A New York State Administrative Law Judge has held that an individual taxpayer is not entitled to an award of litigation expenses incurred in the course of his successful challenge to an assessment of personal income tax, since he did not qualify to be treated as the “prevailing party” under Tax Law § 3030. Matter of Bentley Blum, DTA No. 825455 (N.Y.S. Div. of Tax App., Oct.1, 2015). In the original decision, the same ALJ had held that a “flat sum settlement” the Internal Revenue Service of federal income tax liabilities did not constitute a change that was required to be reported to New York State under Tax Law § 659, and therefore Mr. Blum’s failure to report the federal change did not extend the New York State statute of limitations.

Background. The taxpayer, Bentley Blum, was a promoter of oil and gas partnerships that were examined by the IRS. His federal personal income tax returns were also audited by the IRS, and an Examination Report for the years 1994 through 1997 had been issued proposing adjustments to Mr. Blum’s income. Mr. Blum challenged the assessments, and eventually entered into “a flat sum settlement of $510,000” for the 1996 year, which resolved 1994 through 1996 proposed federal adjustments.

Mr. Blum had timely filed his State and City personal income tax return for 1996, the only year at issue in the State proceeding. Despite the fact that the standard three-year statute of limitations would have expired with on April 15, 2000, the Department issued a Notice of Deficiency for State and City personal income taxes for 1996 on May 22, 2012, relying on a claim that Mr. Blum’s federal taxable income had been increased in an amount 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 final federal changes.

ALJ Decision on the Merits. The ALJ held that a “flat sum settlement” is not included in the list of federal changes required to be reported to the State under Tax Law § 659, and that the settlement did 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 standard three-year limitations period, the notice was canceled. The Department did not file an exception to the ALJ’s decision.

Request for Litigation Expenses. After his initial victory, Mr. Blum moved for an award of litigation expenses, including legal fees, under Tax Law § 3030, which provides that a “prevailing party” is entitled to reasonable administrative costs, including reasonable fees paid in connection with an administrative proceeding. A “prevailing party” is defined as a party who has substantially prevailed, submits an application within 30 days, and had net worth not exceeding $2 million. However, a successful litigant is not a “prevailing party” under the statute if the Department establishes that its position was “substantially justified.”

The ALJ, relying on Matter of Grillo, DTA. No 823237 (N.Y.S. Tax App. Trib., Aug. 23, 2012), held that, in order to prove substantial justification, the Department must show that its position was justified to a degree that would satisfy a “reasonable person.” The ALJ found that the Department satisfied this test, and that it “reasonably” believed that an assessment “based on unreported federal audit changes could be made at any time.” He found that the Department’s audit conclusion that there was additional income was “simply a logical extrapolation” of the federal changes, that there was no contrary controlling precedent, and that there was no failure to follow published guidelines. Therefore, the award of costs was denied.

Additional Insights

Under the standards applied by the Tribunal, it is generally very difficult to obtain an award of costs, and a taxpayer who succeeds on the merits must recognize that there are not many circumstances in which an ALJ is going to find that the Department’s position failed to meet the “reasonable person” standard – at least it is hoped that the Department will seldom take such an extreme position. However, it will be interesting to see what happens should the issue again arise of whether a federal flat sum settlement amounts to a federal change that must be reported to the State, and whether those circumstances might lead an ALJ to reach a different conclusion on the reasonableness of the Department’s position with respect to a taxpayer who meets the net worth condition. Because ALJ decisions are not precedential as to other taxpayers, and the Department chose not to appeal the ALJ merits decision to the Tribunal, there is no binding authority in New York on the issue.

In a somewhat analogous situation, the California Court of Appeals recently upheld an award of over $2.5 million in “reasonable litigation costs” against the State Board of Equalization, finding that the Board’s litigation position was not substantially justified and had been rejected in prior litigation on the same issue, and rejecting the Board’s argument that, as a government entity, it is entitled to make a repeated challenge to a decision with which it does not agree. Lucent Technologies, Inc. v. State Bd. of Equalization, No. B257808 (Cal. Ct. App., 2d App. Dist., Oct. 8, 2015).