Taxpayers tend to face a difficult road when litigating tax disputes. We recently wrote about that here. It can be even more challenging, and costly, for taxpayers when they have to deal with more than one taxing authority on the same issue. For example, a federal income tax audit that increases a federal tax liability may very likely trigger a corresponding increase in state income tax. Indeed, in New York, like in most states, taxpayers have an affirmative obligation to report a “federal change” to the Department of Taxation. If the Internal Revenue Service (IRS) uncovers additional revenue, New York wants to ensure that it gets its piece of the pie, too. Yet, one New York taxpayer just took this issue – the obligation to report a federal change – to court and won. And he did so in a case involving a tax shelter!

In mid-April, a New York State administrative law judge (ALJ) determined that a “flat sum settlement” between an individual taxpayer and the IRS was not the type of federal change that required reporting to the Department of Taxation under Tax Law § 659.  The case, In re Bentley Blum, can be found here.

First, let’s review some of the basics. In general, under Tax Law § 683, personal income taxes must be assessed within three years after a return was filed. The Blum case highlights an exception to that rule. Under Tax Law § 659, if a taxpayer’s federal taxable income is changed or corrected by the IRS, then that taxpayer is required to report those changes or corrections to New York within 90 days after the final determination of such change or correction. A taxpayer can either concede the change or explain how or why he thinks the federal change is incorrect with respect to its impact on his state taxable income. Either way, though, the statute requires disclosure. If disclosure is made, the department has two years to audit the impact of the federal change. If, however, a taxpayer fails to timely report a federal change, the statute of limitations remains open forever.

In this case, Mr. Blum and related entities were involved in promoting certain complex oil and gas investments, which the IRS later challenged as tax shelters. In 2000, the IRS issued an examination report proposing certain adjustments to Mr. Blum’s income for the 1994, 1995, and 1996 tax years. After protracted negotiations, Mr. Blum ultimately reached a “flat sum settlement” with the IRS, wherein he agreed to pay $510,000 in a tax deficiency for the 1996 tax year in settlement of the issues raised for all three years.

We are told that Mr. Blum timely filed his 1996 New York State return in April 1997. Yet, the Department of Taxation issued a tax bill to Mr. Blum for the 1996 tax year, based upon the IRS adjustments, in 2012. Under the three-year rule, the department had until April 2000 to assess any additional tax. But because Mr. Blum did not disclose his IRS settlement to New York, the Department of Taxation argued, not without some basis, that its assessment was not bound by the statute of limitations and was therefore timely.

Mr. Blum, however, had done his homework. He carefully parsed the statute and argued that while Tax Law § 659 lists several types of federal changes that must be reported, a “flat sum settlement” is not among those types of federal changes requiring disclosure. He pointed out that under his final settlement, there were no specific adjustments to his taxable income; rather he entered into a global settlement. The Department of Taxation objected and pointed to the adjustments to income proposed by the IRS in its initial examination report. Ultimately though, the ALJ agreed with the taxpayer. The judge concluded that the “flat sum settlement” constituted an agreed upon sum in satisfaction of the liability and was not a change in Mr. Blum’s taxable income.  As such, the judge canceled the assessment.

While not precedential, this is an interesting case that could prove useful to taxpayers down the line. Like New York, the IRS routinely audits taxpayers. And New York, like other states, routinely looks to piggyback onto federal audits through the disclosure and reporting regime of Tax Law § 659. It may be that taxpayers who negotiate the right type of settlement with the IRS, as opposed to other types of resolutions, may fall outside the state’s reporting requirements. That’s certainly something worth keeping in mind. In his determination, the ALJ commented that the “flat sum settlement” at issue was not a unique method of resolving a federal audit. Thus, this issue could come up with some regularity. Further, the Blum case dealt with New York’s individual income tax, but it could have a similar impact on corporate taxpayers. In the wake of this case, the right corporate taxpayer may be well served by testing that very proposition. As of press time for this post, no appeal has been filed yet. Stay tuned.