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...