In re Reiner: Estoppel Conquers All

In a recent New York State Division of Tax Appeals decision, the court held that when a taxpayer reasonably relies on the published, written guidance of the Division of Taxation (Division), the Division will be estopped from retroactively changing the rules in a way that will cause an avoidable, detrimental effect on the taxpayer; see In the Matter of the Petition of Robert and Naomi Reiner, State of New York Division of Tax Appeals, Administrative Law Judge Unit, DTA No. 820266 (7/13/06).

Facts

In 1996, the taxpayers (a husband and wife who filed jointly), New York state residents, owned and operated a business located in Pennsylvania that engaged in the manufacture and sale of household cleaning products. The business was taxable as an S corporation for both Federal and New York purposes. It reported taxes on an October 1–September 30 fiscal year.

In 1996, the taxpayers reached an agreement to sell substantially all of the business’s assets to a third party. Prior to the sale, and throughout the due-diligence process, the taxpayers were intently focused on the specific dollar amount they would receive from the sale after satisfying all outstanding obligations and taxes. The taxpayers were aware that as S shareholders, items of income, gain, loss and deduction would pass through to them and be included in their personal income tax return. The taxpayers’ position was clear from the beginning that if the after-tax numbers did not reach an acceptable level, the sale would not occur.

Rules: In reaching its decision, the court discussed the possible application of two distinct rules: the “year-end” rule and the “prorate” rule. Under the former, income items of a part-year resident shareholder will be sourced to New York if the shareholder resides there on the last day of the entity’s fiscal year. Alternatively, under the prorate rule, a shareholder’s residency status on the last day of the entity’s fiscal year is irrelevant. The determining factor is the number of days the shareholder is a resident during the year in which the change of residency occurs. The taxpayers’ accountant advised them that the year-end rule would apply to them. This advice was supported by both regulations and court cases in effect at the time. Further, the taxpayers’ accountant had past experience dealing with the issue that supported this advice.

 The taxpayers, in accordance with this advice, and to ensure that the income items would not be sourced to New York, planned to and did relocate out of New York about 15 days before the last day of the entity’s fiscal year.

In December 2000, more than three years after the taxpayers moved out of New York, the year-end rule was repealed by the Greig decision. (In the Matter of the Petition of Robert T. and Susan M. Greig, New York Division of Tax Appeals, Administrative Law Judge Unit, DTA No. 815529 (7/30/98).) The Division audited the taxpayers’ 1997 return and retroactively applied the prorate rule, then issued a deficiency notice asserting additional personal income tax due of approximately $250,000, plus interest.

A Victory for Sound Tax Planning

The court vacated the Division’s decision and cancelled the deficiency notice, based primarily on the well-worn doctrine of estoppel. Under this doctrine, the Division can be estopped from retroactively changing a rule when the (1) taxpayer had a right to rely on the Division’s representation; (2) taxpayer relied on the representation; and (3) reliance had a detrimental effect on the taxpayer. Here, taxpayers clearly had a right to rely on the Division’s representation; they relied on the plain language of a regulation (20 NYCRR 154.6) specifically adopted to address the circumstances of taxpayers who were part-year New York residents. Further, the taxpayers relied “in fact” on the Division’s representation, by (1) having both the intent and ability to avoid New York sourcing under either rule and (2) moving in time to avoid New York sourcing under the year-end rule, which was clearly in effect at the time. Finally, the taxpayers were clearly detrimentally affected by their reliance, because they received a deficiency notice. Having met the test for the application of the doctrine of estoppel, the court cancelled the deficiency notice and determined that the Division should be estopped from retroactively applying the prorate rule.

Conclusion

This decision should not be interpreted broadly. The court took great pains to describe the decision as being narrowly tailored to the facts presented. There are three indications of the limited scope of the court’s decision. First, the court stated the retroactive application of a tax law change is clearly allowed; see In the Matter of the Petition of Alain E. and Brigitte Wertheimer, New York Tax Appeals Tribunal, DTA No. 808770 (1/12/95). Second, as discussed in Reiner, the estoppel doctrine is rarely, if ever, applied to government action. Finally, the taxpayers prospectively tailored their actions in accordance with what they thought to be settled law at the time.

As it stands, the Division may request a review of this decision by the Tax Appeals Tribunal. However, for the time being, it stands as a small victory for well-thought-out and timely New York tax planning.

From Kirk Sinclair, J.D., Holtz Rubenstein Reminick LLP, Long Island, NY