For the Plaintiffs: Ingram Yuzek Gainen Carroll & Bertolotti, LLP, John G. Nicolich, Esq., Roger Cukras, Esq.
For Defendants: Eric T. Schneiderman, Esq., Attorney General of the State of New York, John M. Schwartz, Esq.
Paul G. Feinman, J.
Plaintiffs, Philip Caprio and Phyllis Caprio, commenced this action seeking a judgment declaring certain provisions of the New York Tax Law invalid as applied to them; they also seek injunctive relief enjoining the enforcement of those provisions against them. Defendants, The New York State Department of Taxation and Finance, Thomas H. Mattox, in his official capacity as Commissioner of the New York State Department of Taxation and Finance, The Bureau of Conciliation and Mediation Services, the State of New York and Andrew M. Cuomo, in his official capacity as the governor of the State of New York, move for summary judgment dismissing the complaint. Plaintiffs oppose defendants' motion and cross-move for summary judgment and any further relief as the court may deem just and proper, including reasonable attorneys' fees as part of plaintiffs' costs pursuant to 42 USC § 1988 (b). Defendants oppose plaintiffs' cross motion.
The principal question to be answered on this motion is whether certain provisions of section 632 (a) (2) of the Tax Law, as amended in August 2010, violate the due process clauses of the United States and New York State Constitutions as applied to plaintiffs. Specifically, plaintiffs challenge the purported retroactive application of the 2010 amendment to section 632 (a) (2) by the Department of Taxation and Finance in assessing additional taxes on plaintiffs for the 2007 and 2008 taxable years. For the reasons stated below, the court concludes that the challenged portions of the amended section 632 (a) (2) are not unconstitutional as applied to plaintiffs. Accordingly, defendants' motion for summary judgment dismissing the complaint is granted and plaintiffs' cross motion for summary judgment and attorneys' fees is denied.
1. Plaintiffs' Disposition of their TMC Interests
Prior to 2007, plaintiffs, Philip and Phyllis Caprio, were the sole shareholders  of Tri-Maintenance & Contractors, Inc., d/b/a TMC Services, Inc. ("TMC"), a corporation which had elected S corporation  status for federal and New York tax purposes for the last 10 years. During the relevant time period, plaintiffs were not residents of New York, although TMC did derive a portion of its income from activities in New York. Although plaintiffs represented to the Department of Taxation and Finance in at least one document that TMC was organized under the laws of the State of New York (Doc. 17-7, ex. G, May 3, 2011 Statement of Facts), the complaint alleges that TMC was organized under the laws of New Jersey and had elected to be taxed as a corporation under Subchapter S of the Internal Revenue Code (Doc. 15-1, ex. A, Ver. compl. at ¶ 15).
According to the verified complaint, plaintiffs entered into a "stock purchase agreement" with Sanitors Services, Inc. dated February 1, 2007. Under the agreement, plaintiffs sold all of their respective shares in TMC to Sanitors for an aggregate selling price consisting of a base purchase price of $19, 962, 080.00, subject to certain possible adjustments ("Base Purchase Price"), plus a contingent purchase price based on TMC's financial performance for the fiscal years ending December 31, 2007, 2008 and 2009 ("Earnout Obligation") (Doc. 15-1, ex. A, Ver. compl. at ¶ 15). Sanitors agreed to pay the Base Purchase Price on March 1, 2007, in an aggregate amount equal to $19, 462, 080.00, pursuant to separate promissory notes payable to each plaintiff in proportion to their respective stock ownership with interest at the rate of 3.45%. The remaining $500, 000.00 of the Base Purchase Price was to be paid pursuant to separate promissory notes on February 1, 2008, with 4.45% interest. These promissory notes are collectively referred to as the "Sanitors Installment Obligations."
2. TMC's 2007 Federal Taxes
The federal tax treatment given to the TMC transaction is described in the verified complaint. Pursuant to the "stock purchase agreement, " plaintiffs and Sanitors jointly made an election under section 338 (h) (10) of the Internal Revenue Code by filing a Form 8023. As a result of the section 338 (h) (10) election, for federal tax purposes, the transaction was not treated as a simple sale of all TMC stock by plaintiffs to Sanitors. Rather, section 338 (h) (10) creates a fiction wherein TMC is deemed to have first sold all of its assets, subject to all of its liabilities, to Sanitors as of the close of the acquisition date in exchange for the Sanitors Installment Obligations. Next, TMC is deemed to have made a distribution to its shareholders (plaintiffs) in a deemed liquidation consisting of the same consideration that TMC was deemed to have received in the deemed asset sale (the Sanitors Installment Obligations). The deemed liquidation is treated as if it had occurred as of the close of the acquisition date, but immediately after the deemed asset sale. Thus, as a result of the section 338 (h) (10) election, for federal tax purposes, there was not a sale of TMC stock by plaintiffs directly to Sanitors in exchange for the Sanitors Installment Obligations, but a two-part fictional transaction in which TMC sold its assets to Sanitors in exchange for the Sanitors Installment Obligations, followed by a deemed liquidation in which the consideration received from Sanitors by TMC was distributed to plaintiffs.
In addition to the section 338 (h) (10) election, plaintiffs made another election in reporting their federal taxes that is relevant here. Plaintiffs elected to use the installment method of accounting pursuant to Internal Revenue Code § 453 to report the gain from the deemed asset sale (Doc. 15-1, ex. A, Ver. compl. at ¶ 25). Under the installment method, the gain is recognized only when cash payments are actually received. Thus, the gain from the receipt of promissory notes from Sanitors would only be recognized when cash payments were actually made pursuant to those notes. "TMC filed a final federal Form 1120S for a short taxable year ending on February 1, 2007... [and] reported the Deemed Asset Sale in the same manner as if TMC had actually sold its assets to Sanitors" (id. at ¶ 24). The "short taxable year" ended on the acquisition date for the subject transaction. Since neither TMC nor plaintiffs had received any cash payments from Sanitors by that date, the deemed asset sale "did not result in TMC's recognition of any gain under the installment method on TMC's Federal Stub Return" (id. at ¶ 27). Plaintiffs claim that under section 453B (h) of the Internal Revenue Code, TMC did not recognize any gain by reason of the deemed liquidation of the Sanitors Installment Obligations to plaintiffs in exchange for their stock.
3. Plaintiffs' Personal 2007 and 2008 Federal Taxes
Plaintiffs claim that they did not recognize any gain upon their receipt of the Sanitors Installment Obligations as of the close of the acquisition date, because under Internal Revenue Code § 453 (h) (1) (A), only cash payments actually received under the installment obligations — as opposed to the receipt of the obligations themselves — are treated as payment received in exchange for plaintiffs' stock in TMC. Plaintiffs also claim that, pursuant to Internal Revenue Code § 453 (h) (1) (A), they reported an installment sale of their TMC stock on Form 6252 attached to their 2007 Form 1040. There, they recognized capital gain in 2007 in the aggregate amount of $18, 263, 325.00, which was attributable to plaintiffs' receipt of the initial payments of principal under the promissory notes from Sanitors after those notes had been distributed by TMC to plaintiffs in the deemed liquidation.
It should be noted that because the "stock purchase agreement" provided that Sanitors would make the first payment in an aggregate amount equal to $19, 462, 080.00, plus 3.45%, on March 1, 2007, and TMC's 2007 "Federal Stub Return" only covered through February 1, 2007, plaintiffs' election of the installment method of accounting explains why plaintiffs' individual tax returns for 2007, which covered the entire year and not just up until February 1, would reflect the distribution received by plaintiffs from the deemed liquidation while TMC's "Federal Stub Return" would not.
The next year, plaintiffs reported additional gain from the TMC transaction in an aggregate amount of $1, 139, 061.00 on Forms 6252 attached to their 2008 federal Form 1040, which was attributable to the second cash payments received under the promissory notes from Sanitors, plus the first payment made by Sanitors pursuant to the Sanitors Earnout Obligation.
4. TMC's 2007 New York Taxes
According to plaintiffs, TMC filed a final New York S corporation return using Form CT-3-S for a short taxable year ending February 1, 2007, in which they claim TMC reported the gain from the deemed asset sale under the installment method, "consistent with the approach used on TMC's Federal Stub Return" (Doc. 15-1, ex. A, Ver. compl. at ¶ 34). For the same reasons described above in connection with TMC's "Federal Stub Return, " TMC did not recognize any gain from the deemed asset sale or the deemed liquidation of the Sanitors Installment Obligations. TMC issued a "New York Shareholder Summary" reflecting plaintiffs' individual shares of operating income for the shortened taxable year or "stub period." This summary "did not show any gain with respect to the Deemed Asset Sale, except for a relatively small amount of recapture' income not eligible for the installment method" (id. at ¶ 35).
5. Plaintiffs' 2007 and 2008 New York Taxes
Plaintiffs' 2007 and 2008 New York nonresident income tax returns (Form IT-203) reported their receipt of payments from Sanitors "exactly as those payments were reported on their federal returns — i.e., as payments received under the installment method in exchange for [plaintiffs'] stock in TMC" (Doc. 15-1, ex. A, Ver. compl. at ¶ 38). Claiming that the gain recognized by plaintiffs upon their receipt of payments under the Sanitors Installment Obligations was treated for federal purposes as gain from the sale of stock, the gain did not constitute New York-source income and was not subject to New York tax because under New York Tax Law § 631 (b) (2) and 20 NYCRR § 132.8 (c), gain from the sale of an intangible asset, including stock, is not taxable to a nonresident individual unless the gain is from property employed in a trade or business carried on in New York.
6. The Mintz Determination
In 2009, an administrative law judge of the Division of Tax Appeals issued a determination involving what plaintiffs describe as a transaction identical to their disposition of their TMC stock. According to plaintiffs, in Matter of Mintz (Dept. of Tax Appeals Nos. 821807 and 821806, June 4, 2009), the administrative law judge determined that in a transaction subject to section 453 (h) (1) (A) of the Internal Revenue Code, "nonresident shareholders of an S corporation did not have New York-source income upon their receipt of payments under an installment obligation distributed by the S corporation" (Doc. 15-1, ex. A, Ver. Compl. at ¶ 40); Doc. 20-14, ex. N, Mintz at 5). The verified complaint quotes a passage from Mintz stating, "since the gain petitioners received (via periodic installment payments) in exchange for their stock in [the S Corporation] was gain from the sale of stock held by a nonresident, the same is not includible as New York source income [and] is not subject to taxation by New York State" (id.). Plaintiffs argue that the determination set forth in Mintz "clearly shows that [plaintiffs] properly reported their 2007 sale of TMC stock for New York personal income tax purposes" (id.).
7. Amendment to Tax Law § 632 (a) (2)
Partially as a response to Mintz, in August of 2010, section 632 (a) (2) of the Tax Law was amended by the Legislature in what plaintiffs characterize as a "fundamental change in the application of the installment method to transactions in which an installment obligation is distributed to a nonresident shareholder of an S Corporation pursuant to Section 453 (h) (1) (A) of the [Internal Revenue] Code" (id. at ¶ 42). Specifically, they claim that the 2010 amendment "added a provision that now treats the gain to a nonresident shareholder of an S Corporation, with respect to payments received under the installment obligation, as New ...