Many years ago, New York revised its personal income tax law to achieve close conformity with the Federal system of income taxation. The stated purpose for the revision was to simplify tax return preparation, improve compliance and enforcement, and aid in the interpretation of tax law provisions.[i] In furtherance of this policy of conformity, as the Code is amended by Congress, New York automatically adopts the Federal changes.[ii]
However, New York’s Tax Law does not conform to the Code in all respects. Indeed, there are a number of instances in which New York has chosen to “decouple” from specific provisions or amendments of the Code.[iii]
The most significant example of New York’s conformity to the Code is found in the state’s computation of a New York taxpayer’s state income tax liability; this begins with the taxpayer’s Federal adjusted gross income,[iv] which is then modified by certain New York “additions” and “subtractions”[v] – basically, items for which New York has decided that a different tax treatment is appropriate for its own purposes.
In general, a taxpayer’s adjusted gross income is determined by reducing their gross income by certain deductions attributable to the taxpayer’s trade or business, deductions attributable to the production of rental income, and losses from the sale or exchange of certain property.[vi]
A corollary to the conformity principle requires that any changes to the taxpayer’s Federal adjusted gross income[vii] be accounted for in re-determining the taxpayer’s New York income tax liability.
According to New York’s Tax Law, if the amount of a taxpayer’s Federal taxable income is changed by the IRS – for example, as the result of an audit – the taxpayer must report such change within ninety days after the “final determination” of such change, and must concede the accuracy of such determination.[viii]
If the taxpayer fails to comply with this reporting requirement, then the New York income tax liability resulting from the Federal adjustment may be assessed at any time the state learns of it – the applicable statute of limitations on the assessment of a deficiency is tolled.[ix]
Based on the foregoing, wouldn’t it behoove New York to wait for the IRS to examine a taxpayer’s Federal income tax return, and then assess any resulting deficiency in New York income tax? After all, most of the substantive tax issues presented in a New York income tax return arise under the Code – Federal tax law – as a result of New York’s application of the conformity principle, described above.
Over the last few years, however, it appears that New York has relaxed its “wait-and-see-what-the-IRS-finds” attitude. Instead of piggybacking onto the IRS’s efforts, New York has been initiating the audit of many taxpayers’ income tax returns and, in the process, has been examining the Federal tax issues presented in those returns with the goal of collecting more New York income taxes.[x] After all, the IRS doesn’t examine every return, even when a return is worth at least a second look. Why shouldn’t New York help itself?
If, as many economists are expecting, New York encounters a shortfall in revenues as a result of our continuing economic challenges, the state will seek to bolster its revenues by increasing its audit activity of taxpayers, not only in the realm of taxes that are traditionally imposed and administered at the state level (for example, sales and use taxes) but also income taxes that are based upon taxable income as determined for Federal tax purposes.
The state’s foray into this territory will likely not be limited to the adjustments to Federal taxable income that are required under state law. Instead, it likely will include the examination of those items of taxpayer income, gain, deduction, and loss that are reported on the taxpayer’s Federal tax return; in other words, the base to which any unique state adjustments are then made.
The fact that New York has generally conformed to the Federal tax law will not necessarily facilitate the state’s efforts of the Department to assess and collect more income tax, let alone turn its representatives into Federal tax experts.[xi]
This exposes the New York taxpayer to the risk of inconsistent conclusions being drawn by the IRS, on the one hand, and state tax authorities, on the other.[xii]
That said, there will be plenty of instances in which the state’s application of Federal tax law should not raise serious concerns, as was borne out by a recent decision of the Division of Tax Appeals.[xiii]
Passive Activity Loss
For the taxable year in question, Taxpayer claimed a deduction for losses from rental real estate activities, which reduced their nonpassive income and both their Federal and state income tax liabilities.
New York audited Taxpayer’s return. During the exam, the state sought to determine whether Taxpayer was entitled to the claimed deduction. It requested information regarding the loss claimed; specifically, the state asked Taxpayer to complete a “Federal Schedule E Rental Real Estate Loss Questionnaire.”
After Taxpayer asserted that they qualified as a “real estate professional” within the meaning of the passive loss rules[xiv] for the year in question, the state requested additional information and documentation, including the following: a description of Taxpayer’s other occupation (for which they received a wage), the number of hours worked in such occupation, the services performed by Taxpayer for the rental properties and the hours attributable thereto, copies of Taxpayer’s appointment books, calendars, and other records to support the performance of these services and the hours dedicated thereto.
Taxpayer provided a narrative description of their rental real estate activities but failed to produce any substantiating documentation.
The state then issued a statement of proposed audit changes in which it denied the loss deduction and explained that the material submitted was not sufficient for the state to determine whether Taxpayer qualified as a real estate professional who had materially participated in the rental activities during the taxable year in question.
Real Estate Professional
Rental activity is usually treated as a per se passive activity regardless of whether the taxpayer materially participates. Material participation is defined as involvement in the operations of the activity that is regular, continuous, and substantial. However, if the taxpayer qualifies as a real estate professional, the taxpayer’s rental real estate activity is treated as a trade or business subject to the material participation requirements.
A taxpayer may qualify as a real estate professional if: (i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. Only time spent in those businesses in which the taxpayer materially participates counts toward the requisite 750 hours.
In response to the proposed audit changes, Taxpayer claimed that, after “reviewing my records, it turns out the time I spent was significantly greater than I originally estimated and stated.” However, no supporting records were submitted.
The state issued a notice of deficiency asserting tax due. When Taxpayer failed to convince the Conciliation Conferee[xv] of the merits of their position, Taxpayer petitioned the Division of Tax Appeals.
After hearing their testimony and reviewing the record, the ALJ determined that Taxpayer failed to meet the burden of proving the number of hours spent in real property trades or businesses in which they claimed to have materially participated. Relying a number of U.S. Tax Court decisions, the ALJ rejected Taxpayer’s sometimes inconsistent testimony as “ballpark guesstimates” and, consequently, denied Taxpayer’s petition and sustained the notice of deficiency.
What’s Next for Taxpayer?
Assuming Taxpayer does not ask the Tax Appeals Tribunal to reverse the ALJ’s decision and, instead, satisfies the asserted tax deficiency (plus interest), may Taxpayer rest assured that no Federal tax deficiency will be asserted for the taxable year in question?
Or can Taxpayer expect the IRS to knock on their door in light of New York’s successful reversal of the loss deductions that were claimed not only on Taxpayer’s state tax return but also on their Federal return?
Instead of waiting for the IRS, will Taxpayer be required to inform the IRS of New York’s determination that they did not qualify under Federal law for the tax benefit claimed on their Federal return? Would Taxpayer’s failure to contact the IRS with respect to this development toll the Federal limitations period on the assessment of additional income tax?[xvi]
Notwithstanding a taxpayer’s obligation to report Federal income tax changes to New York, failing which the state’s limitations period on assessment of a deficiency will be tolled, it appears there is no corresponding requirement for a taxpayer to inform the IRS of a change to the taxpayer’s New York return that would affect their Federal income tax liability, failing which the Federal limitations period on assessment would be tolled.[xvii]
That said, there are intergovernmental programs, such as the State Reverse File Match Initiative, through which state agencies provide tax return information filed with the state directly to the IRS for Federal tax administration purposes,[xviii] and the Agreement on Coordination of Tax Administration, which provides for the mutual exchange of tax data between a state tax agency and the IRS.[xix] However, I am not aware of these programs having been utilized to alert the IRS of changes to a taxpayer’s state tax liability in a conforming state.
Stay tuned. The exchange of more detailed information is inexorable.
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[i] Thus, New York’s Tax Law provides that: “Any term used in this article shall have the same meaning as when used in a comparable context in the laws of the United States relating to Federal income taxes, unless a different meaning is clearly required but such meaning shall be subject to the exceptions or modifications prescribed in this article or by statute.” N.Y. Tax Law 607(a). Consistent with the foregoing, a taxpayer’s taxable year and accounting method for purposes of the Tax Law are the same as for Federal income tax purposes. N.Y. Tax Law Sec. 605.
[ii] So-called “rolling conformity.”
[iii] For example, New York elected not to conform to parts of the 2017 Tax Cuts and Jobs Act (P.L. 115-97; the “TCJA”), including the limitation on certain itemized deductions. By decoupling, N.Y. effectively became a “fixed date” conformity jurisdiction: it applies the Federal law as it was prior to the Federal changes.
[iv] IRC Sec. 62.
[v] Start with Tax Law Sec. 612(a), (b) and (c).
[vi] IRC Sec. 62(a). Yes, there are also a few other, very targeted items.
[vii] This may be attributable to the inclusion in the taxpayer’s gross income of a previously omitted item of income, or to the disallowance of a deduction previously claimed by the taxpayer.
[viii] N.Y. Tax Law Sec. 659.
[ix] N.Y. Tax Law Sec. 683(c)(1)(C). The regular three-year statute of limitations on assessment, which begins to run with the filing of the tax return, will not apply. Tax Law Sec. 683(a).
[x] New York has displayed a similar approach with respect to the N.Y. estate tax, especially after decoupling from the Federal estate tax exemption amount.
[xi] The mere fact that the Federal tax law has been adopted by the state and incorporated into its own tax law does not make state examiners into experts on Federal tax jurisprudence.
[xii] See https://www.taxslaw.com/2022/08/new-york-to-taxpayer-forget-what-the-feds-said-youre-a-responsible-person/ in which we discussed one such outcome in the context of an employment tax liability.
More recently, I was brought into a situation in which the state accepted the taxpayer’s request for penalty abatement while the IRS rejected it.
[xiii] In re Kirkpatrick, DTA No. 830077.
[xiv] IRC Sec. 469(c)(7).
[xv] Bureau of Conciliation and Mediation Services (BCMS).
[xvi] IRC Sec. 6501.
[xvii] The absence of such a requirement makes sense because the state’s determination under the circumstances would not be binding on the IRS.
[xviii] IRM 184.108.40.206.17.
[xix] IRM 220.127.116.11.