ALASKA INDEPENDENT BLIND, INC.

BEFORE THE OFFICE OF TAX APPEALS

STATE OF ALASKA

IN THE MATTER OF: Case No. 7-OTA-97

REID BROTHERS LOGGING & CONSTRUCTION

DECISION

Subject Matter: 1992 Corporation Net Income Tax

I. INTRODUCTION

This appeal raises important questions concerning the tax treatment of "S" corporations under the Alaska Net Income Tax Act (AS 43.20). The Internal Revenue Code (IRC) allows small business corporations to elect "S corporation" status. In general, the income of S corporations is not subject to income tax at the corporate level. Instead, the gains and losses of an S corporation are allocated to its shareholders. However, the IRC imposes a corporate tax on gains arising prior to subchapter S election, so called "built-in gains".

The dispute in this case turns on the extent to which the provisions of the IRC governing the tax treatment of S corporations are incorporated into Alaska tax law. The first issue is whether IRC Section 1374, which imposes the built-in gains tax, is incorporated by reference under AS 43.20.021. The second issue is whether Alaska has adopted the IRC provisions for S corporation election. Like previous cases involving questions concerning adoption of parts of the IRC by reference, this appeal raises " involved question(s) of statutory interpretation pertaining to both the Alaska and federal income tax laws, neither of which is a model of clarity." Department of Revenue v. Gibson, 344 P.2d 851, at 852 (Alaska 1975).

Ann Bruner and Brian Durrell, Bogle&Gates, P.L.L.C., represented the taxpayer. Carl Meyer, Chief of Appeals, Income and Excise Division, represented the DOR.

II. FACTS AND PROCEEDINGS

Reid Brothers Logging and Construction, Inc. (Reid) is a small business corporation involved primarily in logging and road construction in Southeast Alaska. Reid was formed in 1988 by the children of Alex and Mary Reid. Alex and Mary owned another logging company, Reid Timber, Inc. In 1990, when the elder Reids decided to retire, the two logging companies merged. As the surviving corporation, Reid acquired the assets of Reid Timber on a carry-over basis in the tax-free merger.

Reid acquired a substantial amount of logging equipment in the merger. In 1992 Reid sold some of that equipment. The sale resulted in taxable built-in gains under IRC Section 1374.
Reid filed a 1992 federal income tax return for an S corporation. Schedule D of the federal return addresses computation of the built-in gains tax. Reid reported $578, 541 of recognized built-in gains over built-in losses for 1992. Reid also reported taxable income of $449,919. Because the federal built-in gains tax under Section 1374 is limited to the lesser of the net recognized built-in gains or taxable income, Reid calculated its federal tax by applying the federal tax rate of 34% to its taxable income for 1992. Reid paid the resulting federal built-in gains tax of $152,972.

Reid timely filed a 1992 Alaska corporate income tax return, checking the S corporation box on that return. The Alaska return, unlike the federal return, did not include a schedule for computing the tax on built-in gains. The instructions to taxpayers and regulations for 1992 Alaska taxes likewise omitted any reference to a built-in gains tax. Reasoning that Alaska did not tax built-in gains, Reid did not pay any corporate tax to Alaska.

On May 11, 1994, the DOR issued a notice of assessment of built-in gains tax for 1992. Reid appealed and requested an informal conference.

On January 17, 1997, DOR issued an informal conference decision (ICD) that affirmed the assessment of built-in gains tax in the amount of $38,332, and interest of $20,369 (through February 15, 1997). The ICD concluded that IRC § 1374, which imposes the built-in gains tax, was adopted by reference under AS 43.20.021 along with all of the other IRC provisions relating to taxation of S corporations ("subchapter S"). The ICD also included an alternative statutory interpretation. The alternative interpretation held that if IRC § 1374 is not incorporated, then none of subchapter S is incorporated and S corporations are therefore treated the same as regular corporations for purposes of the Alaska income tax.

Reid timely appealed the ICD to the Office of Tax Appeals on February 14, 1997. In this appeal Reid challenges both the tax and the interest assessments.

The parties agree that there are no genuine issues of material fact and that the legal issues relating to taxation of S corporations under Alaska law may be decided by summary judgment. The parties filed cross motions for summary judgment. An initial hearing for oral argument on the summary judgment motions was held on June 19, 1997. On December 17, 1997, the Administrative Law Judge (ALJ) issued a memorandum and order for supplemental briefing. A second hearing for oral argument was held at the request of the parties on April 23, 1998. The record was closed and the case submitted for decision at that time.

III. DISCUSSION

A. The independent judgment standard of review applies

At the outset the parties disagreed concerning the appropriate standard of review to be applied in determining the extent to which the subchapter S provisions of the IRC are adopted under AS 43.20. DOR initially argued that the ALJ must use the rational basis standard in reviewing DOR’s determination that Alaska has adopted the built-in gains tax. But after the Alaska Supreme Court issued a decision in February, 1998, which applied the independent judgment standard in deciding whether a different IRC provision was incorporated¹, DOR conceded that the independent judgment standard applies in this appeal.

B. Background to the incorporation issues

This appeal raises two issues concerning incorporation of provisions of the IRC relating to the taxation of S corporations. Although the two issues are intertwined, they will be separately considered and decided.² The primary issue is whether the tax on net recognized built-in gains of an S corporation is incorporated into Alaska law. This issue will be addressed first in part C.

DOR raises a second incorporation issue as an alternative ground to uphold the assessment in the event that the built-in gains tax is determined to be inapplicable. DOR’s alternative argument is that S corporations, like C corporations, must pay corporate income tax under AS 43.20.011 because none of subchapter S is incorporated into Alaska law. This issue is discussed below in part D³.

The provisions of the IRC governing taxation of S corporations are found in subchapter S, 26 U.S.C. § 1361-1379. Subchapter S was enacted in 1958⁴. The congressional objectives in enacting subchapter S were to afford qualified small business corporations the option of eliminating federal income tax at the corporate level, thereby avoiding double taxation, and to make the same tax treatment previously only available to proprietorships and partnerships⁵ also available to those small corporations with economic structures similar to proprietorships and partnerships.

Subchapter S distinguishes between regular "C" corporations and "S" corporations. An S corporation is a small business corporation that files an S election for the tax year. A small business corporation is defined as a corporation that does not have more than 35 shareholders, has only individual shareholders and no resident alien shareholders, and has only one class of stock. IRC § 1361. A "C’ corporation refers to a corporation that has not filed an S election. IRC §1361(a). The basic difference is that S corporations do not pay corporate income tax. IRC §1363. The taxable income of an S corporation is allocated to its shareholders, and the shareholders then pay income tax on their share of the corporate income. IRC §1366.

Although S corporations are exempt from regular corporate income taxes, they are subject to a tax on recognized built-in gains under IRC § 1374⁶. Recognized built-in gain is a gain that arises before a C corporation converts to an S corporation and is realized by the S corporation, through sale or distribution, within ten years of the date that the C corporation becomes an S corporation.

The tax on the built-in gains of S corporations was enacted under the Tax Reform Act of 1986⁷. Congressional intent in enacting the built-in gains tax was to prevent a C corporation from converting to an S corporation prior to liquidation for the purpose of avoiding income tax that otherwise would result from the liquidation⁸.

B. The federal built-in gains tax is not incorporated by reference under AS 43.20.

Summarizing the arguments of the parties at the outset is helpful in understanding the issues. Reid advances several arguments in support of its claim that Alaska has not adopted the built-in gains tax. Reid characterizes the built-in gains tax as a special tax, different from the federal income tax. Reid contends that when the Alaska legislature imposes a tax it does so expressly, not by generally incorporating federal tax provisions. Reid reasons that the absence of any reference to the built-in gains tax in AS 43.20.021 should be construed as legislative intent not to impose the federal built-in gains tax in Alaska.

In addition, Reid argues that the absence of any reference to the built-in gains tax in the Alaska tax forms and instructions for 1992 is further evidence that Alaska does not impose a state tax on the built-in gains of an S corporation. Reid contends that DOR’s failure to publish any regulations, tax forms or instructions pertaining to the built-in gains tax creates an ambiguity in the tax law that must be construed in favor of the taxpayer.

DOR disagrees with Reid’s characterization of the built-in gains tax. DOR says it is an income tax. DOR argues that the built-in gains tax is unambiguously adopted under the plain language of AS 43.20.021(a) because IRC § 1374 is included in the designated sections of the IRC that are expressly adopted by that statute. In addition, DOR contends that the plain language of the other subsections of AS 43.20.021 makes clear that taxes may be imposed through the general incorporation provision of subsection (a). Finally, DOR argues that if the statute is ambiguous, the appropriate rule of statutory construction is the rule that exemptions are narrowly construed in favor of the taxing authority because Reid is in effect seeking an exemption from corporate tax liability.

The first question to resolve is the nature of the tax imposed by IRC § 1374. The language of IRC §1374 indicates that Congress drew a distinction between the corporate income tax and the built-in gains tax. For example, IRC § 1374 (d) separately defines "built-in gains" and the "taxable income" of an S corporation, indicating that the two are different concepts. Another example of how IRC 1374 distinguishes between the income tax and the built-in gains tax is found in subsection (b), which addresses the amount of tax. IRC §1374 (b) provides:

In general. The tax imposed by subsection (a) shall be computed by taking the highest rate of tax specified in section 11 (b) to the lesser of -- the recognized built-in gains of the S corporation for the taxable year,
or
the amount which would be the taxable income of the corporation for such taxable year if such corporation were not an S corporation.

The fact that subsection (b) specifies a tax rate applicable to built-in gains implies that the tax under § 1374 is a special tax, as Reid contends. If the tax on built-in gains were an income tax the corporate income tax rate would necessarily apply without an express provision to that effect. Furthermore, the language "the amount that would be the taxable income of the corporation" indicates that the built-in gains tax is not the equivalent of the normal federal income tax.

Reid’s characterization of the built-in gains tax as a special tax finds further support in an Indiana Tax Court case which held that the built-in gains of an S corporation are exempt from the Indiana adjusted gross income tax. F. A. Wilhelm Construction Co, Inc. v. Indiana Department of Revenue, 586 N.E. 2d 953 (Ind. Tax 1992). DOR attempts to distinguish Wilhelm on the grounds that in that case the court relied on the fact that the Indiana tax statutes expressly exempted subchapter S corporations. While the court did find the express exemption persuasive, it held that even absent the exemption, the built-in gains were not taxable because they were not included in federal taxable income as defined in the IRC, which is the basis for the Indiana income tax. Id., 586 N.E. 2d at 956; Cooper Industries v. Dept. of State Revenue, 673 N.E. 2d 1209, 1213 (Ind. Tax 1996).

I conclude that the built-in gains tax is a special tax that is imposed on S corporations in the place of an income tax. It is a separate tax. The next question is whether AS 43.20.021 (a) should be interpreted as adopting the built-in gains tax by reference. The starting point for this inquiry is the language of the statute. "Statutory construction begins with an analysis of the language of the statute construed in view of its purpose." Borg-Warner Corp. v. Avco Corp. , 850 P.2d 628, 633 n12 (Alaska 1993) (citation omitted.)

The statute at issue here, AS 43.20.021, provides:

Sec. 43.20.021. Internal Revenue Code adopted by reference.
(a) Sections 26 U.S.C. 1-1399 and 6001-7872...as amended, are adopted by reference as a part of this chapter. These portions of the Internal Revenue Code have full force and effect under this chapter unless excepted to or modified by other provisions of the chapter.
(b) For purposes of calculating the federal tax payable on personal holding companies provided for in the provisions of 26 U.S.C. 541 (Internal Revenue Code), the rate is 12.6 percent.
(c) For purposes of calculating the alternative tax on capital gains provided for in the provisions of 26 U.S.C. 1201 (Internal Revenue Code), the rate is 4.5 percent for corporations.
(d) Where a credit allowed under the internal Revenue Code is also allowed in computing Alaska income tax, it is limited to 18 percent for corporations of the amount of credit determined for federal income tax purposes which is attributable to Alaska. This limitation does not apply to a special industrial incentive tax credit under As 43.20.042.
(e) (Repealed, § 10 ch 1 SSSLA 1980.)
(f) For the purpose of calculating the alternative minimum tax on tax preferences provided for in 26 U.S.C.55-59 (Internal Revenue Code), the tax is 18 percent for corporations of the applicable alternative minimum federal tax.
(g) For purposes of calculating the accumulated earnings tax as provided in 26 U.S.C. 531(Internal Revenue Code), the rate is 4.95 percent of the first $100,000 of accumulated taxable income and 6.93 percent of accumulated taxable income in excess of $100,000.

Subsection (a) adopts by reference thousands of sections of the IRC. The IRC § 1374, which imposes the built-in gains tax, falls within the parts of the code that are expressly designated as adopted. This much is clear from the language.

The wording of the other quoted subsections suggests that the specified taxes were incorporated through the general adoption provision of subsection (a). By their express terms, subsections (b), (c), (f) and (g) provide tax rates applicable to the designated federal taxes; they do not impose the taxes. This implies that those taxes were adopted under subsection (a), as DOR contends. DOR’s textual analysis is persuasive to this point.

DOR’s analysis of the statutory language, however, fails to account for the fact that there is no express provision of an Alaska tax rate for the built-in gains tax in AS 43.20.021, or elsewhere in the Alaska tax statutes. The express provision of tax rates applicable to other federal taxes that are adopted by reference, coupled with the salient omission from the statute of a tax rate for built-in gains, suggests, as Reid argues, that the legislature did not intend to adopt the federal built-in gains tax.

The absence of any provision of an Alaska tax rate for built-in gains is troubling for another reason. Assuming that IRC §1374 was adopted by reference, the tax rate specified in the federal statute would seem to apply in the absence of any Alaska-specific rate. IRC §1374 provides that the tax rate for built-in gains is the highest rate specified in IRC § 11(b). That rate was 34 % in 1992. The highest Alaska corporate income tax rate under AS 43.20.011(e) is 9.4 percent (plus $4,500) on taxable income over $90,000. Significantly, the built-in gains tax rate specified in IRC § 1374 is approximately three times the highest Alaska rate. In view of the large discrepancy between the federal and Alaska tax rates it would be difficult to argue that the tax rate provision in IRC § 1374 was adopted even if the tax itself was adopted¹⁰.

The language of AS 43.20.021 is inconclusive on the issue of the adoption of the built-in gains tax. On the one hand, the omission of an Alaska built-in gains tax rate in AS 43.20.021 suggests that the legislature did not intend to adopt the federal built-in gains tax⁹. On the other hand, IRC § 1374 is included within the express designation of code sections that are adopted by reference in subsection (a) and the language of the other subsections indicates that federal taxes may be adopted by reference. The next step in determining legislative intent is to examine the legislative history.

The legislative history suggests that the purpose of the general adoption of the IRC in AS 43.20.021 (a) was to simplify the determination of taxable income for the income tax, not to incorporate by reference federal taxes or tax rates. Some pertinent legislative history is explained in an early incorporation case in which the Alaska Supreme Court decided that a 1969 federal tax rate change was not incorporated by reference under the state income tax law. Department of Revenue v. Gibson, 544 P.2d 851 (Alaska 1975).

Alaska’s original income tax, adopted before statehood, was simply a percentage of the federal income tax that an Alaskan taxpayer paid each year at the federal tax rate. Gibson at 852. In 1965 the Alaska Legislature changed the Alaska law to tie the state tax rate to the 1963 federal rate because of concern over the impact on state revenues of a 1964 reduction in the federal tax rates. Id. In 1975 the Alaska legislature enacted an income tax act that specified graduated tax rates on taxable income rather than basing the Alaska tax on a percentage of the federal income tax determined by the federal tax rates. Id. at 854, n.6. This basic scheme of applying Alaska tax rates to taxable income has remained unchanged since 1975. Thus, this history demonstrates that use of Alaska-specific tax rates, in lieu of federal rates, has been an integral part of the state tax scheme since 1975.

AS 43.20.021 (a) was enacted in 1975¹¹ when the Alaska legislature replaced the original "piggy-back" income tax with a state income tax determined by applying Alaska tax rates to taxable income. The 1975 legislation also included a section, the current AS 43.20.300(a), which provided for the general incorporation by reference of the provisions of the IRC "as now in effect or hereafter amended mentioned in this chapter..." The purpose of this incorporation provision was "to afford a simplified means of calculating the Alaska tax by utilization of federal laws and regulations." Gibson, infra, 544 P.2d at 852. It stands to reason that the similar provision regarding adoption of the IRC in AS 43.20.021 (a) was likewise intended to simplify the determination of taxable income for the Alaska income tax¹².

Although the legislative history suggests that AS 43.20.021 (a) was not intended to adopt by reference federal taxes or tax rates, the legislative history, like the statutory language, is far from clear. What is clear, however, is the fact that the absence of any express provision for a built-in gains tax rate in AS 43.20.021 renders the statute ambiguous as to whether the built-in gains tax is imposed. The express provision in AS 43.20.021of Alaska tax rates for other federal taxes that are adopted by reference serves the essential purpose of notifying taxpayers that Alaska imposes those taxes. Without a similar provision for the built-in gains tax rate, the statute does not provide notice to taxpayers that Alaska imposes the built-in gains tax.

The language of AS 43.20.021 (a) is patently ambiguous because it is qualified by the proviso, "unless excepted to or modified by other provisions of this chapter." The determination as to whether a particular provision of the IRC is "excepted to" often requires analysis of the Alaska tax code and the purpose of the federal provision to decide if there is an implied exception to incorporation. See, e.g. Gulf Oil Corp. v. State, Dept. of Revenue, 755 P.2d 372, 380 (Alaska 1988); State v. OSG Bulk Ships, Inc., Op. No. 4951 (Feb. 20, 1998). This analytical approach to determining which IRC provisions are effectively incorporated means that a taxpayer cannot determine with any certainty whether a particular IRC provision applies from simply reading the tax statutes. That uncertainty is especially problematic when the IRC provision in question imposes a separate tax, like IRC § 1374.

It is a cardinal rule of construction that a statute imposing taxes is to be construed strictly against the government and in favor of the taxpayers and that no person and no property is to be included within its scope unless placed there by clear language of the statute. In the Matter of the Tax Appeal of Hawaiian Telephone Co., 608 P.2d 383, 388 (Hawaii, 1980). There are several important reasons for this rule:

...strict construction is a way to assume that no taxes be enacted except by legislative authority. It has also been reasoned that since tax laws are not founded on a permanent public policy they should not be extended by implication; that a rigid application of revenue measures is for the protection of the citizen by informing him in unambiguous terms as the amount and nature of his duty to pay taxes, and that where tax statues impose burdens upon long-established trades and occupations the balance of economic interest favors the taxpayer and not the state.
3A Sutherland Statutory Construction §§ 66.01, p.2 (5th ed.).

The policy that taxpayers are entitled to notice of a tax before they are required to pay the tax is implicit in the rule that ambiguities in statutes creating tax liabilities are resolved in favor of the taxpayer. Significantly, this same policy is expressed in the Alaska tax statutes. AS 43.20.160 requires the DOR to "prescribe and furnish all necessary forms, and adopt and publish all necessary regulations in plain and concise language…for the assessment and collection of taxes imposed by this chapter." It also requires DOR to "prepare a concise statement of the contents of the code (IRC) sections referred to in this chapter for the information of the taxpayer and make them available to the taxpayer making a return." Implicit in AS 43.20.160 is the policy that Alaska taxpayers are entitled to unambiguous notice of the adoption of a federal tax and the tax rate to use in computing the Alaska tax. The Alaska legislature apparently intended these directives to protect taxpayers like Reid from having to guess as to whether a federal tax applies.

For the 1992 tax year at issue in this appeal DOR had not issued any regulations or instructions which provided taxpayers with notice that Alaska adopted the federal built-in gains tax. Although the federal built-in gains tax had been in effect since 1986, DOR did not publish any clarifying instructions or regulations regarding the built-in gains tax or the tax rate until after 1993¹³. This omission perpetuated the ambiguity in AS 43.20.021 as to whether the built-in gains tax was adopted in Alaska.

The reasons for resolving ambiguities in tax-levying statutes in favor of the taxpayer are particularly pertinent in the instant case. In this case, AS 43.20.021 failed to unambiguously inform a small business taxpayer regarding the duty to pay the built-in gains tax or the amount of the tax. There were no regulations or instructions that clarified whether the built-in gains tax applied or what tax rate to use. The subsequent assessment of tax and interest, based on DOR’s unwritten interpretation of an ambiguous statute, imposed a substantial financial burden on a small logging business. Under these circumstances the balance of economic interest favors the taxpayer instead of the state.

The ambiguity in AS 43.20.021 regarding adoption of the federal built-in gains tax must be resolved in Reid’s favor in accord with the cardinal rule of construction that ambiguities in statutes imposing taxes are resolved in favor of the taxpayer¹⁴. I conclude that Reid is not liable to Alaska for the built-in gains tax that was assessed for 1992.

D. The IRC subchapter S election provisions are incorporated in AS 43.20.

DOR argues, in the alternative, that if IRC § 1374 isn’t incorporated then none of the federal subchapter S provisions are incorporated. If the federal subchapter S election provisions are not adopted then all corporations are equally subject to Alaska income tax under AS 43.20.011. If this argument is valid, Reid owes Alaska corporate income tax for 1992, the tax year at issue, although the built-in gains tax is inapplicable¹⁵.

In support of its alternative argument that subchapter S is not adopted under AS 43.20.021 (a), DOR relies on the plain language of AS 43.20.011 (e), which imposes a tax on the taxable income "of every corporation". DOR also relies on AS 43.20.012, which provides that the "tax imposed by this chapter does not apply to individuals or to fiduciaries" but makes no exception for S corporations. According to DOR, this statutory language shows an intent to tax S corporations like other corporations and to except to adoption of subchapter S.

In addition, DOR contends that strong policy reasons support the conclusion that subchapter S is not adopted in Alaska. According to DOR, the purpose of subchapter S is to avoid the double taxation that results from taxing income at the corporate level and then taxing the shareholders individually on the portion of the corporate income that is distributed as dividends. DOR further contends that the federal purpose of avoiding double taxation does not exist at the state level because Alaska does not impose its income tax on individuals.

DOR cites the Alaska Supreme Court’s recent decision in State v. OSG Bulk Ships, Inc., __ P.2d __, Op. No. 4951 (Alaska, Feb. 20, 1998) in support of its argument that the difference in state and federal tax structure creates an implied exception to incorporation of the federal subchapter S election provisions. OSG held that IRC § 883, which exempted foreign shipping income from the federal income tax, was not incorporated in AS 43.20. That holding was based on the rationale that the purpose of IRC § 883 was to eliminate double taxation of the shipping income of multi-national companies and that purpose conflicted with the state tax scheme which avoids double taxation through apportionment. The court noted in OSG that applying the federal exemption for foreign shipping income under AS 43.20 would result in understating the Alaska taxable income of the taxpayers. Analogizing to OSG, DOR argues that applying federal subchapter S under AS 43.20 results in understating, instead of double-taxing, the income of S corporations doing business in Alaska because the state does not tax the individual shareholders on income passed through to the shareholders from the S corporations.

Whether subchapter S is incorporated or not is a difficult issue. DOR makes some good arguments against adoption. In deciding the incorporation question this ALJ will "adopt the rule of law which is most persuasive in light of precedent, reason and policy." Newton v. Magill, 872 P.2d 1213, 1215 (Alaska 1994). On balance, I am persuaded that the federal subchapter S election provisions are incorporated under AS 43.20.

Precedent is the first reason for concluding that the subchapter S election provisions are adopted in Alaska. Prior to this litigation DOR itself interpreted AS 43.20 to incorporate the federal subchapter S election provisions. Under DOR’s own longstanding interpretation, which was reflected in the written instructions to taxpayers for 1992, subchapter S elections were effective for purposes of the Alaska income tax.

Next, DOR’s argument that S corporations are subject to the corporate income tax under the plain language of the tax statute is problematic. Under DOR’s literal reading of "every corporation", all non-profit corporations, as well as S corporations, would be taxed like regular corporations since non-profits are corporations and are not expressly excluded under AS 43.20.012. The literal interpretation of "every corporation" thus produces a result that is clearly inconsistent with state tax law and policy.

Furthermore, DOR’s literal interpretation of "every corporation" in AS 43.20.011 (e) ignores the fact that the subchapter S election provisions, IRC Sections 1361-1363, are expressly adopted by AS 43.20.021 (a). Interpreting "every corporation" to mean "every corporation that is taxed as a corporation under the IRC" is a preferable construction because it harmonizes and gives effect to both AS 43.20.011(e) and AS 43.20.021(a).

DOR’s textual analysis also ignores the express reference to S Corporation election in AS 43.20.040(b)(5). That statute provides that income is from a source having a taxable situs in Alaska if it is derived from " a corporation which transacts business in the state which has elected to file federal returns under subchapter S of the IRC." This subsection was enacted in 1975¹⁶ when the state income tax applied to individuals as well as corporations. The apparent purpose of this statute was to make clear that non-resident shareholders of an S corporation that transacts business in Alaska must pay Alaska income tax on the income that passes through the S corporation to the shareholders. This suggests that the Alaska legislature recognized and intended to adopt the federal provisions allowing S corporations to elect to be taxed at the individual shareholder level instead of at the corporate level but it is not conclusive¹⁷.

The legislative history of AS 43.20 does not help DOR. DOR’s argument that AS 43.20.011(e) should be read as imposing the corporate income tax on S corporations because Alaska has no individual income tax would be persuasive if the legislature had amended AS 43.20.011(e) to specify that the tax is imposed on "every corporation" at the same time that it repealed the individual income tax in 1980. See, Ch. 1 SSSLA 1980. But the legislative history demonstrates that the phrase "every corporation" dates back to the enactment of Section 11(e) in 1975 when Alaska did tax individual income. In 1975 the Alaska legislature enacted comprehensive legislation that established Alaska-specific tax rates on the taxable income of individuals, fiduciaries and corporations. As enacted in 1975, AS 43.20.011(e) imposed a tax "upon the entire net income of every corporation derived from sources in the state..." § 13 Ch. 70 SLA 1975. This legislative history makes clear that the "every corporation" language in AS 43.20.011(e) is unrelated to repeal of the individual income tax.

Moreover, the express purpose and intent of the 1980 legislation that repealed the individual income tax was to provide tax relief for Alaskans. Ch. 1 SSSLA 1980. One cannot reasonably infer a legislative intent to impose a corporate income tax on S corporations from the 1980 tax relief legislation. The legislature could have included a provision that specifically addressed taxation of S corporations in 1980 (or subsequently) but did not. Although the repeal of the individual income tax provided a substantial policy reason for requiring S corporations to pay corporate income taxes, there is no evidence in the language or the legislative history that the legislature intended to do so.

Finally, although DOR’s policy argument for taxing S corporations is strong, it is also flawed. The purpose of subchapter S was not, as DOR argues, merely to avoid double taxation of corporate income and of corporate profits distributed to shareholders as dividends. The more general congressional purpose was to permit a small business to incorporate for liability reasons without having to take into account major differences in tax consequences compared to doing business as a partnership or other non-corporate entity that is taxed on a flow-through basis. Fulk & Needham, Inc. v. United States, 411 F.2d 1403,1406 (4th Cir. 1969); Byrne v. Commissioner of Internal Revenue 361 F.2d 939, 942 (7th Cir. 1966) (citing 1958 legislative history.) DOR has not shown how the federal purpose of reducing differences in tax treatment between partnerships and economically similar small business corporations conflicts with state policy.

For these reasons, I conclude that there is no express or implied exception to adoption of the IRC subchapter S election provisions. Subchapter S is incorporated under AS 43.20 to the extent that it allows S corporations to elect the pass-through method of income taxation.

IV. CONCLUSION

For the reasons previously discussed, I conclude that (1) the IRC subchapter S election provisions are incorporated in AS 43.20; and (2) the built-in gains tax on S corporations under IRC Section 1374 was not incorporated into Alaska law in 1992.

This is the hearing decision of the Administrative Law Judge under AS 43.05.465 (a). Unless reconsideration is ordered, this decision will become the final administrative decision 60 days from the date of service of this decision. A party may request reconsideration in accordance with AS 43.05465(b) within 30 days of the date of service of this decision.

When the decision becomes final, the decision and the record in this appeal become public records unless the administrative law judge has issued a protective order requiring that specified parts of the record be kept confidential. AS 43.05.470. A party may file a motion for a protective order, showing good cause why specific information in the record should remain confidential, within 30 days of the date of service of this decision.

Dated September 10, 1998

Shelley Higgins
Administrative Law Judge

Footnotes:

¹ State v. OSG Bulk Ships, Inc., __ P.2d __, Op. No. 4951(Alaska, Feb.20, 1998). The issue in OSG was whether a provision of the IRC that exempted foreign shipping income in calculating gross income was incorporated under AS 43.20.021. The Supreme Court noted that the determination was a question of pure statutory construction to be decided in the independent judgment of the Court. Id. at footnote 6. (return to text)

² DOR argues that either all of the IRC provisions relating to S corporations were adopted in their entirety or, alternatively, none were adopted. This "all or nothing" approach to incorporation is not supported by the case law. Prior incorporation cases instruct that a particular federal tax provision may be adopted under AS 43.20 while other provisions related to the same subject are not. See, Gulf Oil Corp. v. State, Dept. of Revenue, 755 P.2d 372 (Alaska 1988). In Gulf Oil the court held that a portion of the IRC dealing with the foreign tax credit was "excepted to or modified by" AS 43.20, which allowed neither a deduction nor a credit for foreign income taxes. In so holding, the court said "[t]hat is not to say that Alaska law incorporates no Code provisions and no federal regulations having to do with the foreign tax credit. Future cases may reveal that it is desirable to conform our law to certain aspects of those federal provisions." Id. at 380. (return to text)

³ Reid has raised yet another incorporation issue; whether IRC Section 6404(e), which allows discretionary abatement of interest on unpaid taxes, is incorporated under As 43.20. IRC Section 6404 (e), like the built-in gains tax and other federal subchapter S provisions, is encompassed within the broad description of federal tax statutes ostensibly adopted by As 43.20.021(a) and presents another substantial and complex incorporation issue. However, is not necessary to address the interest abatement issue given the resolution of the first two incorporation issues relating to the tax treatment of S corporations. (return to text)

⁴ Pub. L. 85-866, Sept. 2, 1958, 72 Stat.1650. (return to text)

⁵ W & W Fertilizer Corp. v. United States, 527 F. 2d 621, 624 (Ct. of Claims 1975); Byrne v. Comm'r of Internal Revenue, 361 F.2d 939, 942 (7th Cir. 1966). (return to text)

⁶ IRC § 1374 states:

If for any taxable year beginning in the recognition period an S corporation has a recognized built-in gains, there is hereby imposed a tax (computed under subsection (b) on the income of such corporation for such taxable year. (return to text)

⁷ Pub.L. 99-514, Oct. 22, 1986, 100 Stat. 2275. The 1986 legislation amended section 1374 generally, substituting provisions imposing a tax on certain built-in gains for provisions taxing capital gains. (return to text)

⁸ House Conference Report No. 99-841, 1986 U.S. Code Cong. and Adm. News, p. 4075 at p. 4287. In this case, Reid had been an S corporation since its inception but Reid Timber had been a C corporation prior to the merger. The parties agree that under federal law, Reid's sale of the former C corporation equipment was a taxable built-in gain. (return to text)

⁹ Reid's reading is in accord with the long-standing principle of statutory construction that when certain matters are specifically addressed in a statute, omissions are understood as exclusions. See, Croft v. Pan Alaska Trucking, Inc., 820 P. 2d 1064, 1066 (Alaska 1991). (return to text)

¹⁰ In fact, DOR did not apply the tax rate specified under IRC § 1374 in assessing Reid for the built-in gains tax. Instead, DOR used a graduated corporate income tax rate under AS 43.20.011(e). At that time there was no provision for an Alaska built-in gains tax rate in the Alaska statutes or regulations.

In early 1998, four years after the assessment at issue in this appeal, DOR adopted a new regulation that addresses the tax rate question without specific reference to the built-in gains tax. 15 AAC 20.130, effective March 6, 1998, provides:

RATES OF TAX. If a provision of the Internal Revenue Code that is adopted by reference under AS 43.20.021 (a) refers to the highest rate of tax under Internal revenue code section 11 (26 U.S.C. 11), a taxpayer shall use the highestrate of tax specified under AS 43.20.011(e).

The validity of this regulation is not at issue here. In fact, the graduated rate that DOR used in assessing Reid was not the highest rate under AS 43.20.011(e), as provided in the new regulation. In this appeal Reid is challenging the tax, not the specific tax rate. (return to text)

¹¹ § 2 ch 70 SLA 1975. (return to text)

¹² The inference from the legislative history that the broad adoption of the IRC in AS 43.20.021(a) was intended to simplify the calculation of taxable income, not to adopt other federal taxes, is consistent with the statutory definition of "Internal Revenue Code". That term is defined in AS 43.20.340 as "the Internal Revenue Code of the United States (26 U.S.C.) as the code exists now or as hereafter amended, as the code and amendments apply to the normal taxes and surtax on net incomes…" (Emphasis supplied). (return to text)

¹³ AS 43.20.160 and AS 43.20.021, read together, suggest that DOR has the authority to determine and clarify which particular code provisions among the thousands of IRC sections designated in AS 34.20.021(a) are incorporated into Alaska law. Assuming, without deciding, that DOR has the authority to decide that federal provisions that impose taxes or tax rates are adopted in Alaska, AS 43.20.160 imposes the attendant responsibility on DOR to inform the public about any federal taxes or tax rates that DOR determines are adopted by reference. DOR did not do that in this case. At the time DOR assessed Reid for the built-in gains tax there were no regulations, forms or written instructions to taxpayers regarding the built-in gains tax or an Alaska tax rate for built-in gains. (return to text)

¹⁴ An alternative rationale for the conclusion that the built-in gains tax is not incorporated under AS 43.20 is that the absence of an Alaska tax rate for built-in gains constitutes an implied exception to adoption. (return to text)

¹⁵ Under this alternative theory the amount of the assessment remains the same because the built-in gains tax was computed for 1992 on the lower amount of taxable income instead of on the amount of net gains in compliance with the ceiling provision in IRC 1374. (return to text)

¹⁶ § 7 ch 70 SLA 1975. (return to text)

¹⁷ Because AS 43.20.040(b) (5) applies to individual income taxes, not corporate taxes, it is not necessarily inconsistent with DOR's position that Alaska taxes S corporations like regular C corporations. (return to text)