A New York State Administrative Law Judge held that an individual taxpayer’s “flat sum settlement” with the Internal Revenue Service of his federal income tax liabilities did not constitute a change in the taxpayer’s federal taxable income that was required to be reported to New York State under Tax Law § 659. Matter of Bentley Blum, DTA No. 824107 (N.Y.S. Div. of Tax App., Apr. 16, 2015).

Background. Bentley Blum was a promoter of oil and gas partnerships that were examined by the IRS. The IRS also examined the returns of the individual investors in the partnerships, and corporations controlled directly or indirectly by Mr. Blum that were involved in the sale or operation of the oil and gas interests. On February 24, 2000, the IRS issued an Examination Report for the years 1994 through 1997, proposing adjustments to Mr. Bentley’s income. The proposed adjustments were challenged by Mr. Bentley, and a settlement was eventually reached that resulted in “a flat sum settlement of $510,000 in a tax deficiency for [Mr. Blum] for the 1996 year” to resolve 1994 through 1996 proposed adjustments; adjustments were also made to Mr. Blum’s 1997 net operating loss carry- forward amounts.

Mr. Blum timely filed his State and City personal income tax return for 1996, the only year at issue in this proceeding. Accordingly, under the standard three-year statute of limitations, the Department would have had until April 15, 2000 to assess a deficiency. The Department issued a Notice of Deficiency for State and City personal income taxes for 1996 on May 22, 2012, relying on the income base that resulted in the $510,000 in federal tax paid to the IRS in settlement. The Department took the position that, because Mr. Blum had failed to report the federal settlement to New York State, the assessment was timely under the extended statute of limitations period of Tax Law § 683(c)(3), which applies when taxpayers fail to report federal changes.

ALJ Decision. The ALJ held that a “flat sum settlement” is not included in the list of federal changes required to be reported under Tax Law § 659, because such settlement does not constitute a change in Mr. Blum’s taxable income. Accordingly, the Department was bound by the standard three-year statute of limitations, and could not rely on the extended statute of limitations period of Tax Law § 683(c) (3) applicable when taxpayers fail to report their federal changes. Since the Notice of Deficiency was issued after the three-year limitation period, the notice was cancelled.

Additional Insights

In computing the amount of a New York resident’s adjusted gross income for personal income tax purposes, New York, like many states, starts with federal adjusted gross income, in accordance with Tax Law § 612(a), and conforms to federal definitions, unless a contrary definition or context otherwise provides. Tax Law § 607. This federal conformity simplifies compliance for taxpayers and administration by states. One of the benefits to states is the ability to follow federal audit adjustments. States routinely require that federal changes be reported, but usually allow a taxpayer to contest its correctness or applicability. Tax Law § 659; 20 NYCRR § 159.4.

In Blum, the IRS had unquestionably proposed adjustments to Mr. Blum’s federal taxable income in its original Examination Report. It also seems clear, as the Department argued, that Mr. Blum would not owe additional tax if there had been no changes to his federal taxable income. Stated simply, the issue is whether a taxpayer must report a final determination of a Revenue Agent’s Report (“RAR”) that had proposed changes to a taxpayer’s income when the settlement does not explicitly reflect a change in federal taxable income. Although flat sum settlements, as the ALJ noted, are not uncommon, the question of whether they must be reported to New York State appears to be an issue of first impression.

The ALJ’s narrow view of the federal change reporting requirement of Tax Law § 659 is somewhat surprising and, if upheld, may reduce the need to report settlements with the IRS to New York State and to New York City. The decision may also impact a corporate taxpayer’s obligations to report both federal and State changes to New York City.

The ALJ did not address whether the “flat sum settlement” or related documents constituted a closing agreement under IRC § 7121, which is deemed a “final determination” under New York’s regulations, 20 NYCRR § 159.5(a). Arguably, Tax Law § 659 can be read to include within its reporting requirements final determinations of changes to a taxpayer’s taxable income proposed in an RAR, even if the final determination itself is couched as a “flat sum settlement.”

The ALJ decision in Blum is not precedential, and as of this writing there is no public indication that an appeal has yet been filed.