An Administrative Law Judge has held that the Division of Taxation properly denied claims for qualified empire zone enterprise (“QEZE”) credits because the petitioner did not have a valid business purpose for restructuring. Matter of Dunk & Bright Furniture Co., DTA Nos. 823026 and 822710 (N.Y.S. Div. of Tax App., Dec. 30, 2010). The business purpose requirement had been added to the statute in 2002 to prevent existing businesses from setting up in a new form solely to obtain QEZE credits.

Petitioner Dunk & Bright Furniture Co., Inc. (“D&B Furniture”) operated a retail home furnishings business. In the late 1990s and early 2000s, the business owner, James Bright, made changes in the company’s operations, including the creation of a special-purpose company to lease warehouse space and sublet the space to D&B Furniture; purchasing property for warehouse space; assuming responsibility for delivering the furniture, a service that had previously been performed by a third party; and engaging in other ventures related to the furniture business. Mr. Bright had considered the business advantages of forming separate special-purpose entities to conduct various parts of the business. In 2002, a plan of reorganization was proposed by counsel, described as a “tax planning idea,” which included setting up a holding company that would allow flexibility to restructure the existing operations, segregate the liabilities, and allow for the realization of additional incentives under the Empire Zone Program. Pursuant to this plan, Dunk & Bright Holdings, Inc. (“D&B Holdings”) was formed, and later changed its name to Dunk & Bright Furniture Co., Inc. Mr. Bright was the sole shareholder of D&B Holdings, and the ALJ found that all decision-making and day-to-day operational authority remained with him or an employee that he oversaw. The Board minutes stated that the reorganization was undertaken “‘to maximize tax benefits,’” and the corporate tax returns contained a statement that the purpose for the reorganization “‘was to provide the corporate structure the flexibility to take advantage of certain New York State incentives.’” A Statement of Business Purpose prepared in connection with the audit also referred to, in addition to the tax benefits, segregation of liabilities, isolation of profits of the various business operations, and financing considerations as additional reasons for the restructuring. However, no other separate entities were created, and none of the claimed business purposes ever materialized.

The Division conducted an audit and concluded that the petitioner did not meet the “valid business purpose” test set forth in the law, and that the reorganization was undertaken solely for the tax benefits.  

The ALJ agreed. First, he reviewed the requirements of the statute. Qualified businesses received certain tax credits and exemptions directly linked to job creation, and the level of benefits was, in very general terms, determined by a comparison of the number of jobs in a base period to the number of jobs in a particular subsequent period. In order to obtain greater benefits, a business like D&B Furniture would have had to either increase its employment level to twice its base year employment level, or become a “new business” so that, with a base period employment level of zero, the addition of even one job would result in its entitlement to 100% of the available benefits. The possibility of an existing business simply forming a new entity to qualify for such benefits had been identified as a potential “loophole” in the law, and the statute was amended to provide that a corporation will not be treated as a new business if it was similar in operation and ownership to an existing entity and was not formed for a valid business purpose as defined in the statute. Tax Law former § 14(j)(4)(B). A valid business purpose must “alone or in combination constitute the primary motivation for some business activity… which… changes in a meaningful way, apart from tax effects, the economic position of the taxpayer.” Tax Law § 208(9) (o)(1)(D).

The business purpose requirement was enacted on May 22, 2002, and was made applicable to entities created on or after August 1, 2002. The change resulted in a significant increase in the number of businesses being set up between May 22 and August 1, and therefore the legislature added an additional requirement that businesses first certified as eligible to receive QEZE benefits prior to August 1, 2002 had to meet the business purpose test to retain those benefits for tax periods beginning on or after January 1, 2005. This case involved assessments of additional personal income tax issued to Mr. Bright and his wife for 2005 through 2007, based upon the disallowance of QEZE-based real property tax credits claimed for those years, and assessments of sales and use tax issued to D&B Holdings for 2005 through February 2008, based upon disallowance of the company’s QEZEbased sales tax exemption.

The ALJ interpreted the statutory language as requiring petitioners to meet both parts of a two-part standard: they had to establish that the reorganization was undertaken for one or more business purposes which, apart from tax avoidance or reduction, constitute the primary motivation for the reorganization; and second, that the reorganization was not undertaken solely in order to gain QEZE benefits. He rejected the petitioners’ argument that the statute required the Division to establish that the reorganization was undertaken solely in order to gain QEZE benefits and to establish that there was no business purpose, holding that such a standard would reverse the appropriate burden of proof and incorrectly place the burden of proof on the Division, when taxpayers should bear the burden of proving entitlement to tax credits and exemptions.

The ALJ interpreted the statutory language as requiring petitioners to... establish that the reorganization was undertaken for one or more business purposes ... and not solely to gain qeze benefits.

Relying on the statements in the Board minutes and tax filings, and the timing of the reorganization (just after the law was changed and shortly prior to the closing of a perceived window of opportunity), obtaining QEZE benefits appeared to the ALJ to be the motive for the reorganization, and not the other considerations raised by the petitioners regarding business expansion, limitation of liability, etc. The ALJ found that “[w]hile the noted reasons for reorganizing are all legitimate and valid … petitioner has provided no evidence of having engaged in any subsequent activities consistent therewith. … It is obviously difficult to accept the premise that any meaningful economic or other changes in business resulted from the reorganization, given that none of the envisioned steps or activities available under the business structure as reorganized were ever undertaken or carried out.” The ALJ found that obtaining the QEZE benefits “was not only the primary motivation for the reorganization but in fact was petitioners’ sole reason for reorganizing.”

Additional Insights

While the “business purpose” for various transactions is often an issue in state tax disputes, many cases involve a dispute about whether a business motive is even necessary if all other statutory requirements are met. This case presents an example of a situation where the statute itself explicitly requires a valid business purpose, since the legislature had already identified what it perceived as a problem in existing businesses simply reconstituting themselves as “new” in order to take advantage of credit opportunities. Here the petitioners admitted that maximizing the QEZE benefits was the purpose from the perspective of the attorney who had proposed and implemented the transaction, but claimed that there were several other legitimate reasons and purposes. However, because none of those reasons or purposes were ever documented, pursued, or implemented, the ALJ was unwilling to accept that any of them was the primary purpose for the reorganization, and instead found that tax savings solely motivated the change in form.