In Matter of Marc S. Sznajderman and Jeannette Sznajderman, DTA No. 824235 (N.Y.S. Tax App. Trib., July 11, 2016), the New York State Tax Appeals Tribunal affirmed an Administrative Law Judge decision upholding an assessment arising from investments in oil and gas partnerships. The Tribunal found the investments constituted abusive tax avoidance transactions under the Tax Law and therefore were governed by a six-year statute of limitations for assessment, making the Department’s assessment timely
Facts. Petitioner Marc Sznajderman, an experienced investor, became a general partner in Belle Isle Drilling Company, a New York general partnership formed in 2001. The partnership, created and controlled by an individual named Richard Siegal, was engaged in oil and gas drilling ventures, which were designed to generate deductible intangible drilling costs (“IDCs”) in the first year of operation. Investors were required to be general partners, which exposed them to greater risk. Mr. Sznajderman investigated the potential investment, including review of statements prepared by investment firms and a review by his accountants who, although they were not specialists in oil and gas, advised that the documents did not appear to be out of the ordinary or raise any undue concern. Mr. Sznajderman’s financial expert advised that Mr. Sznajderman had a “reasonable opportunity to both make and lose money” on the investment and that the investment was structured in a manner consistent with arrangements in the oil and gas industry.
A critical part of the deal was a “turnkey arrangement,” under which the driller accepts a fixed fee for developing wells up to the point at which they enter production. Belle Isle entered into a turnkey contract with SS&T Oil Co., Inc. (“SS&T”), an entity also controlled by Mr. Siegal, under which Belle Isle agreed to pay SS&T $10.8 million, partially in cash and partially in an interestbearing note in the principal amount of approximately $7 million. Pursuant to an assumption agreement, Mr. Sznajderman assumed responsibility for a portion of the loan that the partnership had taken from SS&T. The pricing for the turnkey contract entered into by Belle Isle had been determined by Mr. Siegal, and Mr. Sznajderman did not know how the price had been determined.
Mr. Sznajderman signed a subscription agreement to purchase three units for $840,000, payable in cash of $300,000 and a full recourse subscription note of $540,000, with an 8% interest rate. Interest on the note was payable quarterly the first year, and thereafter payable from his share of Belle Isle’s net operating revenue; to the extent the revenue was insufficient, interest accrued.
Mr. Sznajderman also was required to execute a separate collateral agreement, requiring him to purchase municipal bonds that could be used toward the repayment of his subscription note. The collateral agreement gave him the option to pay the partnership 15% of the face value of the subscription note, payable from his partnership distributions, which SS&T “guaranteed to invest at 7.88% compounded so that at the end of 25 years the sum would be equal to the principal amount” of the note. Mr. Sznajderman, like most of the other investors, chose this guaranteed option. He also received a letter from Mr. Siegal providing that he could assign 60% of his distributions from Belle Isle for a period of up to five years or until such assigned income equaled 15% of the face value of his subscription note, and providing that SS&T would make up any shortfall in the bonds by reinvesting the proceeds. Mr. Sznajderman was assured in another letter from Mr. Siegal that “‘no one has ever been required to pay any portion of their notes’” since he began structuring these transactions in 1981.
For 2002 through 2011, Belle Isle generated substantial income from oil and gas production, accrued and reported interest income due on its partners’ subscription notes, and accrued and deducted interest due on the turnkey note. It made quarterly cash distributions to its partners.
The Audit. In 2006, the Department of Taxation and Finance began investigating approximately 200 oil and gas partnerships, including Belle Isle, all of which had used the same accounting firm to prepare their partnership returns. The Department also worked with the Internal Revenue Service and taxing authorities in California to gather information on the structure of the partnerships designed by Mr. Siegal, and concluded that the partnerships constituted “tax avoidance transactions.”
In 2005, the New York legislature had enacted new requirements mandating disclosure of information relating to certain tax shelter transactions, imposing penalties for nondisclosure, extending the statute of limitations for abusive tax shelter transactions to six years from the usual three years, and creating a Voluntary Disclosure Initiative (“VCI”). See TSB-M-05(4)I (N.Y.S. Dep’t of Taxation & Fin., June 1, 2005). In order to come within the extended six-year statute of limitations, the Department issued a Notice of Deficiency to Mr. Sznajderman for 2001 on March 14, 2008, assessing personal income tax and imposing penalties for failure to participate in the VCI. In 2009, Mr. Sznajderman participated in the VCI, choosing the option that allowed him to retain the right to file a claim for credit or refund.
As permitted under the terms of the VCI, Mr. Sznajderman filed a Petition challenging the assessment, claiming that the six-year statute of limitations was inapplicable, because his investment in the Belle Isle partnership was not an abusive tax avoidance transaction that had tax avoidance as a principal purpose. He argued that the Department had allowed his cash investment as deductible IDC, that his debt was genuine, and that the investment and the partnership transactions had economic substance and significant nontax purposes. The Department argued that the chief purpose of the investment was to avoid or evade income tax and that therefore the six-year statute applied.
The ALJ Decision. The ALJ reviewed the many documents and details surrounding the partnerships, as well as the federal tax cases that had investigated the same transactions. Relying on the U.S. Tax Court’s examination of what the ALJ concluded was the same investment format as the one in Belle Isle in Zeluck v. Comm’r of Internal Revenue, 103 T.C.M.(CCH) 1537 (2012), which found that the underlying subscription note and the assumption agreement constituted genuine debt, the ALJ similarly concluded that the debt was valid. Nonetheless, the ALJ found that the terms of the turnkey contract also had to be considered, and that because Mr. Sznajderman failed to meet his burden to establish how the turnkey price was calculated or that it was reasonable, that failure amounted to “convincing evidence that the transaction had tax avoidance as its primary motive.”
Tribunal Decision. The Tribunal made another careful review of the facts and reached the same result as the ALJ but on a different basis. The Tribunal found that, despite the form of the subscription note and guarantee, Mr. Sznajderman’s payment of 15% of the stated principal for the purchase of bonds effectively protected him from any realistic possibility of liability with respect to the remaining 85% of the principal amount. The Tribunal also found that Mr. Sznajderman’s payment of firstyear interest on the stated principal did not establish that the debt was genuine, since interest was paid only sporadically after the first year, even though operating revenues were available to make larger payments, and it appeared that the “priority” was to use those revenues to effectively reimburse Mr. Sznajderman for the first-year interest payment he did make. The Tribunal also noted that, to the extent its conclusion differed from that of the ALJ, and his reliance on Zeluck v. Comm’r, the facts in that case were distinguishable. Despite involving a similar Siegal oil and gas partnership, in which a partner acquired his interest by a combination of cash and a subscription note, the Tax Court’s decision in Zeluck makes no reference to any option for the taxpayer in that case to satisfy his obligation through the purchase of bonds, which effectively reduced the principal amount of Mr. Sznajderman’s subscription debt.
The Tribunal also found that the turnkey contract lacked economic reality. Since nearly all partners paid their subscription note liability by paying 15% of the principal amount to purchase bonds, those bond payments also satisfied each partner’s turnkey note liability. Therefore, the 2001 losses, nearly all of which were claimed as IDCs, were not matched by any real economic losses to Mr. Sznajderman, or nearly all the other investors, to the extent of 85% of the face value of the subscription and turnkey notes.
The Tribunal expressly recognized that Belle Isle made a real investment in the oil and gas interest; had acquired fractional working interests in 37 undrilled oil and gas sites, incurring substantial costs; and made quarterly distributions to its partners of over $2 million, of which $1.2 million was distributed directly to the partners in cash. However, following language in Treas. Reg. 1.6662- 4(g)(2)(ii), the Tribunal found that economic substance was not sufficient to establish that a transaction was not a tax shelter if other factors indicated it was a tax shelter. Here, the Tribunal found that Mr. Sznajderman’s stated capital contribution was substantially inflated over his real capital contribution, and therefore he had failed to establish that his primary purpose was not tax avoidance.
The Tribunal also upheld the imposition of penalties, concluding that Mr. Sznajderman “knew or should have known” that his first-year partnership deduction could not have exceeded his actual capital contribution because of the bond purchase option.
The Tribunal decision relied heavily on the detailed terms of the collateral agreement and concluded that the economic reality of the transactions limited Mr. Sznajderman’s risk to his initial out-of-pocket investment, particularly since he had been assured in writing that no investors had ever had to pay any portion of their notes since 1981. The fact that the business actually existed, had drilled for oil and returned profit, and therefore had economic substance, was not enough to insulate it from being held an “abusive tax shelter” when the Tribunal determined that investors were claiming benefits out of all proportion to their actual risk.