative measure” enacted to close perceived tax loopholes that would cause considerable legal confusion and unfair tax results if allowed to remain standing for open tax years. (R. 599.) The Legislature could not have been clearer in expressing that retroactive application of the 2010 amendments is needed to 34 serve important public purposes. The Legislature specifically found that the curative 2010 amendments were required “to correct” Baum and Mintz and to prevent the chaos and unfair tax results that these erroneous rulings would otherwise trigger. (R. 86.) Without retroactivity, legal ambiguity regarding the proper tax treatment for already-completed deemed asset sales, with or without installment reporting, would have persisted for all open tax years.9 See, e.g., Montana Rail Link, Inc. v. United States, 76 F.3d 991, 994 (9th Cir. 1996) (retroactive amendment supported by purpose of clarifying ambiguity); Matter of Epstein, 132 A.D.2d at 55 (retroactive amendment supported by “sound and lawful legislative purpose . . . of disambiguating” statutory definition). 9 The Appellate Division held that the 2010 amendments do not correct a “specific error” in pre-amendment law (R. 591), but the Legislature’s ability to enact curative legislation goes well beyond fixing typos in the tax code. Curing erroneous legal interpretations of correctly worded statutes, as the Legislature did here, is a well-accepted and important legislative practice, see, e.g., Carlton, 512 U.S. at 32; Matter of Varrington, 85 N.Y.2d at 31-32, particularly in New York where there is no further appellate review when the Tax Appeals Tribunal rules in favor of a taxpayer. 35 Such continuing ambiguity would have been particularly problematic here because selling shareholders like plaintiffs are not the only parties affected by state-level asset-sale treatment for § 338(h)(10) deemed asset sales. A primary purpose of an asset sale (whether actual or deemed) is to provide purchasers with valuable tax benefits, on which purchasers rely in claiming tax deductions and reduced tax liabilities in future tax filings, and often in offering higher sale prices to selling shareholders. See supra, at 12-13. But Baum and Mintz threatened to deprive purchasers of the New York asset-sale benefits that they had counted on, suggesting that a deemed asset sale under § 338(h)(10), or an actual asset sale and liquidation involving installment payments, would be considered a “stock sale and not a sale of assets for” New York tax purposes. (R. 90.) The Legislature utilized retroactivity to avoid this unfair result and to preserve the reasonable expectations of purchasers that had relied on deemed asset-sale treatment. If Baum and Mintz had been cured only prospectively, purchasers would be subject to ongoing “confusion in the preparation of [tax] returns 36 . . . and protracted litigation of issues that ha[d] been properly administered up to now.” (R. 86.) Purchasers could also face enormous costs and practical problems from being “required to maintain separate book-keeping procedures” for assets purchased in a deemed asset sale or with installment reporting because Baum and Mintz suggested that the purchased assets would receive fundamentally different federal and state tax treatment. (R. 90.) Indeed, plaintiffs have never suggested that purchasers should have been subject to the tax consequences of stock-sale treatment that Baum and Mintz seemed to require. Moreover, retroactivity was needed to preserve the Legislature’s intended distribution of tax burdens among all taxpayers. See Carlton, 512 U.S. at 32; Welch, 305 U.S. at 149. Without retroactivity, nonresident S-corporation shareholders who had paid state taxes on gains from deemed asset sales (whether or not received via installment obligations) would be able to demand refunds for any open tax year, resulting in millions of dollars of unexpected tax losses that would have to be borne by other taxpayers. (R. 86, 89-90, 102, 144.) The Legislature reasonably 37 decided to prevent this loss by closing retroactively the tax loopholes opened by Baum and Mintz, thus placing the tax burden on nonresident S-corporation shareholders, like plaintiffs, who had benefited from conducting business in New York and who the Legislature had always expected would pay state income tax on deemed asset sales. See James Square, 21 N.Y.3d at 248; Canisius Coll., 799 F.2d at 24 (retroactivity properly sought to prevent unexpected refunds based on erroneous rulings). Due process does not prevent this rational and equitable choice. The Appellate Division’s refusal to acknowledge, let alone grapple with, the 2010 amendments’ curative goals as found by the Legislature renders its ruling fundamentally flawed from the outset. Indeed, the Legislature’s need to resolve confusion, protect the reliance interests of purchasers, and prevent unwarranted tax refunds is essentially undisputed here because plaintiffs submitted no evidence to suggest that these express legislative goals are untrue or will not be accomplished through retroactivity. If the uncontroverted public goals of the 2010 amendments are not enough to support retroactivity, as the court below held, the 38 Legislature will be powerless to stem potential legal chaos for open tax years when mistakes open future loopholes with unintended tax consequences. The court below incorrectly treated the 2010 amendments as having only the purpose of raising tax revenues, a purpose the court regarded as insufficiently curative. (R. 592-593.) But the possibility that the 2010 amendments will increase tax receipts cannot negate the many nonrevenue-related public purposes furthered by the 2010 amendments, as found by the Legislature and unrebutted by plaintiffs. In any event, the court below confused a desire to increase revenue through wholly new taxes or substantial alterations of prior tax law with the goal of preventing “significant and unanticipated revenue loss.” James Square, 21 N.Y.3d at 248 (quotation marks omitted). As this Court noted in James Square, protecting against unintended tax losses is a compelling reason for retroactivity, id., and the legislative findings and other record evidence makes clear that the 2010 amendments sought to prevent “many millions of dollars a year” in unexpected 39 tax losses (R. 144; see R. 86 (legislative finding explaining that amendments will prevent “unintended refunds”)). Retroactive application of the 2. amendments to open tax years is rational and fair. The Appellate Division’s disregard of the 2010 amendments’ curative purposes and misapplication of James Square as a paradigm for this case also led to a mistaken analysis of the duration of retroactivity here. The court below simply applied an automatic bar to retroactivity periods longer than the sixteen-month time period disallowed in James Square. (R. 590.) But James Square did not disturb long-established precedent upholding lengthier retroactivity periods for curative tax amendments. See, supra, at 5- 8, 26-31. To the contrary, James Square expressly acknowledged that “longer periods of retroactivity” are often necessary to achieve curative tax legislation’s public goals. 21 N.Y.3d at 249. The Legislature’s express findings, improperly ignored by the Appellate Division, establish that retroactive application of the 2010 amendments to open tax years was required to resolve fully the confusion and disruptive tax consequences of Baum and 40 Mintz. As the legislative findings and history explain, a shorter period would have left many S-corporation purchasers in ongoing legal limbo regarding their ability to continue to claim step-up tax benefits in future tax years for already-completed deemed asset sales. (R. 86, 89-90); see also, supra, at 33-37. And arbitrarily cutting off the 2010 amendment’s retroactive application would have allowed millions of dollars of unexpected tax losses to flow from refund claims, pushing a substantial tax burden onto other innocent taxpayers that the Legislature never intended them to bear. See supra, at 36-39. The Legislature’s decision to apply the curative 2010 amendments to open tax years was thus not only rational but necessary to accomplish the legislation’s important public purposes. Moreover, in addition to achieving a fair tax result for purchasers and other taxpayers through the retroactivity period, the Legislature also specifically addressed concerns about repose and finality by ensuring that the 2010 amendments applied only to tax years for which the statute of limitations had not expired. Especially given that plaintiffs relied solely on their own, unsupported reading of prior law in claiming complete tax 41 immunity, see, infra, at 41-47, they could not reasonably have expected to be free from any future tax assessment while both the tax year and statute of limitations period for their self-reported TMC-sale gains remained open. There is thus nothing unfair about applying the curative 2010 amendments retroactively to plaintiffs. As Justice Andrias explained in dissent, because the duration of retroactivity here is rationally related to the important curative “goal of minimizing the negative impact” of Baum and Mintz and is “within the reasonable expectations of a taxpayer,” the Legislature’s decision to “apply the amendments to past open tax years, for which the statute of limitations had not run,” is a reasonable choice that does not violate due process. (R. 594, 602-603.) The unrebutted legislative findings that 3. the 2010 amendments reaffirmed prior law defeats plaintiffs’ claimed reliance on an existing policy of tax immunity. The Appellate Division’s failure to credit the Legislature’s uncontroverted findings again led it astray in analyzing the last due-process factor—the extent to which plaintiffs reasonably relied on prior law in claiming tax immunity. The Legislature 42 found, and other record evidence confirms, that pre-amendment law required taxpayers to pay proportionate state income taxes on deemed asset-sale gains, whether or not they delayed reporting those gains through installment reporting. Because plaintiffs offered no evidence to rebut this finding, they failed to establish any reasonable reliance on a pre-existing policy of complete tax immunity for nonresidents, a tax result diametrically opposed to the Legislature’s undisputed findings. The Legislature specifically found that long-established pre- amendment law conformed New York’s income tax treatment of deemed asset-sale gains to that of the federal government. (R. 86, 89-90.) This parallel-treatment principle has been the foundation of New York’s income tax law since 1960, when the Legislature amended the Tax Law to impose a state “tax on personal incomes as such incomes are defined for federal income tax purposes,” Ch. 563, 1960 N.Y. Laws at 1746, and is specifically reflected in the statutes governing S-corporation pass-through gains and taxation of nonresidents’ income, see Tax Law §§ 617(b), § 632(e)(2), 660(a). The Legislature further determined that under the pre- 43 amendment laws requiring conformity between federal and state income tax treatment, New York had long taxed taxpayers’ federal deemed asset-sale gains as deemed asset gains for state tax purposes. As the executive memorandum supporting the 2010 amendments explains, Baum and Mintz “effectively undid” these established policies by “re-characterizing what had always been considered” a deemed asset sale under federal and state law into a stock sale solely for New York tax purposes. (R. 90 (emphasis added).) The curative 2010 amendments simply reconfirmed the law “erroneously overturned” by Baum and Mintz rather than imposing any new tax policies. (R. 86.) In the face of these express legislative findings as to New York’s pre-amendment taxation of nonresidents’ deemed asset- sale gains, plaintiffs failed to submit any legal authority to prove that they reasonably relied on a prior policy of complete tax immunity at odds with the legislative findings and history. Plaintiffs did not identify a single IRS ruling, judicial opinion, administrative interpretation, or tax treatise that mentions—let alone endorses—their theory that installment reporting could 44 shelter deemed asset-sale gains from state taxation. Nor did plaintiffs submit an affidavit from any tax expert or practitioner attesting that plaintiffs’ theory was the established or even plausible interpretation of prior New York law. And despite being represented by a large law firm in structuring the TMC sale, plaintiffs did not allege that they were advised by counsel, a tax professional, or anyone else that delaying their reporting of gains by one month would likely result in avoidance of all New York taxes. Without submitting anything to establish that prior law permitted tax immunity, plaintiffs could not have demonstrated that they reasonably relied on any such pre-existing immunity policy. Despite this complete lack of proof, the Appellate Division nonetheless concluded that plaintiffs carried their burden of establishing reasonable reliance on prior law because the “only proof” that defendants submitted to demonstrate pre-amendment taxation of transactions like the TMC sale was an internal DTF presentation. (R. 588.) But this ruling again erroneously ignores the Legislature’s express findings, see, supra, at 42-43, and extensive record evidence. As Justice Andrias explained in 45 dissent, in addition to the unrefuted legislative findings, pre- amendment taxation of deemed asset-sale gains was further established by: (1) an unrebutted, sworn affidavit from a DTF certified public accountant and tax auditor (R. 139-145); (2) a publicly available DTF advisory opinion (R. 160-164); and (3) DTF’s pursuit of tax assessments against the Baum and Mintz taxpayers (R. 602). Plaintiffs failed to rebut any of this record evidence as well. Moreover, although defendants were not required to prove that they took “steps to inform taxpayers” that deemed asset-sale gains would be taxed (R. 588), the unrefuted evidence established that taxpayers were on notice of such taxation. First, parallel treatment is a bedrock tax principle in New York, see, supra, at 10, 16, and many other States. Indeed, several judicial decisions from long before the TMC sale held that federal deemed asset-sale gains had to be taxed for state purposes as asset-sale earnings. See supra, at 16 n.7. Second, DTF published an advisory opinion in 1997, ten years before the TMC sale, explaining that nonresident shareholders must pay proportionate New York 46 income tax on deemed asset-sale earnings.10 (R. 163-164.) Third, other shareholders taking the deemed asset-sale election, such as the taxpayers in Baum, reported their deemed asset-sale gains as taxable New York income. (R. 174.) Finally, if any doubt about New York’s tax policy remained, plaintiffs “could have requested a binding advisory opinion from . . . DTF prior to engaging in the TMC transaction” (R. 601 (citing 20 N.Y.C.R.R. § 2376.1, 2376.4)), but they simply failed to do so. Plaintiffs’ failure to refute the legislative findings and other record evidence establishing that the 2010 amendments clarified rather than changed pre-amendment law sets this case far afield from the reasonable-reliance interest presented in James Square. In James Square, this Court concluded that businesses had established reasonable reliance on prior law when they had relied on 10 Publicly available tax-instruction forms also explained that nonresident S-corporation shareholders were required to include “installment income from an Internal Revenue Code (IRC) 453 transaction” in their New York source income. N.Y. State Dep’t of Taxation & Fin., Publication 88: General Tax Information for New York State Nonresidents and Part-Year Residents, at 11 (Dec. 2007) (“Publication 88”). 47 tax-credit criteria established for almost ten years as well as eligibility certificates confirming their compliance with the criteria, which certificates were retroactively revoked if businesses had not complied with new standards imposed by the tax amendment. 21 N.Y.3d at 240-42. No such circumstances exist here. No state entity induced plaintiffs to rely on an established, pre-existing program in structuring their transaction. And no state entity informed plaintiffs that they had complied with prior law by failing to pay state income taxes on their deemed asset-sale gains. C. Plaintiffs’ Reading of Prior Law Was Neither Well-Established Nor Reasonable. Despite plaintiffs’ failure to submit any factual evidence to rebut the legislative findings and other record evidence establishing that pre-amendment law required taxation of nonresidents’ deemed asset-sale gains, the Appellate Division concluded that plaintiffs had established reliance on a contrary policy of tax immunity because plaintiffs’ own reading of prior law was purportedly “reasonable.” (R. 587-588.) But this ruling is wrong for two reasons. First, due process requires taxpayers to 48 prove reliance on a well-settled expectation of the tax benefits they claim, not reliance on a possible reading of prior law unsupported by any actual experience or practice. Second, even if a taxpayer’s personal reading of the tax code could suffice to establish reliance, plaintiffs’ interpretation of prior law is not reasonable. Due process requires reliance on 1. settled understandings rather than potential interpretations of prior law. This Court and the Supreme Court have made clear that unless retroactive application of a tax amendment will upset taxpayers’ long-settled expectations, retroactivity does not implicate due process at all. See Matter of Varrington, 85 N.Y.2d at 33-35 (no cognizable reliance on temporary alteration of long- standing tax policy); Matter of Replan, 70 N.Y.2d at 456 (due process requires “sufficiently certain” entitlement to claimed tax benefit). To establish such a settled expectation to a particular tax treatment, taxpayers must demonstrate that they reasonably relied on established tax law existing prior to the amendment. See Matter of Replan, 70 N.Y.2d at 456; see also Carlton, 512 U.S. at 34 (cognizable reliance on prior tax regime may be proved when 49 Congress imposes “wholly new tax”). Reliance on unsupported theory does not suffice, even if a taxpayer may have an arguable, technically correct textual construction of tax statutes. See, e.g., Carlton, 512 U.S. at 31-33 (reliance on technically correct reading of prior law “insufficient to establish a constitutional violation”); Kitt v. United States, 277 F.3d 1330, 1333-35 (Fed. Cir. 2002) (reliance on correct reading of prior law did not defeat retroactive application of curative measure). The difference between reliance on a settled tax practice, which can support a due-process claim, and reliance on a potential parsing of pre-amendment law, which cannot, is a matter of fairness. When an understanding of tax law becomes solidified through practical experience or consistent application, taxpayers may reasonably expect that following this understanding will achieve the same tax result that has long been provided. See, e.g., Untermyer v. Anderson, 276 U.S. 440, 445 (1928); James Square, 21 N.Y.3d at 248. But when taxpayers do not follow settled practice but instead rely on novel and untested readings of the law, it is not reasonable for them to expect that their strategy will necessarily or 50 even likely succeed. See Matter of Replan, 70 N.Y.2d at 456 (due process requires taxpayers’ expectations to be “unreasonably disappointed”) (quotation marks omitted) (emphasis in original)). Here, the uncontroverted evidence demonstrates that plaintiffs did not rely on any settled law, practice, or experience. See, supra, at 41-47. Instead, plaintiffs at most made an unsupported guess that they could avoid all state income taxes by delaying receipt of their deemed asset-sale gains by thirty days. Because due process does not protect such an unsettled hope of tax immunity from later application of curative tax legislation, this Court should reverse. Plaintiffs’ interpretation of prior 2. law is unreasonable. a. Pre-amendment tax immunity would serve no discernable purpose. Plaintiffs argued—and the court below accepted—that they “reasonably” interpreted pre-amendment law to allow nonresident shareholders to avoid all state tax on a deemed asset sale simply by using an installment obligation to delay by one month the receipt of $19 million in deemed asset-sale gains. But such a bare 51 reading of pre-amendment law makes no practical or policy sense and would undermine the purposes of the tax provisions relied on by plaintiffs. A loophole that gives nonresident shareholders complete tax immunity for deemed asset sales would defeat the point of a deemed asset-sale election. The purpose of this election is to tax a transaction that would otherwise be considered a stock sale as an asset sale. Neither plaintiffs nor the Appellate Division identify any plausible reason why the Legislature would intentionally grant the tax benefits of an asset sale, while allowing the same transaction to escape the tax consequences of asset-sale treatment. Such a reading would create inconsistency between the transactional parties and call into question the very tax benefits that the deemed asset-sale election is designed to provide. And it would also deviate from federal asset-sale treatment of gains on the same transaction (as well as state treatment of gains for resident S-corporation shareholders). Tellingly, plaintiffs do not claim that nonresident shareholders can use installment reporting to avoid the federal tax consequences that sometimes flow from 52 deemed asset-sale treatment, such as higher tax rates on certain asset-sale gains. See Egan, 116 Penn. St. L. Rev. at 928-29. Moreover, plaintiffs’ theory would undermine the foundational purpose of the S-corporate form. While C-corporation gains are taxed both when earned by the corporation and when distributed to shareholders, S corporations avoid paying corporate-level income tax by passing gains and losses to shareholders, who pay individual federal and state income tax on the pass-through income. Shareholders are then protected against being taxed again if the corporation later distributes its gains because of stock-basis adjustment. See, supra, at 14 n.6. But plaintiffs’ view of pre-amendment law would turn this protection against corporate-level taxation on its head by immunizing S-corporation pass-through gains not from just the corporate income tax but from all income tax. Plaintiffs cannot rely on such an illogical reading of prior law—which would permit sheltering of corporate gains derived from New York sources from even one level of state income tax—to avoid later application of clarifying tax legislation. See, e.g., Carlton, 512 U.S. at 31-33 53 (upholding retroactive application of curative measure when taxpayers’ reading undermined tax statute’s purpose); Wiggins v. Comm’r of Internal Revenue, 904 F.2d 311, 315 (5th Cir. 1990) (rejecting taxpayer efforts to dispute corrective nature of retroactive tax amendment based on illogical reading of prior law as creating tax loophole). b. Pre-amendment tax immunity is not supported by prior law. Plaintiffs’ view of pre-amendment law also does not reflect a reasonable understanding of the way in which the different federal and state tax provisions applicable to deemed asset sales have always fit together. As an S corporation passes through its gains to shareholders (thereby avoiding corporate income tax), shareholders are taxed on the flow-through income in keeping with its character when earned by the corporation. When a deemed asset-sale election is made, the S corporation is treated as having sold its assets, and its gains are passed to shareholders and taxable as asset-sale income under federal and state law. See, supra, at 10-16. Indeed, 54 plaintiffs do not contest that New York conforms its tax treatment of pass-through gains to that of the federal government. Because the S corporation used its assets to do business in New York, shareholders’ pass-through asset-sale gains are New York source income taxable in proportion to the amount of business the S corporation conducted in the State. (R. 54.) The Appellate Division accepted as “reasonable” plaintiffs’ theory that installment reporting recharacterizes all deemed asset- sale gains into stock-sale earnings. But such a theory makes no sense. The purpose of installment reporting is to delay reporting of gains, not to transform earnings into a different form to avoid taxes altogether. Notably, Treasury regulations extended installment reporting to deemed asset-sale transactions because many S- corporation purchasers were unable to pay in all cash up front. See Gregg D. Polsky, Installment Reporting for Sales of S Corporation Stock with a § 338(H)(10) Election, 74-Aug. Fla B. J. 44, 46 (2000); Sydney E. Unger, New York City Bar Reports on Installment Method Reporting for Stock Sale Elections, 97 Tax Notes Today 108-38, ¶ 7 (June 5, 1997) (“Bar Report”). But neither these federal regulations 55 nor New York law remotely suggest that shareholders can avoid the consequences of the deemed asset-sale treatment they chose by using installment obligations to delay reporting their deemed asset- sale gains by one month, or even by one day. The Appellate Division concluded that such a bizarre result was possible under pre-amendment law because § 453(h)(1)(A) states that when a shareholder receives an installment obligation in a liquidation, the installment payments rather than receipt of the note “shall be treated as the receipt of payment for the stock.” (R. 581-582, 587.) But the court below is confusing the deemed asset sale and the deemed distribution in liquidation—two distinct steps that make up every deemed asset-sale transaction. Only after the S corporation sells its assets does it liquidate and distribute the sale proceeds to shareholders. The shareholders are taxed under federal and state law on the pass-through gains, but are usually protected from another round of taxes on the liquidating distribution because of stock-basis adjustment. See, supra, at 14 n.6. In this manner, the deemed asset-sale election preserves the protection against corporate-level taxation and 56 ensures that shareholders pay taxes only once, but it does not trigger immunity from all taxation. Under no circumstance, including the use of installment reporting, does the liquidating distribution unwind the first phase of the transaction, transform all of the asset-sale gain as stock- sale earnings, and undo the purpose of a deemed asset-sale election. Rather, when installment reporting is in effect, the S corporation is treated as receiving an installment note instead of cash in the deemed asset sale. See, supra, at 14-16. When the S corporation distributes this note to shareholders in the liquidation, the installment rules protect the corporation and shareholders from having to recognize taxable gain from the distribution or receipt of the note prior to any payments being received. See 26 U.S.C. §§ 453(h)(1)(A), 453B(h). But § 453B(h), the installment rule for S-corporation liquidating distributions on which plaintiffs rely (R. 53), specifically states that shareholders must still report their “gain or loss” pursuant to the normal pass- through income rules, namely, as if their earnings were realized directly by the corporation. 26 U.S.C. § 453B(h); id. § 1366(b). As a 57 result, the installment rules allow shareholders to delay reporting the pass-through asset-sale income, but do not allow transformation of asset-sale gains into stock-sale earnings. Indeed, DTF specifically instructed nonresidents to include “installment income” reported under § 453 as New York source income. Publication 88, at 11. The Appellate Division ignored this crucial piece of the regulatory scheme, and fundamentally misunderstood the role that the liquidating distribution plays in a deemed asset sale. Accordingly, plaintiffs’ theory of pre-amendment law is unreasonable and does not support a due process claim. 58 CONCLUSION For the reasons set forth above, this Court should reverse the judgment of the First Department and grant summary judgment to defendants. Dated: New York, NY October 20, 2014 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