In Uncategorized on 03/11/2015 at 18:47

No, not the Harry Watt 1941 classic reality show starring Perc Pickard and Speedy Powell, both later killed in action with the RAF. No, this is about New York State’s carefully-guided largesse to those who bring investment, development and jobs to the impoverished corners of The Empire State. Our State’s Constitution prohibits direct gifts to corporations or individuals from the State treasury. But politicians, like love, will find a way.

And who better to explicate the bounty targeted by The Capital District to those who bear the goodies to the ruined counties of Our Fair State than The Great Dissenter, a/k/a The Judge Who Writes Like a Human Being, s/a/k/a the Implacable, Irrefragable, Irrepressible, Indefatigable, Indispensable Foe of the Partitive Genitive, Judge Mark V. Holmes?

Today’s bearers of goodies (and recipients of the not-insubstantial-but-Constitutionally-indirect largesse) are David J. Maines and Tami L. Maines, 144 T. C. 8, filed 3/11/15. And as in my recent blogpost “Nothing Succeeds”, 2/26/15, State law collides with the IRC, and, unlike the Texans, the NYers come off second best.

Judge Holmes here confronts the EZ Investment Credits, the EZ Wage Credits and the even-more-cutesy QEZE Real Property Tax Credit. NYS calls them “credits”, but like EITC, these are refundable. In Dave’s and Tami’s case, as they are partners and S Corp shareholders, the tax benefits flow through to them. The benefits are initially allocated at the entity level, but the K-1s reflect each partner’s (shareholder’s) piece, which can offset their personal State income tax.

But there’s a catch. While the Investment Credit and Wage Credit are solely income tax items, the Real Property Tax credit allows real estate taxes paid by the entity to flow through as income tax credits to the partners (shareholders).

Now TEFRA raises its head, but Judge Holmes pushes it back. The real estate taxes are “affected items”, don’t need any partnership-level slice-and-dice so long as IRS buys the 1065, which it does. So no FPAA, and straight to Dave’s and Tami’s personal return. As a result of the targeted largesse, Dave and Tami wiped out three years’ worth of NYS income taxes. In one year, only half the wipe-out was largesse, the other half nonrefundable credits not at issue here. The other two were all wipe-outs.

“But having done just what New York wanted, the Maineses reaped a bountiful harvest of the New York EZ credits for this period. And because they had little to no state income-tax liability in these years for the credits to offset, the refundable credits led to large ‘refund’ payments from New York to the Maineses.” 144 T. C. 8, at p. 10.

So IRS claims the “refunds” are income, and not refund of NYS income taxes now or formerly paid by Dave and Tami. Enter our old friend the tax benefit rule. If you got a deduction in one year, but the deductible item is reimbursed in another, the reimbursement is taxable, because it wasn’t taxed the first time. Judge Holmes’ example is the bad debt deduction (taken quite properly) in Year One, but in Year Two the formerly deadbeat debtor hits the lottery and pays off the debt. The payback, even though ordinarily not income (repayment of loan principal isn’t income), is taxable because the lender got the Year One tax break. So if you got no tax break (either because you didn’t or couldn’t) in Year One, no income to you in Year Two.

And getting back to Dave and Tami, they never took the itemized deduction for NYS income tax. Judge Holmes: “We have to agree with the Maineses in part. They are correct that New York calls these payments ‘credits’ and that New York says these “credits” are ‘overpayments’ of state income tax. But in truth the Maineses didn’t pay this amount in state income tax.” 144 T. C. 8, at pp. 14-15.

So the key question in this case becomes whether a federal court applying federal law has to go along with New York’s definition. “The Maineses understand the importance of this question, and they argue that if New York State tax law calls these payments ‘overpayments’ we have no power to call them something different.” 144 T. C. 8, at p. 15.

Summarizing all sorts of decisions from the Supremes, “…state law creates legal rights and interests; federal law designates how those rights or interests will be taxed.” 144 T. C. 8, at p. 15.

A Taishoff “good try” to Dave’s and Tami’s attorney. “The Maineses contend that New York’s tax-law label of these excess EZ Credits as overpayments is a legal interest that binds the Commissioner and us when we analyze their taxability under federal law. The Commissioner warns that if this were true, a state could undermine federal tax law simply by including certain descriptive language in its statute. To use Lincoln’s famous example, if New York called a tail a leg, we’d have to conclude that a dog has five legs in New York as a matter of federal law.” 144 T. C. 8, at p. 16. (Citation omitted).

You can see where this is going. Lincoln’s five-legged dog wins best-in-show. “Our precedents establish that a particular label given to a legal relationship or transaction under state law is not necessarily controlling for federal tax purposes.. Federal tax law looks instead to the substance (rather than the form) of the legal interests and relationships established by state law.” 144 T. C. 8, at p. 16. (Citations omitted).

Looking at substance, at least as to the Wage Credit and the Investment Credit, “Neither credit is, in substance, a refund of previously paid state taxes deducted under federal law. They are just transfers from New York to the taxpayer–subsidies essentially.” 144 T. C. 8, at p. 18. The credits never offset tax due from Dave and Tami. For a credit to be nontaxable, it must be used to offset or reduce a tax liability. In these two cases, it wasn’t, entirely.

So whatever didn’t offset Dave’s and Tami’s tax liability is income, and taxable accordingly. And it doesn’t matter whether the State or anyone else paid it. And although Dave and Tami claim exemption on the grounds that the “refunds” were “general welfare payments”, and thus not taxable, they weren’t based on need, so not general welfare, although, as Judge Holmes suggests, critics might call it “corporate welfare”. Anyway, give Dave’s and Tami’s counsel a Taishoff “Oh please”.

But the Real Estate Tax Credit is another story. Those taxes were actually paid, even though the giveback is by way of income tax and not real estate tax. Footnote- in NYS, real estate taxes are paid to municipalities, while State income tax is paid to the State. Here in the Big Apple we also have City income tax. Don’t ask.

But the Sub S Corp got a deduction for those taxes, passed through a lesser distribution to Dave and Tami, who therefore paid less tax. So to the extent Dave and Tami benefited from the deduction of real estate taxes on their 1065, which flowed through to them on their K-1s, any Real Estate Tax Credit is taxable now to that extent. “It is of no consequence that it was [the S Corp] that paid and deducted the property taxes while it is the Maineses who are receiving the refundable credit. The Maineses needn’t have been the ones that personally claimed the earlier deduction if their tax-free receipt of the credit is fundamentally inconsistent with the earlier tax treatment.” 144 T. C. 8, at p. 28.

Judge Holmes is a New Yorker, according to the Tax Court website.


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