The deductibility of a deceased individual’s losses from investments in oil and gas partnerships, and the Tax Department’s ability to assess income tax after the three-year statute of limitations has closed, is the subject of an interesting recent decision by a New York State Administrative Law Judge. The decision addresses whether the taxpayer filed false or fraudulent returns (for which there is no statute of limitations) and whether the deficiency was attributable to an “abusive tax avoidance transaction” (for which there is a six-year statute of limitations). Matter of Richard Siegal (Estate of), Gail Siegal, Administrator, DTA Nos. 826661 & 826750 (N.Y.S. Div. of Tax App., Feb. 15, 2018). 

Facts. Richard Siegal (now deceased) was a New York resident during the tax years 2001 and 2002. He had been involved in the oil and gas industry since the 1970s and created partnerships to participate in oil and gas ventures. For the years in issue, he was a general partner in several oil and gas partnerships that generated losses, principally through the deduction of intangible drilling costs. The taxpayer reported his distributive shares of those losses for both federal and New York State personal income tax (“PIT”) purposes. In 2003, following an audit of those partnerships by the Department’s Tax Shelter Unit for the years 2000 and 2001, the Department concluded its audit without adjustment and notified the taxpayer that no further action was required with respect to his New York State returns.

In 2005, the Department’s Field Audit Bureau commenced an audit of the taxpayer’s PIT returns, initially for the years 2002 through 2004, and later expanded to include 2001, primarily relating to his claimed losses from the oil and gas partnerships. The Department’s Tax Shelter Unit informed the Field Audit Bureau that there were other audit cases involving the same partnerships, and that the partnerships “might be questionable.” The three-year statute of limitations for assessment had already expired for 2001, but the Field Audit Bureau took the position that the six-year statute of limitations for understatements attributable to tax shelter activity was instead applicable. With that six-year period about to expire for the 2001 tax year, the Department issued a notice of deficiency (“Notice”) based on the disallowance of the taxpayer’s losses from the partnerships. A separate Notice was issued asserting a fraud penalty based on the taxpayer’s alleged failure to participate in a 2005 New York State voluntary compliance initiative.

In 2013, while the Notice for 2001 was being contested at the Department’s Conciliation Bureau, the Department issued a Notice for 2002, also based in the disallowance of the partnership losses, and also asserting a penalty for failure to participate in the 2005 voluntary compliance initiative. Both the three-year and six-year statute of limitations for the 2002 year had expired, but the Department took the position that the taxpayer’s returns were false or fraudulent and it claimed that therefore no statute of limitations was applicable. It is unclear from the decision when and on what basis the initial fraud determination was made, but the Department’s auditor testified that the fraud determination was made by the Department’s Office of Counsel. The taxpayer’s estate maintained that the Notices were time-barred.  

The decision — which is 74 pages long — goes into considerable detail regarding the nature of the oil and gas industry, including drilling risks and drilling contract types, as well as the taxpayer’s cash and subscription note investments in those partnerships, all of which is beyond the scope of this article (although it is recommended reading for learning about the industry). The decision discusses the fact that the oil and gas partnerships entered into “turnkey drilling arrangements.” Under this common arrangement, a turnkey driller accepts a fixed fee to develop the oil and gas wells and runs the considerable risk of cost overruns. As a result, turnkey contracts are more costly to investors. 

More than half of the wells drilled by the partnerships generated hundreds of millions of dollars of oil and gas revenues. However, they were all designed to be eligible to deduct intangible drilling costs in the first year of operation. The taxpayer’s finance and valuation expert testified at the hearing that the three principal purposes for investing in oil and gas ventures — potential profit, portfolio diversification, and tax benefits — were all present here. The taxpayer’s oil and gas expert testified that the terms of the turnkey drilling contracts were reasonable relative to industry standards. The Department’s petroleum engineer expert testified that the industry-standard mark-up for turnkey drilling contracts was 10-25% above drilling costs, far less than the mark-ups in question, which were paid to drilling companies controlled by the taxpayer. However, the Department’s expert admitted that he had limited experience evaluating turnkey contracts, and he made several concessions regarding the limited scope of his research.

Law. As relevant here, there are two exceptions to the three-year statute of limitations. First, the tax may be assessed at any time if a “false or fraudulent return” is filed “with intent to evade tax.” Tax Law § 683(c)(1)(B). The limitation period is extended to six years “if the deficiency is attributable to an abusive tax avoidance transaction.” Tax Law § 683(c)(11)(B). The Department bears the burden of proving that the taxpayer filed a false or fraudulent return (here, for the 2002 tax year). On the other hand, the taxpayer bears the burden of proof to rebut an assertion of an abusive tax avoidance transaction (for the 2001 tax year).

ALJ determination. The ALJ first concluded that for 2002 the Department did not meet its burden of proof to show that the taxpayer filed a false or fraudulent return through “clear, definite and unmistakable evidence of every element of fraud.” The ALJ found that the Department’s “asserted basis for finding fraud has been fluid and inconsistent throughout the proceedings herein,” and she did not find the testimony of the Department’s expert to be “compelling.” Moreover, the ALJ rejected the claim made in the Department’s post-hearing brief that the taxpayer promoted abusive tax shelters, noting that the assertion was not at issue at the hearing.

As for whether the taxpayer’s investments in the oil and gas partnerships were abusive tax avoidance transactions triggering a six-year statute of limitations, the test was whether the taxpayer proved that his investments were not “for the principal purpose of avoiding tax.” The ALJ found that the taxpayer met his burden for some, but not all, of the partnerships. The critical difference among them was that for some partnerships the subscription note for the taxpayer’s partnership investment was shown to be genuine debt but for other partnerships similar proof was not provided. 

The ALJ distinguished Matter of Sznajderman, DTA No. 824235 (N.Y.S. Tax App. Trib., July 11, 2016), appeal to 3rd Dep’t pending, where the Tribunal upheld the Department’s reliance on the six-year statute of limitations for abusive tax avoidance transactions in a case involving some of the same oil and gas partnerships as were involved here, and for one of the same tax years. The ALJ found that the “lynchpin” of that decision — that the investor’s subscription note obligation representing his investment in the partnership lacked “economic reality” — was not present in this case, and she ruled that the Department’s reliance on Sznajderman was misplaced.

For two of the partnerships for which the taxpayer did not meet his burden of proof regarding tax avoidance, however, the ALJ found that the Department lacked a rational basis for disallowing the taxpayer’s share of losses, noting that the Department did not explain the reason for disallowing losses resulting from the taxpayer’s cash-only investments in those partnerships.

Finally, for the disallowed losses that were found to be timely asserted, the ALJ upheld the imposition of penalties for the taxpayer’s failure to participate in the 2005 New York State voluntary compliance initiative, noting that there are no provisions in the Tax Law for the abatement of such penalties. 

ADDITIONAL INSIGHTS

The Department’s claim that the taxpayer’s 2002 return was false or fraudulent return seems particularly tenuous, and the ALJ provides a thorough analysis of why the Department did not meet its considerable burden of proof as to fraud. While the tax benefits of investing in an oil and gas partnership invite scrutiny, there was scant evidence that the taxpayer’s income tax returns were false or fraudulent.

The question of whether the taxpayer’s investments constituted abusive tax avoidance transactions (thereby permitting a six-year statute of limitations for 2001) was less clear cut, as evidenced by the ALJ’s fact-intensive analysis for why the taxpayer met his burden of proof as to some partnerships but not as to others. While Sznajderman involved similar facts and issues, the ALJ found that the decision was not determinative because of the crucial differences regarding the economic substance of the respective taxpayers’ subscription notes for their investments.

It is interesting that while it appears that the Department and the IRS cooperated on their audits of the oil and gas partnerships, and the IRS did not propose any adjustments, the ALJ did not reference that fact in the ALJ’s conclusion.

Both this decision and the decision in Matter of Steuben Delshah, LLC (discussed in the preceding article) illustrate the significant evidentiary hurdles that the New York State and City tax departments must meet in order to disregard the statute of limitations by proving that the taxpayer filed a false or fraudulent return with willful intent to evade tax.