Prince v. State Department of Revenue, No. 2080634 (Ala. Civ. App. 1/22/2010)

• Decision Date: 22 January 2010
• Docket Number: No. 2080634.,2080634.
• Parties: James E. Prince, Jr. v. State Department of Revenue.
• Court: Alabama Court of Civil Appeals

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James E. Prince, Jr. v. State Department of Revenue.

No. 2080634.

Court of Civil Appeals of Alabama.

January 22, 2010.

Appeal from Montgomery Circuit Court, (CV-06-2766).

THOMPSON, Presiding Judge.

James E. Prince, Jr., appeals from the summary judgment of the Montgomery Circuit Court affirming the State Department of Revenue's final income-tax assessment against him. For the reasons stated herein, we affirm.

In 1996, two Alabama residents formed a corporation called Zebra.Net, Inc. ("Zebra.net"), an Alabama corporation. The Alabama residents elected to have Zebra.net treated as an "S corporation" for federal income-tax purposes. This court recently described such a corporation as follows:

"[A]n S corporation is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. ... [A]n S corporation generally pays no corporate income taxes on its profits. Instead, the shareholders in the S corporation pay income taxes on their proportionate shares of the profits of the S corporation. See Coggin Auto. Corp. v. Commissioner, 292 F.3d 1326 (11th Cir. 2002), in which the United States Court of Appeals for the Eleventh Circuit discussed the difference between a C corporation and an S corporation:

"`Simply speaking, under Subchapter C of the Internal Revenue Code, the income of a C corporation is subject to corporate tax and any distributions it makes to its shareholders will be subject to a second, individual tax. Under Subchapter S, certain C corporations are permitted to elect to be S corporations. While the S corporation determines taxable income at the corporate level, this corporate income is passed through to the S shareholders and taxed to them at their individual rates.'

"292 F.3d at 1327 n.3 (internal citations omitted)."

Giardina v. Giardina, 987 So. 2d 606, 612 (Ala. Civ. App. 2008). Alabama law recognizes S corporations and, like federal law, treats them for taxing purposes as pass-through entities. See § 40-18-160 et seq., Ala. Code 1975.

After the two Alabama residents formed Zebra.net, they approached Prince, a Mississippi resident, about investing in it. Prince agreed to do so, and, after making an investment, he became a shareholder in Zebra.net, owning one-third of the shares of Zebra.net. The two Alabama residents managed Zebra.net's day-to-day operations; Prince did not engage in the operation or management of the company.

In 1999, the three shareholders of Zebra.net entered into a "Merger Agreement and Plan of Reorganization" ("the merger agreement") for the purpose of merging Zebra.net with another company ("the merger transaction"). As part of the merger agreement, the stock in Zebra.net was converted into a right to receive payment from the company acquiring Zebra.net. The form of the payment, which was to total approximately $6.6 million, less certain of Zebra.net's liabilities, was based on whether Zebra.net's shareholders would agree to have the acquisition of Zebra.net treated, under 26 U.S.C. § 338(h)(10), as an acquisition of all Zebra.net's assets.¹ If they did not do so, the shareholders would receive 80% of their payment as stock in the parent corporation of the company acquiring Zebra.net and the remaining 20% as cash. If they agreed to make such an election, however, they would receive the entire payment as cash. With regard to the election under 26 U.S.C. § 338(h)(10), the merger agreement provided:

"In the event that an election is made pursuant to Section 1.2(d) hereof, as soon as practicable after the Closing, Parent and Stockholders shall make a joint election under Section 338(h)(10) of the Code and Treasury Regulation Section 1.338(h)(10)-1 (and any comparable election under state or local law) with respect to the purchase (an `Election'). At the Closing, the parties will execute and deliver a Form 8023 in form and substance agreed to by the parties. Parent and Stockholders will cooperate with each other to take all actions necessary and appropriate (including filing such additional forms, returns, elections, schedules and other documents as may be required) to effect and preserve a timely Election in accordance with the provision of Treasury Regulation Section 1.338(h)(10)-1 (or any comparable provisions of state or local law) or any successor provisions. Parent and Stockholders shall report the transactions contemplated by this Agreement in a manner consistent with the Election and shall take no position inconsistent therewith in any tax return or any proceeding before any taxing authority or otherwise."

The merger agreement was dated September 15, 1999, and was signed by all three of Zebra.net's shareholders, including Prince, as well as by representatives of the company acquiring Zebra.net and that company's parent corporation. The merger transaction was consummated at a law firm located in Georgia.

Although, as noted above, an S corporation does not pay income tax but, instead, passes that liability through to its shareholders, an S corporation must still file an informational tax return with the Alabama Department of Revenue ("the Department"), as well as with the Internal Revenue Service. Zebra.net filed such a return with the Department on June 29, 2000, for the 1999 tax year, the year of the merger transaction. Zebra.net's return indicated that it had income of $5,133,333. Attached to Zebra.net's return was a "Shareholder's Statement of Income & Deductions" (known as a "Schedule K-1") for Prince. That form indicated that Prince's distributive share of Zebra.net's income was $1,711,109 in 1999, or approximately one-third of Zebra.net's total income.

Prince paid income tax on his distribution from Zebra.net in Mississippi, his state of residence. He did not pay income tax to the State of Alabama. The Department, having received a Schedule K-1 for Prince indicating that Zebra.net had distributed $1,711,109 to him from the sale of its assets and from other income, assessed income tax, with penalties and interest, against Prince in the amount of $141,245.87. Prince appealed that assessment to the Department's administrative law division, which upheld the fact of the assessment but lowered the amount of the assessment, with penalties and interest, to $108,822.92 to take into account certain net operating losses sustained by Zebra.net in the years preceding 1999. Prince paid the assessment under protest and filed a timely appeal to the Montgomery Circuit Court ("the trial court").

As part of his appeal to the trial court, Prince filed a three-count complaint against the Department, which he subsequently amended. First, he asserted that the income he received from the merger transaction could not be taxed under Alabama law because the merger involved only the sale of his shares of stock in Zebra.net, which he owned in Mississippi, and the sale of which occurred in Georgia. According to Prince, the only basis for the imposition of income tax under Alabama law on a nonresident individual is for income derived from "property owned or business transacted in Alabama." In his second count, Prince asserted that Alabama's taxation of his income from the merger transaction violated his right to due process under the United States Constitution. In his third count, Prince asserted that Alabama's taxation of the income he derived from the merger transaction violated the Commerce Clause of the United States Constitution.

Subsequent to the Department's filing an answer denying the assertions in Prince's complaint, the parties filed crossmotions for a summary judgment. In his motion, Prince contended that, under Alabama law, nonresidents could be taxed only on income from property owned or business transacted in Alabama. He argued that, because he owned his stock in Zebra.net in Mississippi and did not transact any business in Alabama, he was not subject to Alabama income tax. He next argued that the Due Process Clause of the Fourteenth Amendment to the United States Constitution requires that an individual have minimum contacts with a state before that state can exercise jurisdiction to levy a tax on that individual. He argued that he had no such minimum contacts with the State of Alabama. Finally, he contended that the Commerce Clause of the United States Constitution, art. I, § 8, cl. 3, prohibits a state from imposing a tax on an activity that has little or no nexus with that state. In this case, Prince argued, there was no substantial nexus between the sale of his stock in Zebra.net and Alabama because he owned his Zebra.net stock in Mississippi and sold it in Georgia.

In its summary-judgment motion, the Department argued that Zebra.net's shareholders, including Prince, exercised the option to treat, under 26 U.S.C. § 338, the merger transaction as the sale of all Zebra.net's assets rather than the sale of their stock in Zebra.net. Thus, argued the Department, the fact that Prince owned his Zebra.net shares in Mississippi was of no consequence; the income he received was not based on a sale of his stock but, rather, on the distributive share of income that he received from the sale of Zebra.net's assets, assets that were located in Alabama. As a result, the Department asserted, the minimum contacts and nexus requirements of the federal constitution had been satisfied, and Alabama was not barred from imposing income tax on Prince's distributive share of Zebra.net's income. Prince responded to the Department's motion by arguing, among other things, that the parties had not validly elected to treat the merger transaction as a sale of Zebra.net's assets, rather than as a sale of the shareholders' stock in Zebra.net, and that, as a result, the Department's legal argument was without merit.

The trial court conducted a hearing subsequent to which it entered a judgment in favor of the Department, upholding the assessment against Prince. In its judgment, the trial court found that Zebra.net's shareholders had made...