When state legislatures are in need of additional funds – as they often are – it is tempting to enact retroactive legislation to bring more dollars into state coffers. Two recent developments have Due Process Clause questions of retroactivity back in the news in the SALT world. In Caprio v. N.Y. State Dep’t of Taxation & Fin., No. 651176/11, 2014 NY Slip Op. 02399 (N.Y. App. Div. Apr. 8, 2014), a New York court rejected a retroactive amendment reaching back three years into the past. Virginia, however, recently amended its add-back statute (H.B. 5001, § 3-5.11) with an even longer retroactive period of 10 years.

New York’s Three and a Half Year Retroactive Tax Struck Down As-Applied

In Caprio, Florida residents sold their stock in a New Jersey S corporation in exchange for an installment note. The S corporation was a janitorial services company that also did business in New York. The parties to the transaction made an IRC § 338(h)(10) election for treatment as a deemed asset sale, with the installment note thereby deemed to be distributed in liquidation to the shareholders. When the shareholders subsequently received payments on the installment note, they did not report any New York source income because they treated the payments as gain from the sale of stock, not sourced to New York any more than would be a sale of stock in a Fortune 500 company.

Treatment of gain from a nonresident’s sale of S corporation stock as not sourced to New York was upheld by the New York State Division of Tax Appeals in In re Mintz, DTA nos. 821807, 821806 (Jun. 4, 2009), but retroactive legislation in 2010 reversed the result. 2010 N.Y. Laws, c. 57, Part C (amending N.Y. Tax Law § 632(a)(2)).  Caprio voids the retroactive application of the 2010 amendment to the taxpayers as violating the Due Process Clause.

Applying New York’s three-factor test set forth in James Square Assoc. LP v. Mullen, 993 N.E.2d 374, 377 (N.Y. 2013), aff ’g, 91 A.D.3d 164 (N.Y. App. Div. 4th 2011) (which we discussed recently inState Tax Notes), the Appellate Division considered the factors of (1) taxpayer’s forewarning and the reasonableness of the retroactive change, (2) the length of the retroactive period, and (3) the public purpose of the retroactivity. The majority concluded that the 2010 amendment was unconstitutionally retroactive:

• The taxpayers had no actual forewarning of the 2010 amendment at the time they entered into the transaction, and they reasonably relied on the law as it existed to structure the sale;

• A three and a half year retroactive period was excessive; and

• Raising $30 million for the state budget was not a sufficiently compelling public purpose.

The Questionable Validity of Virginia’s 10 Year Retroactive Add-Back Amendments

Just before Caprio came down, Virginia amended its add-back statute, retroactive to 2004, to narrow the subject-to-tax and conduit exceptions. See H.B. 5001, § 3-5.11. Retroactive enforcement of these amendments would essentially codify the Virginia Department of Taxation’s application of Virginia’s add-back statute and would strengthen the Department’s hand in a number of pending cases.

The validity of Virginia’s retroactive amendments under the Due Process Clause is questionable.  10 years is an outrageously long period of retrospective effect. The Department may argue that the amendments are really a technical clarification of existing law rather than a truly retroactive change in the law, but taxpayers facing alleged liabilities as a result of the amendments will certainly experience a real change.