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New York Affirms that a Contribution of Capital to a Corporation May Be a Sale Subject to Sales Tax

March 2002
By Charles A. Simmons and David Bunning, Greenberg Traurig, New York

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The New York State Division of Tax Appeals, in a decision by an administrative law judge,1 recently reaffirmed the rule that, although not subject to federal income tax, a capital contribution of tangible personal property to a corporation, except in certain cases narrowly defined by statute, is a retail sale subject to sales tax. In Matter of Robert Weichbrodt, DTA Nos. 817590 and 817591 (January 31, 2002), the taxpayer owned a sole proprietorship and an S corporation, each of which owned four McDonald’s restaurants. In the transaction at issue, the sole proprietorship transferred its four restaurants to the corporation. Pursuant to the Assignment, Bill of Sale and Assumption Agreement between the individual and the corporation, the consideration was 10 additional shares of stock. It also provided that the assets were transferred subject to the associated debts and liabilities. This transaction would not be subject to federal income tax pursuant to Internal Revenue Code Sections 351 and 1032(a).2

"This case serves as a reminder of the myriad complexities of the New York sales and use tax law, a creature of statute and regulation, rather than of logic."

The New York State Department of Taxation and Finance ("Department") became aware of the transfer because the corporation filed a "Notification of Sale, Transfer or Assignment in Bulk" ("bulk sales notice")3  with the Department shortly before the transfer of assets, listing the value of the assets as zero. The Department audited the transaction and determined that sales tax was due. When the representative of the individual and the corporation refused to extend the statute of limitations a second time, the Department estimated the tax due based on the value of the assets as listed on the balance sheet of the sole proprietorship, which was $939,029. The Department assessed sales tax of $65,032 against both the individual and the corporation. It also assessed a penalty of $26,013 and interest of $22,704 through February, 1999, for a total of $113,749 against the corporation. Similar amounts were assessed against the individual.

The taxpayers presented two arguments. First, they argued that the individual had received nothing for the transfer of assets since both before and after the transfer he owned 100% of the corporation. Second, they argued that the amount of the sales price, upon which sales tax was calculated, was overstated.

The administrative law judge rejected both arguments. She relied on earlier cases which hold that the transfer of assets from a sole proprietorship to a corporation in exchange for stock, where both are wholly owned by the same individual, is a sale subject to sales tax. The reason is the explicit language of the sales tax statutes. Every sale of tangible personal property is subject to tax unless exempted. The most widely used exemptions from sales tax are a sale for resale and a sale to a tax-exempt organization. Specific exemptions with respect to transfers to corporations exist only for (1) a transfer of property to a corporation upon its organization in consideration for the issuance of its stock, and (2) a transfer of tangible personal property to a corporation, solely in consideration for the issuance of stock, pursuant to a merger or consolidation under the law of New York or any other jurisdiction. New York State Tax Law Section 1101(a)(4)(iv) (A) and (D). The Division rejected the taxpayers’ argument that there was no sale because "the individual received nothing of value since he owned 100% of the corporate stock both before and after the transfer" as "meritless."

"Upon its organization" means when the corporation is incorporated. A transfer of tangible personal property to the corporation after incorporation does not meet this exception. Indeed, according to Example 4 of Tax Regulation Section 526.6, the transfer must be made at the time of incorporation in order to be exempt. In that example, a corporation was formed and was dormant for two years. The shareholder then determined that it should be activated, and transferred tangible personal property in exchange for the first stock to be issued. The regulation concludes that "the transfer is not excluded from the definition of retail sale, as it was not made upon the organization of the corporation."

The regulations contain other examples where corporate reorganizations other than mergers or consolidations — which reorganizations are exempt from income tax — are nevertheless subject to sales tax. The tax regulations state that corporate reorganizations under Internal Revenue Code section 368(a)(1)(C), and a corporation’s purchase of another corporation’s assets paid for with stock, do not meet the exception for mergers and consolidations.

On the second issue presented by the taxpayers, the sales tax is to be calculated on the "receipts from every retail sale." Consideration includes assumption of liabilities. Where there is no direct evidence of the sales price, it may be estimated, including by use of fair market value "where the consideration paid is not an adequate indication of the true value of the property transferred." Tax Regulation Section 526.6(d)(8)(i). Since the corporation did not pay cash for the assets, the auditor determined the value of the fixed assets from the corporation’s federal income tax returns. This was upheld by the administrative law judge as consistent with the regulations and the instructions on the bulk sales form. The taxpayers provided no evidence that the actual value of the assets was lower than their book value as shown on the balance sheet of the sole proprietorship just before the transfer.

This case illustrates some of the complexities of New York sales tax law with respect to the bulk sales notice and transfers to corporations. It also raises two issues which merit some discussion.

The first question to ponder is why the bulk sales notice was filed. The notice (Form AU-196.10) is required to be filed by the purchaser whenever a registered sales tax vendor "makes a sale, transfer, or assignment in bulk of any part or the whole of his business assets, other than in the ordinary course of business." If the procedures are not followed, the purchaser of assets runs the risk of being held liable not only for the sales taxes due on the transfer of assets, but also for the seller’s sales tax liability incurred for past operations. In a transaction between an unrelated buyer and seller, the buyer has a tremendous incentive to file the notice to protect against undisclosed sales tax liability generated by the seller in the course of its business.

In this case, though, the buyer (a corporation) and the seller (a sole proprietorship) were owned by the same individual. Thus, the buyer should not have been concerned about undisclosed liabilities of the seller. Accordingly, there appears to have been no reason to file the bulk sales notice. If the purchaser had wanted to pay sales tax, it could have reported and paid that on a sales tax return. However, it did not want to pay tax; hence the zero valuation for the assets.

Second, the transaction could have easily been structured to avoid sales tax by complying with the statutory exceptions. If the individual had simply formed a new corporation ("Newco"), immediately transferred the four restaurants in the sole proprietorship to Newco in exchange for stock, and then merged Newco into the existing corporation, the two exemptions discussed above would have been met and there would be no sales tax. Granted, that is more work than simply transferring the restaurants to the existing corporation, but it would have saved $113,000 in tax, penalties, and interest.

With large, publicly-held entities it may not be possible to effectuate the simple restructuring discussed above. In many instances the statutory "sale to an exempt organization" exception has been utilized by working with one of the many New York Industrial Development Agencies to effectuate a transaction that will eliminate or reduce applicable sales tax.

This case serves as a reminder of the myriad complexities of the New York sales and use tax law, a creature of statute and regulation, rather than of logic. In this case, it might be "intuitive" that no sales tax can be due because there was no "sale." But the statutory scheme is clear, and has been so held on many occasions. Unless a transaction is properly structured, it may trigger a sales tax liability that might be avoided or reduced by a different structure, even though the practical result is the same. State and local tax planning is often an afterthought, and as this case demonstrates, sometimes with unforeseen and unpleasant consequences.



1 The Division of Tax Appeals is an independent body within the New York State Department of Taxation. Hearings are held before an administrative law judge. Either side may appeal that decision to the three-member Tax Appeals Tribunal, an appellate body which reviews the record for errors of law.

2 The transaction would be subject to federal income tax only to the extent, if any, that the liabilities assumed exceed the basis in the property transferred, unless certain exceptions are met. Internal Revenue Code §357(c)(i)(A) and (c)(2). Otherwise there would be no recognition of gain by the shareholder or by the corporation.

3 Such a notice is required to be filed when a registered sales tax vendor makes a sale, assignment, or transfer in bulk of part or all of the business assets other than in the ordinary course of business. The purchaser’s failure to make the filing can lead to sales tax liability not only for the tax due on the transaction but also for any of the seller’s unpaid sales tax liability resulting from the seller’s operations.


© 2002 Greenberg Traurig

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