New York’s Department of Taxation and Finance cannot impose a retroactive tax on certain corporate deals going back three and a half years, a divided state appeals panel has ruled, reversing a lower court judge.

The 4-1 Appellate Division, First Department, panel in Caprio v. Department of Taxation and Finance, 651176/11, held that applying the 2010 tax on sales of certain stock would violate taxpayers’ due process rights.

Justice Rosalyn Richter (See Profile) wrote the majority opinion, joined by justices Rolando Acosta (See Profile), Karla Moskowitz (See Profile) and Sallie Manzanet-Daniels (See Profile). Justice Richard Andrias (See Profile) dissented.

The plaintiffs, Philip and Phyllis Caprio, are a married couple living in Florida who formerly owned a janitorial services company, Tri-Maintenance & Contractors, Inc., which is incorporated in New Jersey and does some business in New York. TMC elected to be chosen as an S-corporation under New York and federal law. S-corporations are allowed to avoid corporate income taxes by passing their profits and losses on to their shareholders, who include them in their individual tax returns.

In February 2007, the Caprios sold their stake in TMC to another company, Sanitors Services, for $20 million plus some additional contingent payments.

The transaction was structured so that TMC would sell all its assets to Sanitors in exchange for promissory notes, which would then be handed over to the Caprios. TMC would be liquidated. Because TMC never received a cash payment, it declared no corporate income tax.

The Caprios did declare their gain from the sale on their personal federal tax return.

They did not pay taxes on the sale in New York, however. Under New York’s Tax Law §631(b)(2), non-New York residents generally do not have to pay taxes on the sale of stock that is not in New York, even if the stock belongs to a company that does business in New York.

In 2009, the New York State Division of Tax Appeals ruled in Matter of Mintz, 2009 WL 1657395, that a transaction very similar to the Caprios’ was covered by §631(b)(2).

The Tax Department subsequently proposed a law requiring sales of the stock of S-corporations doing business in New York be taxed, effectively closing the Mintz exception. The law also said that it was retroactive. It was passed in August 2010.

In February 2011, the Tax Department told the Caprios that they owed about $775,000 under the new law for tax years 2007 and 2008. The Caprios sued the Tax Department, seeking a judgment that enforcing the law retroactively would violate their due process rights.

In September 2012, then-Manhattan Supreme Court Justice Paul Feinman, now a First Department justice, dismissed the case, and the Caprios appealed.

Richter, in the majority opinion reversing Feinman, noted that retroactive laws could be constitutional if they are retroactive for a “short period” under certain circumstances, quoting the Court of Appeals’ 2013 decision in James Sq. Assoc. LP v. Mullen, 21 NY3d 233, 246. The test under James is whether retroactive application of a law is “so harsh and oppressive as to transgress the constitutional limitation.”

In James Sq., the Court of Appeals laid out three factors for deciding whether a tax statute could be retroactive: whether taxpayers had forewarning of a change, and the reasonableness of reliance on current law; the length of the retroactive period; and the public purpose of retroactive application.

“Because plaintiffs structured the TMC transaction in reasonable reliance on the previous law, and in the absence of any evidence that they had any forewarning of the change in the law, the first James Sq. factor weighs in their favor,” Richter wrote.

Richter said that the second James Sq. factor also favored the Caprios because in James Sq., the Court of Appeals found a much shorter retroactive period of 16 months excessive. She rejected the Tax Department’s argument that a longer period should be allowed because the 2010 law was merely correcting an error, saying that reading was not supported by legislative history.

Finally, Richter said the third factor, public purpose, also favored the Caprios, though it was a “close question.” The legislative history of the 2010 law, she said, showed that it was passed largely to raise revenue for the state. That is an insufficient reason for imposing a tax retroactively, she said.

Andrias, in his dissent, said that the retroactive statute was constitutional because the Tax Department had collected taxes on transactions like the Caprios’ before, and said in an internal document that it intended for such transactions to be taxable.

Richter wrote in the majority opinion that the internal document was not enough, because there was no evidence that the department ever tried to communicate its intention to taxpayers.

Andrias also wrote that the Caprios could not rely on the Mintz decision because it was decided after their sale. Richter addressed that point too, saying that the Caprios were relying on a reasonable understanding of the statute in 2007.

Finally, Andrias said he viewed the 2010 law as curative, unlike the majority.

“Even if the amendments did not correct a mistake in law, they were supported by the legitimate purpose of fixing a perceived loophole that departed from DTF’s long-established tax practice of holding shareholders to the federal elections they make in structuring S-corporation transactions, and giving the transactions parallel treatment under state law, and the amendments rationally furthered that purpose,” he wrote.

Roger Cukras, a partner at Ingram Yuzek Gainen Carroll & Bertolotti, who represents the Caprios, said the court had made “the right decision.”

“I’m glad that the client had the fortitude to keep on slugging it out,” he said.

“I think [the decision is] going to make jurisdictions a little bit more wary when they have retroactive tax legislation,” he added. “The tax department tried to reverse, on a retroactive basis, several decisions on similar issues that were decided by the tax appeals tribunal.”

The Caprios were also represented by Ingram Yuzek partner John Nicolich and by Vincent Pitta of Pitta & Giblin.

The state was represented by Cecelia Chang, special counsel to the solicitor general, and by former deputy solicitor general Richard Dearing, who has since left the state attorney general’s office to become chief of appeals for the New York City Corporation Counsel’s Office.

A spokeswoman for the state AG’s office declined to comment on the decision.

Joseph Lipari, a partner at Roberts & Holland who was not involved in the case, said that while the decision was unlikely to have a broad effect on tax law, it would affect a number of transactions that were structured in a manner similar to the Caprios’ deal. He also noted that it is “rare” for the Legislature to try to enact a retroactive tax. “I can’t remember the last time,” he said.