United States: New York ALJ Allows Extended Statute Of Limitations Period On Abusive Tax Avoidance Transaction

A New York Administrative Law Judge (ALJ) of the Division of Tax Appeals applied a six-year statute of limitations to uphold a deficiency because a taxpayer's investment in an oil and gas partnership was determined to be an abusive tax avoidance transaction.1 The ALJ also declined to abate related penalties.

Description of Taxpayer's Transaction at Issue

Due to the unique and speculative nature of the oil and gas industry, the Internal Revenue Code contains specific provisions directed at encouraging individual investment and influencing the competitiveness of small independent producers in the industry. Specifically, Congress enacted a deduction for intangible drilling costs (IDC) with this purpose in mind.2 Intangible drilling costs are treated as current expenses for federal income tax purposes, rather than depreciated over the life of an oil well, because they have no salvage value.

Belle Isle Drilling Company (Belle Isle) was a New York general partnership formed by Richard Siegal in 2001 for the purpose of acquiring, drilling and developing oil and gas wells. The taxpayer, a New York resident and experienced investor, became a general partner in Belle Isle during 2001. Belle Isle's investment proposal indicated that investors could expect an annual cash flow of approximately 10 to 15 percent of the cash funds invested and an income tax deduction equal to 2.5 times out-of-pocket expenses in the first year of business.

The taxpayer purportedly had three objectives for investing in Belle Isle: (i) to diversify his investment portfolio; (ii) to make money on his investment; and (iii) to reap the associated tax benefits. The taxpayer purchased three units in Belle Isle and initially committed $300,000 cash, $200,000 of which was borrowed via an interest-free note from an entity related to Siegal. Furthermore, the taxpayer signed a subscription agreement to purchase the three units for a total of $840,000, including a note at 8 percent interest for the remaining $540,000 due. The notes and interest were duly reflected in Belle Isle's books and records as assets and interest income, respectively, as well as on Schedule K-1 of Belle Isle's federal partnership returns. The note was assigned to SS&T Oil Co., Inc. (SS&T), which was wholly owned by relatives of Siegal, as security of partnership indebtedness, and the taxpayer pledged as collateral a security interest in his share of Belle Isle. Beginning in 2002, the taxpayer received quarterly invoices from SS&T and timely paid the interest due on this obligation.

In addition to the subscription agreement and note, the taxpayer executed a separate collateral agreement with SS&T requiring him to purchase municipal bonds to be utilized towards the repayment of his subscription note upon maturity. Alternatively, the taxpayer could exercise an option to pay the partnership 15 percent of the face value of the subscription note.

Subsequently, the payment and surety provisions of both the subscription note and collateral agreement were modified to reflect assignment by the taxpayer of 60 percent of his distributions from Belle Isle to SS&T for the purpose of purchasing the required municipal bonds. Also included in this modification were provisions that the taxpayer assignment of distributions be increased to 75 percent, but only to commence after the taxpayer had received cash distributions equal to or greater than the money expended on interest to date (i.e., the taxpayer was never in a negative cash position).

The taxpayer understood that the municipal bonds provided collateral for repayment of the subscription note, as well as a turnkey note (described below) issued by Belle Isle for drilling. The arrangements were established to satisfy the taxpayer's ultimate responsibility to repay the principal due. Thus, the taxpayer also entered into an assumption agreement with Belle Isle and SS&T whereby he agreed to assume personal liability for his pro rata share of the turnkey note, limited to the amount of his subscription note obligation.

The primary service provider responsible for Belle Isle's physical operations was the drilling contractor. Typically, drilling contractors are compensated based on one of three types of payment arrangements: day rate basis (agreed upon rate per day), footage basis (agreed upon rate per foot drilled), or turnkey basis (fixed fee to the point of production). With a day rate contract, the operator bears all the cost and time risks of the drilling operation. Day rate contracts are usually the least expensive if the drilling operation is efficiently managed. Turnkey drilling contracts, which were utilized by Belle Isle, provide risk mitigation for operators and push the cost and time risks to the contractor.

Belle Isle entered into a turnkey drilling contract with SS&T to minimize the risks and expenses associated with its drilling operations. The fee established for this turnkey contract included reimbursement to SS&T at a rate of approximately 500 percent of the cost of a day rate contract. Standard industry markup on a turnkey contract is 10-25 percent more than the cost of a day rate contract.3

New York Tax Posture and Response from Division

The taxpayer timely filed a New York resident personal income tax return for 2001 pursuant to extension on June 19, 2002. Included in this return were income and deductions related to his investment in Belle Isle. Belle Isle included significant IDC in its 2001 return, which were reflected in the taxpayer's deductions on his federal and New York income tax returns. For years 2002 through 2011, Belle Isle made quarterly cash distributions to the taxpayer and its other investors and realized significant income.

In 2006, the New York Division of Taxation's desk audit unit identified two questionable New York State audit cases involving IDC. Further investigation of the preparer of these returns led to the discovery of multiple oil and gas partnerships, including Belle Isle, with similar deductions. Between 2007 and 2008, the desk audit shelter unit of the Division, Division field auditors and the Internal Revenue Service (IRS) cooperated on audits of these partnerships. The shelter unit concluded that the transaction engaged in by Belle Isle constituted an abusive tax avoidance transaction.

As a result of this determination, the Division issued a notice of deficiency to the taxpayer based on disallowance of all deductions related to his investment in Belle Isle on March 14, 2008, nearly six years after the taxpayer had filed his New York return. The notice included personal income tax due as well as associated penalties. The taxpayer timely protested the notice and filed an election to participate in the New York tax shelter voluntary compliance initiative for tax year 2001, electing to retain the right to file for refund any amounts paid. Subsequently, the Division reduced the deficiency to reflect this filing and to allow Belle Isle-associated deductions up to the amount of the cash portion of the taxpayer's investment, disallowing only those exceeding the taxpayer's $300,000 cash commitment.

The taxpayer paid the adjusted amounts assessed, then filed an amended personal income tax return for 2001, which constituted a valid claim for refund. Upon the Division's denial of the refund claim, the taxpayer filed a petition in the Division of Tax Appeals seeking the refund. The taxpayer's motion for summary determination on the petition was denied in a written opinion.4 A full hearing was requested to determine whether the Division's notice of deficiency was barred because it was issued more than three years after the taxpayer filed the return, and if not, whether reasonable cause had been demonstrated to allow for abatement of penalties.5

Ruling on Abusive Tax Avoidance Transaction Treatment

Under New York law, while the general statute of limitations is three years,6 tax may be assessed at any time within six years after the return is filed if the deficiency is attributable to an abusive tax avoidance transaction.7 Therefore, a determination of whether the taxpayer's transaction constituted an abusive tax avoidance transaction was crucial, as the Division's notice was issued immediately before the expiration of the six-year period. The taxpayer believed the six-year statute of limitations8 applied by the Division was inapplicable because he did not believe his investment in the Belle Isle partnership was an abusive tax avoidance transaction. Specifically, the taxpayer claimed that tax avoidance was not a principal purpose for investing in the partnership, the debt was genuine under the applicable law, the Division allowed his cash investment as deductible IDC, and the investment and partnership transactions had economic substance and significant nontax purposes.

In its decision, the ALJ cited applicable law, noting the New York statutory and regulatory definitions of abusive tax avoidance transaction,9 reportable transaction,10 and listed transaction.11 The burden of proof with respect to whether the transaction at issue was considered an abusive tax avoidance transaction rested solely with the taxpayer.12 The ALJ identified as necessary proof of this fact not just the creation of a valid partnership, but also economic substance apart from the tax benefits, which it noted would "not be concluded if the transaction was based on nongenuine debt or if any key part of the transaction was not reasonable, such as that the IDC deductions generated were also not reasonable."

The ALJ determined that the structure of the particular transaction at issue in this case was virtually identical to a structure examined by the IRS to determine whether genuine debt was created.13 The case involved another oil and gas partnership owned by Siegal in which an investor engaged in a transactional structure identical to the investment made by the taxpayer in Belle Isle. However, unlike the taxpayer, that investor failed to make payments on the subscription note and also failed to make scheduled interest payments. In that instance, the IRS accepted the debt as genuine. Substantially relying upon that case, the ALJ found that the investment transaction created genuine debt, initially supporting the taxpayers' claim that the investment was not an abusive tax avoidance transaction.

Despite this taxpayer-favorable determination, the ALJ continued to scrutinize the taxpayer's transaction to decide whether the terms of the turnkey contract were reasonable, such that the IDCs generated were not abusive. The ALJ looked to a Second Circuit Court of Appeals case which focused on examining the validity of IDC deductions for federal income tax purposes. The Second Circuit determined in that case that it was the burden of taxpayers to prove the reasonableness of the deductions,14 so the ALJ found that the terms of the turnkey contract must be considered. Even allowing for the value of overhead costs, profit margin and insulation from risk, the turnkey price was established to be exorbitant. Notably, the ALJ stated that the "absence of arm's-length negotiations coupled with a complete lack of transparency fueled the strong incentive to overstate the drilling costs to maximize the IDC and made it impossible to find the turnkey price reasonable." Interestingly, the ALJ mentioned the absence of original signed copies of the agreements at issue, which required the ALJ to come to a separate determination that such agreements actually had been executed.

As the taxpayer failed to meet his burden of proof as to the reasonableness of the turnkey contract, the ALJ determined that the taxpayer failed to demonstrate that the investment was not an abusive tax avoidance transaction, concluding that the transaction had no economic substance apart from the tax benefits conferred. The Division's allowance of the deduction for a portion of the IDC to the extent of the taxpayer's cash contribution was found to be irrelevant to the decision.

Penalty Abatement

The ALJ also found the penalties assessed by the Division for negligence and substantial understatement of tax, as well as penalties asserted and paid by the taxpayer under the New York voluntary compliance initiative to be appropriate. Referencing the taxpayer's business expertise, the ALJ found that the taxpayer knew, or should have known, that the generous terms of the turnkey agreement were not made at arm's length and warranted further investigation.


Cases involving potential and actual abusive tax avoidance transactions are typically interesting, and this matter, which is one of the first decisions to comprehensively analyze and interpret the New York abusive tax avoidance transaction provisions, is no exception. Curious facts critical to the final decision include the absence of original signed and executed legal documents relevant to the transaction at issue and the unreasonable price agreed upon for the turnkey contract between entities owned by related individuals.

Taxpayers engaged in any transactions between related parties, which are often subject to a higher level of scrutiny by taxing authorities than transactions between third parties, should have a heightened awareness of the related risks. The fact that the taxpayer in this instance (an intelligent, experienced investor as evidenced by the record) made a knowledgeable decision to engage in the transactions at issue seems to have contributed to the ALJ's decision to refuse abatement of penalties. There is a clear expectation by the Division, and now the Division of Tax Appeals, that savvy investors must perform adequate due diligence prior to engaging in any transactions, especially those including tax minimization as an expected benefit. The question left unresolved in this decision is how much due diligence is necessary to be performed with respect to a particular transaction to prevent the abusive tax avoidance transaction tag in New York.

This decision should further encourage taxpayers to be fully aware of the potential risks and rewards associated with any investment prior to entering into a transaction, including state tax ramifications. Likewise, the decision is instructive in the manner in which one can expect the Division of Tax Appeals to interpret abusive tax avoidance transaction matters.


1 In the Matter of the Petition of Marc S. Sznajderman and Jeannette Sznajderman, New York State Div. of Tax Appeals, ALJ, No. 824235, Mar. 6, 2014.

2 IRC § 263(c); TREAS. REG. § 1.612-4[a]. Intangible drilling expenses are defined as payments for nonsalvageable capital expenditures incurred in connection with oil and gas drilling.

3 Based upon testimony by the Division's expert petroleum engineer. The specific terms and conditions of the contract between Belle Isle and SS&T were noted in the ALJ determination.

4 Matter of Marc S. Sznajderman and Jeannette Sznajderman, New York State Div. of Tax App., DTA No. 824235, Apr. 12, 2012.

5 Penalties were asserted by the Division of Taxation in this case pursuant to N.Y. TAX LAW § 685(b)(1), (2); (p), and pursuant to Laws of 2005, Part N, Section 11(1) for failure to participate in the Voluntary Compliance Initiative available for participants in abusive tax shelters.

6 N.Y. TAX LAW § 683(a).

7 N.Y. TAX LAW § 683(c)(11)(B).

8 Id.

9 N.Y. TAX LAW § 683(c)(11)(B) defines abusive tax transaction as "a plan or arrangement devised for the principal purpose of avoiding tax. Abusive tax avoidance transactions include, but are not limited to, listed transactions ... ."

10 N.Y. TAX LAW § 685(p-1)(5) refers to the definitions of reportable transaction and listed transaction provided in N.Y. TAX LAW § 25. A New York reportable transaction is a transaction that has the potential to be a tax avoidance transaction as determined by the Commissioner and may be prescribed by regulation. The Commissioner has the authority to designate specific transactions that are the same as, or substantially similar to, transactions the Commissioner has determined to be tax avoidance transactions. Further, N.Y. COMP. CODES R. & REGS. tit. 20, § 2500.3(a) includes a definition of a New York reportable transaction.

11 N.Y. COMP. CODES R. & REGS. tit. 20, § 2500.3(b); TSM-05(2)(C); TSB-M-05(4)I.

12 Citing Matter of Sholly, N.Y. Tax Appeals Tribunal, DTA Nos. 801151 and 801152, Jan. 11, 1990. 13 Zeluck v. Comm'r. of Internal Revenue, 103 TCM 1537 (2012). The decision was based in part upon a test for genuine indebtedness garnered from Welch v. Commissioner, 204 F.3d 1228 (9th Cir. 2000).

14 Bernuth v. Comm'r., 470 F.2d 710 (2nd. Cir. 1972).

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