Affirming the decision of an Administrative Law Judge, the New York State Tax Appeals Tribunal held that the Department of Taxation and Finance properly denied claims for Qualified Empire Zone Enterprise (“QEZE”) credits because the petitioner did not establish that it had a valid business purpose for restructuring its business and that its purpose was anything other than obtaining tax credits. Matter of Dunk & Bright Furniture Co. and James F. Bright, DTA Nos. 823026 and 822710 (N.Y.S. Tax App. Trib. Div. of Tax App., June 28, 2012).

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 specialpurpose 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 specialpurpose 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 the 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. 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.’” No other separate entities for the carpet operations and furniture operations were created, and none of the identified business purposes ever materialized.

Under the QEZE program, qualified businesses received certain tax credits and exemptions directly linked to job creation. 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 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.

The Department 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. It issued assessments of additional personal income tax to Mr. Bright and his wife for the years 2005 through 2007, resulting from the disallowance of QEZE-based real property tax credits claimed for those years, and assessments of sales and use tax to the company for 2005 through February 2008, also based upon disallowance of the company’s QEZEbased sales tax exemption.

The ALJ Decision. The ALJ agreed with the Department, finding that the company had failed to demonstrate that it had reorganized for business purposes and not merely to obtain the tax credits. 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.

The Tribunal Decision. The Tribunal agreed in all respects with the ALJ. First, it reviewed the requirements of the statute, and agreed with the Department and the ALJ that the statute “imposes both a requirement and a restriction”–the entity must establish that it was formed for valid business purposes, and that it was not formed solely to acquire Empire Zone benefits. While it noted that the business purpose test is “not a strict standard, but rather a flexible test,” and that consideration of tax consequences of business activities is permissible, “such consideration cannot serve as the primary motivation.” Here, the Tribunal found no contemporaneous documentation that the goal of segregating liabilities served as a primary purpose. There was no business plan, correspondence, or minutes referencing such a motivation, and the only available contemporaneous documentation referenced tax-planning motives. The Tribunal also found that the reorganization did not meaningfully change the company’s economic position, since none of the necessary changes that would have accomplished the alleged purpose of segregating liabilities ever occurred. Therefore, the Tribunal found that the company did not meet either prong of the valid business purpose test.

The Tribunal also rejected the company’s second argument, based on a recent Appellate Division case, James Square Associates LP, et al. v. Mullen, 91 A.D.3d 164 (4th Dept. 2011), that a different burden of proof should apply, and that the business purpose requirements were unconstitutional since they were being retroactively applied. In James Square, covered in the January 2012 issue of New York Tax Insights, the Appellate Division, Fourth Department, held that retroactive application of certain 2009 legislative changes to the QEZE program improperly deprived the taxpayers of promised benefits on which they had relied in making decisions on how to conduct their business. The Tribunal found, first, that James Square did not apply a different burden of proof, but merely used a “balancing of the equities” test to determine whether the 2009 amendments could constitutionally be applied to the taxpayers in that case. On the retroactivity question, the Tribunal distinguished the facts from those in James Square, where amendments enacted in 2009 were retroactively applied back to January 1, 2008. The anti-“shirt changing” amendments had been enacted in April 2005, and were being applied to periods from December 1, 2005 through February 29, 2008. Since there was no deprivation of a preexisting, actual vested right, but merely a prospective change to stop a perceived abuse, there was no violation of the Constitution.

Additional Insights. The attempt to demonstrate a valid, nontax “business purpose” for transactions with obvious tax benefits can be very challenging, particularly when, as was apparently true in this case, the documentary evidence refers repeatedly to the anticipated tax advantages, and the taxpayer is unable to produce contemporaneous records of additional motives. While generally the business motivations for a transaction are only one element of the dispute, here 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 in order to take advantage of Empire Zone benefits. The Tribunal found that, while at the hearing the company representatives provided testimony about the furniture business, the potentials for growth, and business considerations leading up to and after the reorganization, and a “Statement of Business Purpose” was created by the company during the Department’s audit, there was no contemporaneous documentation demonstrating any of these motivations. The Tribunal distinguished these facts from such cases as Matter of Graphite Metallizing Holdings, DTA No. 822416 (N.Y.S. Tax App. Trib., July 7, 2011), discussed in the August 2011 issue of New York Tax Insights, in which contemporaneous documentation of non-tax business purposes was presented, and the Tribunal sustained the use of QEZE credits, despite the presence of additional tax-saving motivations.