An Empire Zone Case Strikes Back: Appellate Division Reverses Long-Time Tax Department Policy

A couple weeks ago, the Third Department of the New York Supreme Court, Appellate Division issued its decision in Matter of Schreiber, reversing a prior decision of the Tax Appeals Tribunal, finding that its interpretation of Tax Law § 16(f)(2)(C) and Matter of Purcell, both related to the calculation of qualified empire zone enterprise (QEZE) tax reduction credits, was irrational. We’ve been following this issue for almost a decade, dating back to our review and analysis of the Purcell case, which you can read about here. The Schreiber case presents an interesting new twist in the story, and the Court’s analysis could impact cases beyond the realm of QEZE credits.

As described in our prior blog post, one of the benefits for taxpayers under the old Empire Zone Program was the availability of a “tax reduction credit” that essentially did what it said: it reduced the New York State taxes payable for qualifying taxpayers in Empire Zones. The specific issue here arose in the context of S corporation shareholders who lived in New York (i.e., who were NY residents). The law provided that these taxpayers were entitled to a credit for tax on the flow-through portion of their S corporation income that was “allocated to the State.”  For resident shareholders, though, arguably ALL their income is allocated to the State because residents pay tax on all of their income. The tax department has taken the position, however, that even though such resident shareholders pay 100% tax on their S corporation income, they only get a corresponding credit for the amount of such S corporation income that was properly apportionable to the State under the business allocation percentage (BAP) rules that apply to nonresident shareholders. And if the S corporation had a significant amount of out-of-state sales, for instance, the NY resident shareholder’s tax reduction credit would be minimal, even though they would have paid 100% tax on their S corporation income as a resident of the state.

Taxpayers won several cases on this issue before the Tax Appeals Tribunal issued its decision in Purcell, finding that the Tax Department’s approach—to limit the credit to the amount of income allocated to New York under the BAP—was at least reasonable, and that decision was later affirmed on appeal by the Appellate Division, Third Department.  That seemed to settle the issue, but not for Mr. Schreiber. In Schreiber, the issue before the Court was whether it was rational for the Tribunal to rely on Purcell to require the application of the BAP to determine what portion of the taxpayer’s income was “allocated within the state” for purposes of calculating the taxpayer’s QEZE credit.

The facts in Schrieber were like Purcell: New York resident shareholders of an S corporation that did business in New York State sought a credit for tax on the flow-through portion of their S corporation income that was “allocated to the state.” The business, a Manhattan-based photography company, calculated their QEZE credit based on all their taxable income, including income from sales that were shipped out of state. The Tax Department and Tribunal, relying on Purcell, took the position that the business’s BAP needed to be applied to figure out the correct calculation of the QEZE credit, which significantly reduced the refund owed to the taxpayer. But unlike the S corporation in the Purcell case, which operated in New York and Virgina, the business in Schreiber did not have any out-of-state operations. The company’s only location was in New York; the reason it had a BAP less than 100% was because under the S corporation BAP computation, income gets allocated based customer location. But all of the taxpayer’s operations were in New York State, and more specifically within an Empire Zone.

The Court found these distinctions significant enough to rule in favor of the taxpayer. Most notably, the Court stated that use of the BAP created an irrational result, noting that it made sense to reduce the QEZE in Purcell given the extent of the S Corporation’s out-of-state activities, but not when a business was located only in New York. The Court added that to restrict the QEZE credit to only sales with an end destination in New York would be contrary to the statutory purpose of the Empire Zones Program.

Perhaps most importantly, the Court noted that the Tax Department’s attempted use of the BAP to determine income allocated within New York was simply at odds with the plain language of the statue, which makes no reference to using the BAP at all.

That’s where this otherwise odd-ball Empire Zone case gets interesting. Specifically, there are other situations where the Tax Department tries to use a company’s BAP as a proxy for determining how income should be allocated within the state. A good recent example of that involves the tax department’s efforts to tax nonresidents on the gain from the sale of their partnership interests. This effort arises out of a 2018 law that characterizes a nonresident’s gain from the sale of a partnership interest as New York source income, if the purchaser treats the transaction as the purchase of assets under IRC § 1060. Under Tax Law § 632(a), if a nonresident is a partner in a partnership where a sale of the membership interest is subject to the provisions of IRC § 1060, then any gain recognized on the sale is treated as New York source income allocated in a manner consistent with the applicable methods and rules for allocation under this article. But there’s nothing in the law or regulations that specifies how the sourcing computation is done. However, in an informational publication, the tax department instructs taxpayers in such a case to use the BAP of the selling partnership in the year of sale to determine the amount of gain derived from New York sources (see TSB-M-18(2)).

But neither the statute nor regulation directs a taxpayer to use the BAP when allocating gain from the sale of assets by a partnership. And TSB-Ms are not law; the tax department cannot use a TSB-M to set a new rule. They need a law or regulation to do that. So if there is a situation similar to Schrieber where the BAP over-estimates the amount of New York activity (which often happens with New York’s arcane three-factor partnership apportionment test), then the Schreiber case should give support for an argument that the use of the BAP is improper, and that some other more rational method is allowed. This could be significant given the Tax Department’s recent efforts to enforce the 2018 law.

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