In Matter of Marc S. Sznajderman and Jeannette Sznajderman, DTA No. 824235 (N.Y.S.   Div. of Tax App., Mar. 6, 2014), a New York State Administrative Law Judge upheld an assessment arising from investments in oil and gas partnerships, which were held to be abusive tax avoidance transactions, and therefore also governed by a six-year statute of limitations for assessment.

Facts. Petitioner Marc Sznajderman, an experienced investor, became a general partner in Belle Island Drilling Company, a New York general partnership formed in 2001. The partnership, created and controlled by an individual named Richard Siegal, conducted oil and gas drilling ventures, which were designed to generate deductible intangible drilling costs (“IDC”) 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 investments, 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 with 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 interest-bearing 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 promissory note of $540,000, with an 8% interest rate. To fund his $300,000 commitment, Mr. Sznajderman paid $100,000 from personal funds and borrowed the balance from another entity controlled by Mr. Siegal. He also executed a separate collateral agreement requiring him to purchase municipal bonds that could be used towards the repayment of his subscription note.

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 enacted new requirements mandating disclosure of information relating to certain tax shelter transactions, imposing penalties for nondisclosure, extending the statute of limitations for such transactions to six years from the usual three years, and creating a Voluntary Compliance 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 tax and including penalties for failure to participate in the VCI. In 2009, Mr. Sznajderman participated in the VCI, choosing the option which allowed him to retain the right to file a claim for credit or refund, and made a payment of approximately $98,000.

As permitted under the terms of the VCI, Mr. Sznajderman filed a Petition challenging the assessment. In 2012, the ALJ denied a motion for summary determination, in which Mr. Sznajderman had challenged the applicability of the extended six-year statute of limitations, finding that a hearing was necessary, as reported in the June 2012 issue of New York Tax Insights. At the hearing, Mr. Sznajderman continued to argue that the six-year statute 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 noted 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.

The Decision. The ALJ undertook a lengthy and careful review of the many documents and details surrounding the partnerships, as well as of the federal tax cases that had investigated the same transactions. He found that the Tax Court had upheld the same investment scheme as the one in Belle Isle in Zeluck v. Comm’r of Internal Revenue, T.C. Memo 2012-98, Dkt. No. 10393-09 (T.C.M. Apr. 3, 2012), noting that “[t]he court appeared to go out of its way to confirm the propriety of the transaction.” The ALJ found that the underlying subscription note and the assumption agreement constituted genuine debt, just as the Tax Court had done. He analyzed the purchases of investment interests with cash and debt, and concluded that Mr. Sznajderman’s investment transaction created genuine debt, supporting his claim that the partnership was not an abusive tax avoidance transaction. The ALJ noted that Mr. Sznajderman’s “credible testimony” established he had investigated the partnership and recognized the risks, and also that he “valued the tax incentives outlined in the investment proposal, which he understood had the potential to deliver a deduction estimated to be 2.5 times an investor’s cash investment the first year.”

Although the structure of the investment was found to create genuine debt, the ALJ concluded that a determination was also necessary on whether the terms of the turnkey contract were reasonable and not abusive. On this issue, the ALJ noted that Mr. Sznajderman had no knowledge of how the turnkey contract price was reached, although he knew how important that contract was to the venture. He also found “baffling” Mr. Sznajderman’s failure to consult with any oil or gas experts or tax advisers with oil and gas experience, and that he knew, or should have known, that Mr. Siegal’s interests conflicted with his own, since Mr. Siegal would profit considerably even if Belle Isle’s wells never became productive.

With respect to the turnkey arrangement, the ALJ found that Mr. Sznajderman failed to meet his burden to establish that the contract price was reasonable. The ALJ accepted the testimony of the Department’s expert witness that the turnkey price appeared to be exorbitant, although he did note that the expert’s analysis and estimate was “rudimentary.” Mr. Sznajderman’s expert, on the other hand, while testifying that the turnkey contract “‘appears reasonable relative to standard industry practice,’” did not have an opinion on the average markup in such a contract, and did not specifically support the turnkey price, stating in his report only that “one would assume that all costs were reasonably covered.”

The ALJ therefore concluded that, in the absence of clear evidence of how the turnkey price was calculated, and the lack of any arm’s length negotiation, Mr. Sznajderman failed to meet his burden of proving the reasonableness of the turnkey contract, and that amounted to “convincing evidence that the transaction has tax avoidance as its primary motive.”

Additional Insights

Oil and gas partnerships, largely because of their generation of deductions for intangible drilling costs in significant amounts, have been the target of investigation by both the federal government and the Department of Taxation and Finance.  It appears that similar partnerships have survived federal challenge, and the ALJ explicitly noted that, although the Department is challenging “various aspects of Mr. Siegal’s scheme to create fractional general partnership interests in  oil and gas wells, thus qualifying them for IDS deductions, it has been no more successful therein than the IRS or earlier efforts of its own to demonstrate that the structure of the deal was unsound.”  However, despite sustaining the general structure of the deal, the ALJ’s detailed investigation of the terms and pricing of the turnkey contract — an important element  in the operation of the partnership — led to the conclusion that Mr. Sznajderman was unable to demonstrate that the pricing of that contract was reasonable or even that he had properly investigated that important element.