State courts generally have allowed legislatures a fair amount of flexibility in adopting retroactive statutes, but a recent New York case held that, under the circumstances presented, the retroactive application of a statute was unconstitutional.   In Matter of Jeffrey and Melissa Luizza (DTA No. 824932) (Aug. 21, 2014), Mr. Luizza agreed to sell all of the stock of an S corporation to an unrelated buyer in a transaction governed by Section 338(h)(10) of the Internal Revenue Code.  Under Section 338(h)(10), Mr. Luizza’s sale of his stock was ignored for income tax purposes and the transaction was treated as if the corporation had sold its assets and distributed the proceeds to Mr. Luizza.  Under the Subchapter S rules, the liquidation was essentially tax-free.  The corporation’s gain was passed through to Mr. Luizza as the sole shareholder.  Mr. Luizza was a nonresident of New York and under the law in effect when the sale occurred (March 2008) it appeared that a nonresident shareholder was not taxed on the gain in a 338(h)(10) sale because the transaction was treated as a sale of stock.

In 2009, the State Tax Appeals Tribunal confirmed that although a 338(h)(10) transaction was treated as a sale of assets by the corporation for federal income tax purposes, it was in fact a sale of stock and, since nonresidents are not subject to New York State income tax on gains from the sale of stock, even of a corporation doing business in New York, a nonresident selling stock of an S corporation in a 338(h)(10) transaction cannot be taxed by New York State on the resulting gain.  In Matter of Gabriel S. and Frances B. Baum, et al., (DTA Nos. 820837, 820838) (Feb. 12. 2009) (McDermott Will & Emery filed an amicus brief supporting the taxpayer’s position in that case.)

The State Department of Taxation and Finance was not happy about the result of this litigation.  It convinced the legislature to reverse that result by amending the statute to provide that a shareholder’s share of the corporation’s gain in a 338(h)(10) transaction would be treated as New York source income that was taxable to nonresidents.  The legislation was adopted in 2010 and was made effective retroactively to all years open under the statute of limitations.

Mr. Luizza objected to the retroactive application of the statute to him, and the administrative law judge agreed that, on his facts, the retroactivity was so harsh as to be unconstitutional under the Due Process Clause of the United States Constitution.  The ALJ pointed out that the taxpayer relied on the law as it existed in 2008 and that at the time of the sale the prevailing authority was that the transaction was not taxable.  Mr. Luizza was advised by his tax advisors that there would be no additional New York tax due.  Because of his reliance, he did not have an opportunity to seek a higher sale price or to require the buyer to indemnify him for any additional taxes resulting from [...]

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