The New York State Tax Appeals Tribunal has overturned the decision of an Administrative Law Judge and held that the taxpayer properly claimed Qualified Empire Zone Enterprise (“QEZE”) credits, since it established a valid business purpose for restructuring its business other than to obtain tax credits. Matter of Ward Lumber, Co., Inc., DTA Nos. 823209 and 823163 (N.Y.S. Tax App. Trib., July 10, 2012).

Petitioner Ward Lumber conducted a family-owned business that had operated for approximately 120 years. In the late 1990s and early 2000s, it experienced serious financial problems, and incurred large operating losses. Its primary creditor, NBT Bank, N.A. (“NBT”), downgraded its credit rating, and repeatedly suggested shutting down the lumber mill that the business had historically operated. Eventually, the Empire State Development Corporation (“ESDC”) and the New York State Energy Research and Development Authority (“NYSERDA”) became involved, trying to find ways to allow the business to continue. The owners were encouraged by the ESDC and the NYSERDA to pursue Empire Zone benefits, as well as other grants and credits. The business eventually reorganized as a new entity, reincorporated in Delaware, and received economic development benefits from the ESDC, including a grant and certain Empire Zone benefits. It was able to reduce its losses, convince NBT to extend additional credit, acquire new equipment, and finance upgrades. Over a period of time, Ward Lumber returned to “modest profitability.”

Ward Lumber claimed QEZE credits on its New York corporation franchise tax returns and, after an audit, the Department denied those credits for the years 2005 and 2006 on the basis that Ward Lumber did not have a valid business purpose.

Availability of QEZE Benefits. Under the QEZE program, qualified businesses receive certain tax credits and exemptions directly linked to job creation. As discussed in last month’s New York Tax Insights, reporting on the decision in Dunk & Bright Furniture Co. Inc. and James F. Bright, DTA Nos. 823026 and 822710 (N.Y.S. Tax App, Trib., June 28, 2012), the possibility of an existing business simply forming a new entity to qualify for such benefits without actually creating any new jobs, a practice known as “shirt changing,” had been identified as a potential problem by the Legislature, and the statute was amended in 2002 to provide that an entity “shall not be deemed a new business if it was not formed for a valid business purpose . . . and was formed solely to gain empire zone benefits . . . ” 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 Legislature then 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.

In Dunk & Bright, the Tax Appeals Tribunal rejected arguments that the taxpayer could prevail by meeting either part of the test, and held that the statute imposes two requirements: the entity must establish that it was formed for valid business purposes, and that it was not formed solely to acquire Empire Zone benefits.

Tribunal Decision. In Ward Lumber, the Tribunal adhered to the legal standard it announced in Dunk & Bright¸ requiring the taxpayer to prove both that it was formed for valid business purposes and that it was not formed solely for QEZE benefits. However, unlike the situation in Dunk & Bright, where no valid business purpose was found, in Ward Lumber the Tribunal concluded that the taxpayer had met the test. First, the Tribunal found that the ALJ had erred by “viewing the reorganization in isolation as opposed to part of a larger plan.” The ALJ focused only on testimony, and a statement attached to Ward Lumber’s tax return, which did indicate that a purpose of the reorganization was to acquire Empire Zone benefits. However, other parts of the record, disregarded by the ALJ, established that the reorganization was just one component of a larger plan to save the business, which included a grant from the ESDC, a loan from the NYSERDA, and the extension of credit by NBT.

The Tribunal found that the primary motivation for the reorganization was the acquisition of a credit extension from the bank, and that all the other elements “helped induce the credit extension.” The Tribunal also found that the new business was not the same business it had been before: the reorganization resulted in a new entity with a new credit rating, and significant upgrades were made to the business’s facilities which allowed it to improve efficiency, enter new markets, and save jobs.

The Tribunal also explicitly noted that, in light of the legislative purpose of the Empire Zones Program to stimulate investment and job creation, and the fact that the result in this case was the creation of a new business that saved a significant number of jobs in the specified region, it found “the position of the Division and the pursuit of this case by its Audit Department to be inappropriate.”

Additional Insights: The contrast among the various cases decided by the Tax Appeals Tribunal involving QEZE credits demonstrates the importance of building as complete a factual record as possible, and the critical nature of the underlying facts. Here, the company was able to demonstrate that its restructuring, while undoubtedly resulting in the acquisition of QEZE benefits, also achieved a number of other purposes, and, most importantly, put the business back on a firm financial footing and saved a considerable number of jobs, which was exactly the purpose of the QEZE program. It was critical that the company was able to demonstrate the entire scope of its business restructuring, and the many varied activities that were all ongoing at the same time, as well as their successful conclusion. At times, auditors tend to focus solely on the tax-related motivations, and lose sight of the many other important concerns a business will be trying to manage simultaneously.