New York State Tax Department Again Tries to Tackle Federal Issues

During the past several years, we have seen a continuing trend in New York personal income tax audits involving the examination of federal tax issues. The New York State Tax Department, overall, has one of the more sophisticated and aggressive personal income tax audit groups in the country. For years, as I have outlined in numerous blogs and articles, the Tax Department’s residency audit program has been second to none. But as we have seen, the Tax Department focuses more on flow-through entity issues. We also have seen the expansion of an interesting phenomenon: federal tax audits being conducted by New York tax auditors.

As I have often found in practice, these “federal tax audits” can be very difficult, in large part because New York tax auditors are generally not trained on federal tax issues. Thus, often when these issues arise, the questions and conclusions we hear from the auditors often are inconsistent with the general application of federal tax rules. Some of these issues came to a head in a Matter of Steve and Linda Horn, a recent decision issued our of New York’s Tax Appeals Tribunal case. The issue in that case was whether or not the taxpayers’ S corporation was engaged in for-profit businesses, thus allowing deductions for claimed losses against their New York taxable income. The taxpayers were successful both at the administrative law judge level and then at the Tribunal level. And the analysis of the 58‑page decision is fairly interesting, since it reads more like a federal tax case than a New York tax case. Overall, the taxpayer was able to establish that under applicable federal tax rules, the S corporation was engaged in appropriate for-profit activities and therefore all losses were allowed.

A couple of comments:

First, this certainly requires practitioners to develop a different skill set, if they do not already have it. Thankfully, though my practice is almost exclusively based on state and local issues, I am able to lean on my federal tax counterparts in the firm for assistance when these issues arise. I often find this gives us an advantage over the New York auditors who are usually only trained in New York taxes. This can be frustrating sometimes too, since we do not believe that the New York auditors are often on the right track on these federal tax issues. The Horn case could be a good example of that, where the right federal tax analysis prevailed.

Another interesting issue arises, however, if it turns out the Tax Department is correct. Does that mean the taxpayer has to immediately report the changes to the federal government? The answer, quite simply, is no. There is no “upstream” reporting of New York tax changes to the federal government. We are told that the Tax Department reports such changes to the IRS, but in practice we rarely, if ever, see the IRS following up on New York adjustments. So that is something to keep in mind as well.

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