The opinion
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This opinion is uncorrected and subject to revision before
publication in the New York Reports.
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No. 115
Robert R. Burton et al.,
Appellants,
v.
New York State Department of
Taxation and Finance et al.,
Respondents.
Kenneth I. Moore, for appellants.
Judith N. Vale, for respondents.
RIVERA, J.:
Plaintiffs, nonresident shareholders in an S
corporation, challenge under New York State Constitution Article
16, § 3 a tax imposed on their pro rata share of gains from the
sale of the corporation's stock. We conclude that there is no
constitutional bar to taxation of a nonresident's New York-source
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income earned from a stock sale, and therefore affirm.
I.
The facts are not in dispute. Plaintiffs are several
nonresident former owners and shareholders of JBS Sports, Inc.
(JBS), a Tennessee business organized as an S corporation for
federal and New York State tax purposes. An S corporation is
structured so that its corporate income, losses, deductions, and
credits pass through to its shareholders, based on their
individual percentage ownership in the corporation (26 USC §
1366; Tax Law §§ 617 [a] and 632 [a] [2]; 1 Hellerstein and
Hellerstein, State Taxation 20.08 [2] [a] [iii] [3d ed. 2015]).
The shareholders, in turn, report their pro rata share of the
income and losses on their personal income tax returns in
accordance with federal and state tax laws, and are assessed
taxes at their individual tax rates (see 26 USC § 1366; Tax Law
§§ 617 [a] and 632 [a] [2]). Thus, the corporation does not pay
corporate income taxes and avoids double taxation on both the
corporation and the shareholders (see Matter of Smathers, 19 Misc
3d 337, 343 [Sur Ct 2008]). Hence, the terms "pass through" and
"flow through" income are used to describe the income itself, as
well as the movement of income from the corporation to
shareholders for tax purposes (see e.g. 26 USC § 1366).
In 2007, plaintiffs sold their JBS stock to Yahoo,
Inc., and JBS and Yahoo decided to treat this transaction as a
"deemed asset sale" for tax purposes under the Internal Revenue
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Code (see 26 USC § 338 [h] [10]). Deemed asset treatment is not
automatic or mandated by statute, but instead requires a
voluntary election by both the seller and purchaser, respectively
JBS and Yahoo, to treat the transaction as an asset sale (see 26
USC § 338 [h] [10]; 26 CFR § 1.338 [h] [10] - 1 [c] [3]; 26 ALR
6th 219 § 2). Thus, plaintiffs freely chose to proceed with the
JBS stock transfer as a deemed asset single-transaction sale,
presumptively aware of the tax consequences of their choice.
A deemed asset sale provides counter-balanced
advantages and disadvantages for purchaser and seller. On one
side of the equation, the deemed asset sale makes possible
significant future tax benefits to the purchaser because the
assets are treated as sold at fair market value and the assets
obtain a "stepped up," rather than a carryover, basis for the
purchaser's future depreciation and amortization deductions (see
26 ALR 6th 219 § 2; 26 USC § 338 [h] [10]). On the other side,
the deemed asset sale may result in negative tax consequences for
the corporate seller shareholders, who are responsible for
personal taxes on their share of the gains. However, even this
can be offset by an agreement to a higher purchase price (see
Heather M. Field, Binding Choices: Tax Elections & Federal/State
Conformity, 32 Va Tax Rev 527, 583 [2013]).
As a result of the JBS stock transaction, JBS realized
over $88 million in gains. The JBS earnings then passed through
to plaintiffs as shareholders (see 26 USC § 1366 [b]; Tax Law §§
617 [a], [b], 632 [e] [2], and 660). JBS reported these
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corporate gains and the amount passed to plaintiffs as part of
its federal tax return, but excluded the amount distributed to
plaintiffs from its 2007 New York S corporation franchise tax
return. For their part, plaintiffs reported and paid federal
taxes for the 2007 tax year on their respective shares of the
asset sale income, as required by federal law (see 26 USC §
1366), but did not report or pay any New York State taxes
associated with the sale.
Based on the results of a subsequent audit, defendant
New York State Department of Taxation and Finance assessed
$167,000 in state income taxes on plaintiffs' JBS transaction
gains, relying on Tax Law § 632 (a) (2), which was amended in
2010 to provide, in relevant part, that "any gain recognized on
[a] deemed asset sale for federal income tax purposes will be
treated as New York source income." Plaintiffs paid the taxes
and thereafter demanded refunds, claiming that their corporate-
derived income was obtained from the sale of JBS stock, which is
considered intangible personal property and nontaxable.
After defendant rejected the refund demands, plaintiffs
filed the instant declaratory judgment action against defendant
and the Commissioner of the New York State Department of Taxation
and Finance, challenging the tax as unconstitutional.1 Supreme
1
During the pendency of the matter before Supreme Court
plaintiffs abandoned their challenge to the retroactive
application of Tax Law 632 § (a) (2). We reject just such a
challenge and uphold the retroactivity of the statute in Caprio v
New York State Dept. of Taxation and Finance (___ NY3d ___,
[2015] [decided herewith]).
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Court denied plaintiffs' motion for summary judgment, granted
defendants' motion for summary judgment, and declared that the
statute "is constitutional" (see Burton v New York State Dept. of
Taxation & Fin., 43 Misc 3d 316, 319 [Sup Ct, Albany County
2014]). Supreme Court noted that plaintiffs could not complain
because they had elected to treat the JBS transaction as a deemed
asset sale under federal income tax law (see id. at 318-319). We
retained jurisdiction over plaintiffs' direct appeal under CPLR
5601 (b) (2),2 and now affirm.
II.
Plaintiffs allege that Article 16, § 3 of the New York
Constitution absolutely precludes taxation of gains from the sale
of a nonresident's intangible personal property, in this case JBS
stock. Plaintiffs therefore contend that as nonresident
shareholders they are immune from income taxation on their pass-
through pro rata shares of the JBS transaction earnings. Hence,
plaintiffs argue that Tax Law § 632 (a) (2), as amended in 2010,
is unconstitutional to the extent it directly permits taxation of
nonresidents' income derived from the Internal Revenue Code (IRC)
§ 338 (h) (10) deemed asset sale.
Defendants respond that Article 16, § 3 does not apply
2
Under CPLR 5601 (b) (2) "[a]n appeal may be taken to the
court of appeals as of right . . . from a judgment of a court of
record of original instance which finally determines an action
where the only question involved on the appeal is the validity of
a statutory provision of the state or the United States under the
constitution of the state or of the United States."
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to plaintiffs' flow-through income realized from the sale of JBS
corporate assets because the constitutional prohibition relied
upon by plaintiffs applies to location-based taxes on intangible
personal property domiciled outside of New York State.
Alternatively, defendants alleged that plaintiffs waived any
challenge to the tax by electing to treat the transaction as a
deemed asset sale under IRC § 338 (h) (10).
As a preliminary matter, there is no question that New
York State's Tax Law, including Tax Law § 632 (a) (2), as amended
in 2010, contemplates the taxes that defendants assessed on the
New York-source portion of plaintiffs' deemed asset sale gains.
That conclusion is obvious from the applicable state and federal
statutes, and is not seriously disputed by the parties.
Turning to the constitutionality of the assessment, we
first recognize as a foundational tenet of our state tax law that
New York seeks to achieve a certain amount of parallel treatment
of state and federal taxation (see Tax Law §§ 617 [b], 632 [e]
[2], and 660 [a]). New York S Corporation shareholders must
report for state income tax purposes the same "income, loss,
deduction and reductions . . . which are taken into account for
federal income tax purposes" (Tax Law § 660 [a]). Furthermore,
under federal and state law, deemed asset flow-through income is
taxed based on the character of the income when earned by the
corporation, meaning the income is treated as coming from the
same source as received by the corporation (26 USC § 1366 [b];
Tax Law §§ 617 [a], [b] and 632 [e] [2]; see Hellerstein, State
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Taxation, at 20.08 [2] [b] [iii] ["the source of a shareholder's
pro rata share of S corporation income is first characterized by
reference to corporate income-producing activities under Section
1366 (b) of the Internal Revenue Code, and then, as
characterized, is sourced to locations according to the rule that
applies to that type of income"], citing Valentino v Franchise
Tax Bd., 342 Cal Rptr 2d 304, 309 [4th Dist. 2001]). Gains
passed to the S corporation shareholders retain "the same
character" for state income tax purposes as held for federal
income tax purposes (Tax Law §§ 617 [b] and 632 [e] [2]). Thus,
if the corporation's income source is located in New York, it is
taxable to the extent allowed under New York law. For example, a
nonresident's pass-through income is taxed based on the
percentage of the income "derived from or connected with New York
sources" (Tax Law § 631). In contrast, the entirety of a New
York resident's pass-through income is taxable (Tax Law § 617
[a]).
Section 631 (a) (1) (B) further provides that
nonresidents are subject to tax on income "derived from or
connected with New York sources," such as income derived from an
S corporation (Tax Law § 631 [a] [1] [B]). Moreover, New York
source income includes "dividends, interests, and gains from the
disposition of intangible property" only if that intangible
property is "employed in a business carried on in this state"
(Tax Law § 631 [b] [2]).
Tax Law § 632 (a) (2), as amended in 2010, includes as
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New York source income any gains from a deemed asset sale under
IRC § 338 (h) (10). That section provides, in relevant part:
"[I]f the shareholders of the S corporation
have made an election under section
338(h)(10) of the Internal Revenue Code, then
any gain recognized on the deemed asset sale
for federal income tax purposes will be
treated as New York source income allocated
in a manner consistent with the applicable
methods and rules for allocation under
article nine-A of this chapter in the year
that the shareholder made the section
338(h)(10) election"
(Tax Law § 632 [a] [2]).
In accordance with these provisions, defendants treated
plaintiffs' gains from the JBS deemed asset sale as New York-
source income, and assessed taxes in proportion to the JBS income
derived from New York sources, which defendants calculated to be
13% of its total corporate income (see Tax Law §§ 617 [a], 631
[a] [1] [B], and 632 [a] [2]). This assessment is wholly in line
with the statutory scheme, and absent a superior legal
restriction on our state's taxation of plaintiffs' pass-through
income, plaintiffs are without grounds to demand a refund.
Plaintiffs claim that a constitutional bar to the tax
is found Article 16, § 3 of the New York Constitution. That
provisions states,
"Moneys, credits, securities and other
intangible personal property within the state
not employed in carrying on any business
therein by the owner shall be deemed to be
located at the domicile of the owner for
purposes of taxation, and, if held in trust,
shall not be deemed to be located in this
state for purposes of taxation because of the
trustee being domiciled in this state,
provided that if no other state has
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jurisdiction to subject such property held in
trust to death taxation, it may be deemed
property having a taxable situs within this
state for purposes of death taxation.
Intangible personal property shall not be
taxed ad valorem nor shall any excise tax be
levied solely because of the ownership or
possession thereof, except that the income
therefrom may be taken into consideration in
computing any excise tax measured by income
generally. Undistributed profits shall not be
taxed"
(NY Const art. XVI, § 3 [emphasis added]).
"In construing the language of the Constitution, as in
construing the language of a statute, the courts . . . give to
the language used its ordinary meaning" (Matter of Carey v
Morton, 297 NY 361, 366 [1948], citing Matter of Sherill v
O'Brien, 188 NY 185, 207 [1907]). As is obvious from the
language of Article 16, § 3, there is no express prohibition on
income taxation of a nonresident's intangible personal property.
Nevertheless, plaintiffs contend such a prohibition is the
logical consequence of the situs-rule adopted in the first
sentence of section three. In other words, plaintiffs argue that
defendants must treat any income generated by the stock as
nontaxable because New York's constitution requires a
nonresident's intangible personal property, not employed in
carrying on business in New York, be treated as domiciled outside
of the state.
This view is unsupported by the plain language of
Article 16, § 3, and misconstrues the constitutional prohibition.
Plaintiffs assume that according an out-of-state domicile to a
nonresident's intangible property, such as stocks, insulates the
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nonresident shareholder from all types of taxes for all purposes.
There is no textual support for such an expansive interpretation
of Article 16, § 3. In fact, this Court has been careful to
avoid overextending the application of section three beyond the
obvious meaning of its text, purpose and history (see Ampco
Printing-Advertisers’ Offset Corp. v City of N.Y., 14 NY2d 11,
22-23 [1964] [New York City commercial rent or occupancy tax is
neither an ad valorem nor excise tax, nor tax applicable to
intangible property encompassed within Article 16, § 3]).
Moreover, we reject plaintiffs' proposed constitutional analysis
that we find to be grounded in an atomized reading of section
three's component parts, but lacking in the necessary
consideration of those parts' interconnectedness and relationship
to the tax system. Plaintiffs simply ignore that the component
sentences work in harmony to proscribe physical location-based
taxes on nonresidents' intangible personal property.
The first sentence of section three states that the
domicile of a nonresidents' intangible personal property, not
employed in business in New York, is the domicile of the owner of
the property. This ensures that intangible personal property
without an in-state business connection is treated as out-of-
state property, even though the property is physically located
within New York.
The second sentence of section three is a specific
interdiction on ad valorem taxes, which are taxes assessed based
on ownership and imposed according to the property's value. When
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determining the coverage of this proscription, this Court has
previously adopted the general understanding that "[a]n ad
valorem property tax is always based upon ownership of property
and is payable regardless of whether the property is used or not"
(Ampco, 14 NY2d at 22, citing Matter of Guardian Life Ins. Co. v
Chapman, 302 NY 226, 238-239 [1951], and Powell v Gleason, 50
Ariz 542, 547-548 [1937], and Walla Walla v State, 197 Wash 357,
362 [1938]). The second sentence of section three also prohibits
excise taxes "levied solely because of the ownership or
possession of the intangible property." Together these clauses
preclude taxation based on physical ownership, possession, or
presence in New York State.
The text of section three makes no mention and provides
no language supporting extending the prohibition on ad valorem
and ownership/property-based excise taxes to income taxes. There
is simply no language in Article 16, § 3 that expressly or
implicitly constrains the state from imposing any other non-
location based taxes. We have rejected a prior effort to
interpret the prohibition broadly to encompass other categories
of taxes. Thus, in Ampco this Court declined to treat the New
York City Commercial Rent or Occupancy Tax Law as within the
ambit of Article 16, § 3 because the City's tax had none of the
characteristics of an ad valorem tax. It was "not based merely
upon ownership or possession regardless of whether the property
is used or not; there [was] no provision for the determination or
assessment of the value of the property; nor [was] the tax
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imposed according to the property's value" (Ampco, 14 NY2d at
22). The same is true of the income tax at issue here.
The third sentence in section three declares that
undistributed profits shall not be taxed. This prohibition,
however, is not implicated by the facts and legal issues involved
in this appeal, and the plaintiffs do not suggest that it
supports their reading of the constitutional text.
As should be clear from this analysis, we need look no
further than the text of section three to reject plaintiffs'
argument. Nonetheless, because the history of Article 16, § 3 so
clearly establishes that the plaintiffs' interpretation is at
variance with the intended purpose of this section, we think the
historical documents and the matters debated as revealed in these
documents deserve brief mention.
At the time of section three's adoption, the drafters
intended to "write into the Constitution a well-settled rule of
domicile with respect to taxation," which generally treated the
situs of intangible property as the owner's domicile (see Revised
Record of the Constitutional Convention of the State of New York,
vol. II, p. 1113 [1938]). This rule, based on the doctrine of
mobilia sequuntur personam, meaning the "movables follow the
person," (see Matter of Brown, 274 NY 10, 17 [1937] op mod on
denial of rearg, 274 NY 634 [1937] and revd sub nom. Graves v
Elliott, 307 US 383 [1939]), is unambiguously reflected in the
first sentence of section three.
The other concern addressed by the drafters in section
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three was the impact of taxation of securities and stocks based
solely on presence in New York State. The drafters desired to
attract and retain in the state monies and securities of
nonresidents. In order to make the state attractive the drafters
constitutionally prohibited taxation of intangibles "until the
[holders] employ them in business in the State," believing that
this "tends to develop the financial supremacy of the City of New
York" (see Revised Record of the Constitutional Convention of the
State of New York, vol. II, p. 1113 [1938]).
The drafters further prohibited ad valorem taxes of
intangibles, seeking to ensure the end of those property taxes
because that system had "utterly failed" (id.), leading to its
replacement in 1919 with an income tax (see L 1919 ch 627). The
drafters' intent to attract stocks and securities is also evident
from the prohibition on excise taxes solely based on possession
and ownership. This prohibition was included to prohibit
taxation based on presence in the state until such time as the
property was employed in business, or was transferred.
In response to questions about the anticipated coverage
of section three as applied to the stock transfer tax, the Chair
of the Committee on Taxation, which sponsored section three's
addition to the Constitution in 1938, stated that,
"[t]he stock transfer tax is an excise tax
upon the transfer, and those are the very
taxes which I submit...we are going to reap
the benefit from, because if we can increase
this intangible wealth from the other states
you will be able to impose the transfer taxes
which will bring you substantial revenues
that you never calculated"
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(see Revised Record of the Constitutional Convention of the State
of New York, vol. II, p. 1114 [1938]). He further added,
"we want to make it impossible for the
Legislature itself, or for the Legislature to
delegate the right, to levy an excise tax on
the mere possession of the property. In
other words, the property may enjoy that
privilege or it may be used for some purpose,
and then you can levy an excise tax on it if
and when it is used"
(id. at 1115).
The interpretation advocated by plaintiffs is not
merely rejected by this original history from the 1938
Constitutional Convention, but is also counter to the general
understanding of section three publicized during the 1967
Constitutional Convention. According to the report on state
finance submitted by the Temporary State Commission on the
Constitutional Convention, section three was understood to
provide that "[a]d valorem taxes or excises on the ownership or
possession of intangible personal property are prohibited.
However, income from such property may be taxed" (State of NY
Temporary State Commission on the Constitutional Convention,
State Finance: Report 8 [March 24, 1967] at 37).
The 1938 and 1967 Constitutional Convention Committee
and Commission statements reveal that the intent of section three
is to prohibit taxation of intangible assets based merely on
their physical presence with the state, and to ensure a
proscription on the ad valorem taxation system as applied to
intangible personal property. This was necessary to encourage
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the importation and retention of nonresident wealth in the form
of intangibles such as stocks. However, the prohibition does not
eliminate all taxation, as illustrated by the excise tax and
transfer tax explicitly referenced approvingly by the drafters,
and as further recognized by the comprehensive review conducted
by the 1968 Commission of section three and other provisions.
Here, defendants assessed an income tax on the gains
realized by plaintiffs from the JBS deemed asset sale. It is not
an ad valorem tax by definition or application, or an excise tax
levied solely because of ownership or possession (Ampco, 14 NY2d
at 22). Instead, the tax is based on income generated by those
intangibles which are derived from New York sources. Therefore,
the subject tax does not fall within the prohibition contained in
section three.
To the extent plaintiffs argue that the deemed asset
sale is a fiction of federal law, suggesting there are no real
consequences associated with such fiction, that is simply a
convenient but inaccurate characterization of the JBS
transaction. In reality "the § 338 (h) (10) 'fiction' simply
allowed the parties to change the means by which the gain was
realized and by whom" (Gen. Mills, Inc. v Commr. of Revenue, 440
Mass 154, 170 [2003]). Nothing changes the fact that plaintiffs
sold something of value and reaped the benefits from that sale.
Article 16, § 3 in no way supports plaintiffs' attempts to avoid
paying state taxes on those gains.
Accordingly, the order and judgment should be affirmed,
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with costs.
* * * * * * * * * * * * * * * * *
Order and judgment affirmed, with costs. Opinion by Judge Rivera.
Chief Judge Lippman and Judges Read, Pigott, Abdus-Salaam, Stein
and Fahey concur.
Decided July 1, 2015
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