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Division of Tax Appeals

State of New York

*1 IN THE MATTER OF THE PETITION OF ROBERT AND NAOMI REINER

for Redetermination of a Deficiency or for Refund of New York State and New

York City Personal Income Taxes under Article 22 of the Tax Law and the New

York City Administrative Code for the Year 1997

DTA No. 820266

July 13, 2006

CONCLUSIONS OF LAW

A. Petitioners, Robert and Naomi Reiner, were residents of New York for a portion of the year 1997, specifically until September 12, 1997, and thereafter were nonresidents of New York. With regard to such part-year residents, Tax Law § 601(e) imposes New York personal income tax to the extent that an individual's taxable income for the period of nonresidence is derived from or connected with New York sources. For the year in issue, 1997, New York's taxation of the Reiner's income was governed specifically by Tax Law § 638(a), pursuant to which part-year residents such as the Reiners were required to split their tax year into a resident period and a nonresident period. Section 638(a) provides that the New York source income of a part-year resident shall be the sum of the taxpayer's:

(1) New York adjusted gross income for the period of residence, determined in accordance with Part II of [Article 22] as if the taxpayer's taxable year for federal income tax purposes were limited to the period of residence, and

*6 (2) New York source income for the period of nonresidence, determined in accordance with section six hundred thirty-one as if the taxpayer's taxable year for federal income tax purposes were limited to the period of nonresidence.

Neither Tax Law § 638, nor any other New York statutory provision instructed part-year residents as to how to allocate specific items of income including, as is relevant here, income from S corporations, between the resident and the nonresident periods. Rather, guidance was provided by the Division's regulations.

B. Prior to 1987, Tax Law former § 654 governed the taxation of part-year residents. The relevant regulation then in effect with regard to the allocation of specific items of income was 20 NYCRR former 148.6. This regulation provided a "year-end" rule whereby items of partnership income, gain, loss and deduction were to be allocated according to the taxpayer's resident status on the last day of the partnership's tax year, as opposed to an allocation based on either the particular date of the receipt or expenditure of each item or on the annual amounts of such items distributed on a proportionate basis. In 1986, the Court of Appeals issued its decision in McNulty v. State Tax Commn. (70 NY2d 788, 522 NYS2d 103), in which the Court invalidated 20 NYCRR former 148.6 because it was inconsistent with the Legislature's preference for a proration under Tax Law former § 654. Thus, the Court in McNulty held that Tax Law former

§ 654 required taxpayers to utilize a "prorate" rule, so as to allocate their items of partnership distribution based on a proration of such items across the taxpayer's resident and nonresident periods "in a manner that either reflects the actual date of receipt or expenditure or encompasses an annual amount distributed on a proportionate basis." (McNulty v. State Tax Commn., supra., 70 NY2d at 791, 522 NYS2d at 104.) In response to the decision in McNulty, the Division began retroactively applying the prorate rule in its audits, including those involving tax years prior to the issuance of the Court's decision.

C. The Legislature made significant substantive changes to the Tax Law in 1987 with passage of the Tax Reform and Reduction Act of 1987 (chapter 28 of the Laws of 1987). Included within this Act was the repeal of Tax Law former § 654, and the enactment of a new Tax Law § 638 to address part-year resident taxation (L 1987, ch 28, § 28; see, Conclusion of Law "A"). In turn, the Division repealed regulation 20 NYCRR former 148.6, which had provided a year-end based allocation rule but, as above, had been held invalid under Tax Law § 654 by the Court in McNulty. At the same time, the Division enacted another regulation, to wit, 20 NYCRR former 154.6 (20 NYCRR 148.6, amendment filed August 30, 1988, eff. September 14, 1988, renum as 20 NYCRR 154.6). This regulation, in reliance upon the change of law concerning part-year residents which occurred with the enactment of Tax Law § 638, reinstituted the year-end allocation rule of 20 NYCRR former 148.6. [FN3] In this regard, the New York State Register for May 16, 1990 provided, in relevant part, as follows:

*7 These amendments reflect a reconsideration of the Court of Appeals decision in McNulty v. State Tax Commission, 70 NY2d 788, in light of legislative changes with regard to the taxation of part-year residents enacted by the Tax Reform and Reduction Act of 1987 (Chapter 28 of the Laws of 1987). Specifically, prior to the Tax Reform and Reduction Act of 1987, where there was a change of residence, two separate returns computing taxable income applicable to the resident and nonresident periods were required, and certain prorations between the two returns were also required. The Court of Appeals decision in McNulty (decided in 1987 and involving the taxpayer's 1979 taxable year) allowed the taxpayer to also prorate such taxpayer's partnership items. Accordingly, section 148.6 of the Personal Income Tax Regulations was amended to take into account the McNulty decision and provided that where a partner changes resident status during the taxable year, the distributive share of partnership items attributable to such partner are to be prorated between the resident and nonresident periods with the portion of such item prorated to the nonresident period being limited to the extent such items are derived from or connected with New York State sources. Such amendments also included the provisions relating to shareholders of S corporations.

With the enactment of the Tax Reform and Reduction Act of 1987, where there is a change of residence, a single return for the taxable year is required, thus obviating prorations between returns. Therefore, where there is a change of residence, the amount of partnership items to be included in the numerator of the New York source fraction under section 601(e) of the Tax Law should be determined according to the status of the taxpayer as a resident or a nonresident at the time the taxable year of the partnership ends. This conforms with the federal principle contained in section 706 of the Internal Revenue Code that partnership items are recognized by a partner at the time the partnership taxable year ends.

D. The validity of the year-end rule espoused in 20 NYCRR former 154.6 was challenged by Robert Greig, a partner in an international law firm who had moved into New York in the middle of 1992. On his 1992 tax return, Mr. Greig applied the prorate rule rather than the year-end rule then in force under 20 NYCRR former 154.6 to determine the portion of his 1992 partnership income subject to New York taxation. On audit, the Division assessed additional tax, interest and penalties against Mr. Greig based upon his failure to allocate according to the year-end rule of 20 NYCRR former 154.6. On appeal, the Division argued that the prorate rule set forth by the Court of Appeals in McNulty was no longer applicable because of the repeal of Tax Law former § 654. However, the Tax Appeals Tribunal disagreed, citing to McNulty, and held that 20 NYCRR former 154.6 and its year-end rule was invalid, and that the partnership income should be allocated pursuant to the prorate rule (Matter of Greig, Tax Appeals Tribunal, September 16, 1999). Following the Tribunal's decision in Greig, the Division issued a Technical Services Bureau Memorandum (TSB-M-00[1]I), dated February 23, 2000, announcing that part-year resident partners and shareholders of New York S corporations would be required to use the prorate rule in calculating tax on flow-through income, and also stated that "[t]he rules discussed in this memorandum are effective for tax years beginning in 1999 and thereafter. They also apply to any prior tax year for which the statute of limitations is still open." It is upon the Tribunal's Greig decision and the noted memorandum that the Division employed the prorate rule in its redetermination of petitioners' tax liability for the year 1997.

*8 E. Petitioners do not argue that the Division is precluded from correcting its prior mistakes, and thus can never apply the prorate rule, retroactively. In fact, the Division's retroactive application of the prorate rule initially determined to be appropriate in McNulty, and again upheld as appropriate in Greig notwithstanding the change in the law and the Division's specific enactment of a new regulation reinstituting the year-end rule in light of such change of law, has been specifically upheld in Matter of Wertheimer (Tax Appeals Tribunal, March 14, 1996) and in Montgomerie v. Tax Appeals Tribunal (291 AD2d 129, 740 NYS2d 141). Petitioners, however, distinguish their situation from the Wertheimer and Montgomerie cases by the absence of any claim or evidence that the taxpayers in those cases engaged in any particular actions in reliance upon the Division's regulation, but rather simply filed their tax returns based on their respective situations after having physically moved into New York (as in Wertheimer) or out of New York (as in Montgomerie). Accordingly, rather than focusing the dispute on the general propriety of retroactively applying the prorate rule, petitioners argue most directly that under the particular circumstances of this case, wherein they specifically relied to their detriment upon the regulation at 20 NYCRR former 154.6 and its mandated use of the year-end rule, the Division should be estopped from applying the prorate rule.

F. As a general proposition, unless there are exceptional facts which require its application to avoid a manifest injustice, the doctrine of estoppel does not apply to governmental acts (Matter of Consolidated Rail Corp., Tax Appeals Tribunal, August 24, 1995, confirmed 231 AD2d 140, 660 NYS2d 549, appeal dismissed 91 NY2d 848, 667 NYS2d 683; Matter of Harry's Exxon Service Station, Tax Appeals Tribunal, December 6, 1988). This proposition is considered especially strong where a taxing authority is involved, since public policy supports the enforcement of the Tax Law (Matter of Glover Bottled Gas Corp., Tax Appeals Tribunal, September 27, 1990). The Tax Appeals Tribunal has developed a three-part test in order to determine whether to invoke an estoppel, to wit, (i) whether there was a right to rely on a representation made by the Division, (ii) whether there was such reliance and (iii) whether the reliance was to the detriment of the party who relied upon the representation (see, Matter of Consolidated Rail Corp., supra.; Matter of Harry's Exxon Service Station, supra).

G. Several matters relevant to this case are not in dispute. First, the Division admits that taxpayers are entitled to rely upon the written guidance of the Division in matters of tax planning and in the filing of their returns (see, e.g., Matter of Bolkema Fuel Co., Inc., Tax Appeals Tribunal, March 4, 1993). This is, of course, especially true when such written guidance is in the form of a regulation specifically adopted to address the circumstances of taxpayers such as petitioners who were part-year residents of New York. Second, the Division admits that petitioners in fact relied upon the Division's regulation in forming and carrying out their course of conduct. That is, petitioners tailored their conduct as to the point in time they chose to abandon their New York domicile and move to Florida so as to achieve a particular tax result in clear reliance on the Division's regulation at 20 NYCRR former 154.6. In this regard, a review of the record provides detailed proof that petitioners had extensive discussions with their tax and legal advisors, were explicitly advised of the Division's regulation and its implications on their tax liability for the year in issue, and made their decision as to when to move on the basis of this information and guidance. There is no dispute that petitioners could, and would, have moved at any prior point in time necessary to effectuate the result they sought, and the fact that they did not move at an earlier point in time was due to the clear advice they received in reliance upon the Division's regulation (see, Findings of Fact "11" and "12"). Given that the relevant regulation (20 NYCRR former 154.6) was specifically adopted by the Division to "resurrect" and reinstitute the year-end rule (see, Conclusion of Law "C"), and that petitioner's tax accountant had prior audit experience wherein the use of the year-end rule was specifically examined and "passed muster" on audit (see, Finding of Fact "10"), it is not surprising that petitioners received advice that they could take the steps they took to achieve the tax planning result they sought, or that such advice could be given by their advisors with confidence. [FN4] Petitioner's tax accountant tellingly offered his view that his failure to have advised his clients of the potential tax planning advantage available by tailoring a course of conduct to come within the explicit terms of a regulation might be considered malpractice. It is also significant to note that the Division imposed penalties in enforcing the year-end rule set forth in 20 NYCRR former 154.6 on audit against a taxpayer who chose not to follow the regulation and instead utilized the prorate rule (Matter of Greig, supra.) In contrast, petitioners clearly undertook their course of action in the timing of their move out of New York in direct reliance upon the Division's regulation then in effect, and thereafter filed their tax return in compliance with such regulation.

*9 H. In view of the foregoing, petitioners have established both a right to rely, as well as actual reliance, upon the Division's regulation. Thus, this case devolves to the third element necessary to determine whether to invoke an estoppel, to wit, whether petitioner's reliance upon the Division's representation (regulation) was to their detriment. In turn, under the unique facts and circumstances of this case, it is clear that petitioners' reliance was to their detriment. Accordingly, all three necessary elements of an estoppel are present and it is appropriate to grant such remedy. Petitioners directly, specifically and consequentially structured their course of conduct in reliance upon the Division's published guidance. Without such reliance, petitioners would not have suffered the fiscal detriment they now face, but rather could, and clearly would, have avoided the same by the simple expedient of altering their course of conduct and moving out of New York at an earlier point in time. This was a choice which petitioners clearly were aware of and possessed the wherewithal and willingness to accomplish, if the same had been presented as necessary. Instead, however, petitioners asked and were specifically advised that, under the regulation, they could move at any point in time up to September 29, 1997 (see, Findings of Fact "9", "11" and "12").

In the Wertheimer, Greig, and Montgomerie cases, there was no evidence or even any claim that the conduct or timing of the taxpayers in making their respective moves was undertaken in reliance on the regulation. Here, in stark contrast, petitioners have claimed, and supported by direct evidence, that they sought specific advice, relied reasonably thereon and acted accordingly by postponing or delaying their move, the result of which was that they incurred a tax liability which was entirely avoidable. While it is true that the fiscal measure of petitioners' detriment is simply increased tax liability, it is also clear that there is no specific quantity or dollar amount of detriment which must be suffered by a taxpayer in order for an estoppel to be invoked and to apply (see, Matter of Consolidated Rail Corporation, supra.; Matter of Harry's Exxon Service Station, supra.) That is, the size of the deficiency is not necessarily determinative in order to qualify for estoppel. Thus, the Division's allegation that petitioners will not be "plunged into bankruptcy or suffer any severe hardship much less interfere with the standard of living that they are accustomed to if the deficiency is sustained" is not only unsupported by any facts but is largely irrelevant to the determination of whether an estoppel should be invoked. In this case, an increased personal income tax liability of nearly a quarter of a million dollars, which was avoidable but for petitioners' reliance, is obviously sufficient fiscal detriment to support estoppel.

I. The Division asserts that the prorate rule set forth in Greig must be applied retroactively and that estoppel may not be invoked in this case because such remedy is not available to correct a mistake of law. Thus, the Division maintains that it is essentially "forced" to apply the prorate rule and that the deficiency must simply be sustained. Petitioner, as noted earlier, has focused his argument most directly on the appropriateness of invoking estoppel under the specific facts of this case (see, Conclusion of Law "E"). At the same time, however, petitioner does challenge the Division's positions that estoppel may not be applied to correct an error of law, and that the Division must apply the prorate rule against petitioner retroactively, per Greig. In this regard, petitioner asserts that retroactive application of a decisional change in the law is not mandated in all cases, especially where the decisional change establishes "a new principle of law, either by overruling clear past precedent on which litigants may have relied or by deciding an issue of first impression whose resolution was not clearly foreshadowed," citing Chevron Oil Co. v. Hudson (404 US 97,106) and Matter of NewChannels Corp. (Tax Appeals Tribunal, September 23, 1993). Petitioner notes in this context that each of the prior cases addressing the year-end versus prorate allocation issue (i.e., McNulty, Wertheimer, Greig and Montgomerie) involved part-year resident partners and their items of partnership income, gain, loss and deduction, whereas the instant matter involves a part-year resident shareholder in an S corporation. Thus, petitioner posits that since the issue of retroactive application of the prorate rule has never before been addressed judicially in the specific context of an S corporation and its shareholder, the issue is one of first impression and militates in favor of prospective application (see, Chevron Oil Co. v. Hudson, supra.; Matter of NewChannels Corp., supra.)

*10 J. With regard to the basic question of whether estoppel is an available remedy in this case, it is particularly noteworthy that the Tribunal stated in Wertheimer, that "petitioners would have a stronger equitable argument if they could identify specific actions they took in reliance on [the year-end rule] which now work to their detriment under the retroactive application of McNulty [and its prorate rule]." This statement clearly indicates that estoppel would be an available and appropriate remedy in a proper case, to wit, where the evidence establishes that there was reliance upon a regulation in choosing and following a specific course of action with resulting detriment. The fact that this statement was made by the Tribunal in a case directly involving the same prorate versus year-end rule question as is at issue herein, clearly supports the proposition that estoppel may be applied in this matter, undermines the Division's argument that estoppel can never be available and applied to correct a mistake of law, and that the Division is thus simply "forced" under Greig to apply the prorate rule against petitioners (Matter of Wertheimer, supra.; Matter of Bolkema Fuel Co., Inc., supra., citing Schuster v. Commissioner, 312 F2d 311, 317 [we regard this proposition (that estoppel is generally inapplicable to correct a mistake of law) as one of general application, not as embracing the concept that the Commissioner might always (retroactively) correct a legal mistake regardless of the injustice which will result]). In fact, and of particular note, since no penalties were asserted in Wertheimer, it follows that the only "equitable argument" the Tribunal was addressing would concern an estoppel against retroactively applying the prorate rule based upon the taxpayer's reliance in undertaking specific actions. As described, the evidence in Wertheimer did not support any such "specific actions" undertaken in "reliance on" the Division's regulation. Here, however, the evidence does show that specific actions were undertaken in reliance, and thus estoppel is appropriate.

Turning to petitioner's "new principle of law" argument, it is true that the prior cases cited by petitioner dealt with partners and partnerships rather than S corporations and their shareholders. However, the impact of petitioners' argument is lessened by the substantial similarities in the manner in which partners of partnerships and shareholders of S corporations are taxed on their distributive or flow-through items of income, loss, gain and deduction. In this regard, petitioner has not specified or identified any particular distinctions between the two situations (partners versus S corporation shareholders) which might have a determining impact on the subject allocation method issue. Indeed, the regulation at 20 NYCRR former 154.6 as well as the Division's Technical Services Bureau Memorandum (TSB-M-00[1]I) essentially provide for the allocation rule applicable to a part-year resident partner to be likewise applicable to a part-year resident S corporation shareholder (see, 20 NYCRR former 154.6[a][3][i]; 154.6[b][1]; TSB-M-00[1]I). At least by implication, then, while Greig spoke directly to the regulation's impact on the allocation of a part-year resident partner's income, it can also reasonably be expected that the analysis and result would apply to a part-year resident S corporation shareholder's income so as to treat the two in identical fashion for allocation purposes.

*11 K. In sum, the evidence in this case specifically demonstrates and supports the fact that petitioners were aware of the need to move in order to minimize the tax impact of the SQP sale, had the ability and willingness to move at any time, and fashioned their course of conduct to achieve their desired result in direct reliance on the Division's regulation. Given the clarity of petitioner's focus in the sale of SQP on his "bottom line" result, and the direct impact of the tax at issue thereon, it is abundantly clear that, but for such reliance on the regulation, petitioners could and would have made their move out of New York at a different time, i.e., prior to 1997, so as to achieve the result they sought in mitigation of the tax impact of the sale of SQP. This is a simple matter of legitimate tax planning that petitioners were unquestionably permitted to pursue, but are being effectively deprived of after the fact under the imposition of the tax deficiency herein asserted against them (see, Matter of Consolidated Rail Corporation, supra.) Simply put, petitioners' reasonable and specific reliance upon the Division's regulation in choosing the time of their move out of New York gave rise to the detriment of the unexpected and entirely avoidable economic impact of the deficiency they are now being asked to pay. Petitioners structured their course of conduct to arrive at the selling price and after-tax "take" from the SQP sale bearing in mind that this would form the basis for their retirement income (see, Finding of Fact "7"). This is far different than simply effecting a course of conduct and thereafter filing a tax return and applying a rule which arrives (at least initially) at a fortuitous tax result, as in Wertheimer and Montgomerie, or by effecting a course of conduct and then choosing not to apply the existing rule but rather to challenge the same by filing in a manner inconsistent with such rule, as in Greig. Petitioners have established that they did, in fact, act in reasonable and specific reliance upon the Division's written guidance to their detriment. Accordingly, the Division is estopped from applying the prorate rule against petitioners and the deficiency in question based thereon must be cancelled.

L. The petition of Robert and Naomi Reiner is hereby granted and the Notice of Deficiency dated September 25, 2003 is cancelled.