Pearlstein v. Commonwealth
| Decision Date | 02 December 2021 |
| Docket Number | No. 741 F.R. 2017,741 F.R. 2017 |
| Citation | 267 A.3d 593 |
| Parties | James and Karen PEARLSTEIN, Petitioners v. COMMONWEALTH of Pennsylvania, Respondent |
| Court | Pennsylvania Commonwealth Court |
D. Alicia Hickok, Philadelphia, for Petitioners.
James D. Harrison, Deputy Attorney General, Harrisburg, for Respondent.
BEFORE: HONORABLE P. KEVIN BROBSON, President Judge, HONORABLE PATRICIA A. McCULLOUGH, Judge, HONORABLE ANNE E. COVEY, Judge, HONORABLE MICHAEL H. WOJCIK, Judge, HONORABLE CHRISTINE FIZZANO CANNON, Judge, HONORABLE ELLEN CEISLER, Judge, HONORABLE J. ANDREW CROMPTON, Judge
OPINION BY JUDGE WOJCIK
James and Karen Pearlstein (Taxpayers) petition for review of the order of the Board of Finance and Revenue (Board), which sustained in part and denied in part the Department of Revenue's (Department) assessment of Personal Income Tax (PIT) against Taxpayers, plus interest and penalties, for the years 2013 and 2014. The issue is the Board's assessment of PIT for Taxpayers’ net gains or income from the disposition of property, specifically PIT owed on like-kind exchanges of real property during the 2013 and 2014 tax years. Taxpayers, who are partners in a number of real estate development and management partnerships, and who use the Federal Income Tax (FIT) method of accounting, argue that net gains on like-kind exchanges should be taxed when the property is sold, because such deferrals are permitted under Section 1031 of the Internal Revenue Code of 1986, as amended , 26 U.S.C. § 1031 ( IRC § 1031 ). The Board decided that net gains on like-kind exchanges should be taxed in the years the exchanges occurred, because unlike IRC Section 1031, the Tax Reform Code of 1971 (TRC)1 does not permit tax deferral on net gains from like-kind exchanges of real property. For that reason, the Board decided that the FIT method of accounting does not clearly reflect income. The Board decided that Taxpayers should be assessed PIT and interest, but not penalties. For the reasons that follow, we affirm.
The facts and procedural history were stipulated to by the parties. Taxpayers hold equal shares in a number of limited partnerships, organized under Pennsylvania law, for the purpose of buying, selling, developing, and managing commercial or residential rental real estate, in which they share equally in all items of taxable income and loss. Joint Stipulation of Facts (JSOF) ¶¶5-8. Each limited partnership reported its respective property transactions for the tax years 2013 and 2014 in a deferred like-kind exchange of properties under the requirements of IRC § 1031. Id. ¶9. Because the limited partnerships are pass through entities, Taxpayers reported no gain or loss on these like-kind exchanges on their federal or state tax forms. Id. ¶10.
Each limited partnership maintained only one set of books for both book and tax purposes for the relevant tax years using a platform called Rent Manager. JSOF ¶¶17, 18. The platform is designed to generate financial review for Taxpayers, and to be accessed and used by Taxpayers’ certified public accountants to prepare income tax returns. Id. ¶¶18, 19. Taxpayers used the FIT method of accounting for the relevant tax years. FIT may be characterized as an "Other Comprehensive Basis of Accounting" (OCBOA) as set forth in public accounting standards. Id. ¶¶19, 20. Under FIT, the reporting entity keeps its books using the rules set forth in the IRC to determine its income, loss, gain, and deductions for tax reporting purposes. Id. ¶20. FIT is used as a method of accounting by businesses that buy, sell, develop, and manage real estate. Id. ¶21.
The Department considers certain rules and principles under Generally Accepted Accounting Principles (GAAP), which is a set of standards promulgated by the Financial Accounting Standards Board, to "clearly reflect income" under Section 101.2 of the PIT regulations, 61 Pa. Code § 101.2. JSOF ¶22. The Department does not take the position that all GAAP principles clearly reflect income. Id. The Department considers any accounting rule or practice that incorporates federal tax gain deferral principles to be "contrary to accepted accounting principles" and to not "clearly reflect income" as defined by PIT regulations and the TRC. Id. ¶23. The Department prepared and made available to Taxpayers certain instructions to prepare "Schedule C, Profit or Loss from Business or Profession," includable with certain Pennsylvania tax forms, as well as guidance in the form of a bulletin entitled "PIT Bulletin No. 2006-7, ‘Pennsylvania Tax Treatment of IRC § 1031 Like-Kind Exchanges’ " (Bulletin). Id. ¶¶24, 27. The Bulletin was available on the Department's website from October 2006 through December 2017, and was included as Exhibit H to the JSOF. Id. ¶27. The Bulletin states in relevant part:
Pennsylvania personal income tax law does not contain a provision analogous to IRC § 1031. Therefore, exchanges of property that result in gain or income are generally subject to tax. However, the Department has determined that gain or loss on like-kind exchanges does not have to be recognized at the time of the exchange if a taxpayer's method of accounting permits the deferral of gain from a like-kind exchange. For example, [Accounting Principles Board] Opinion 29 provides for non-recognition of gain or loss on certain like-kind exchanges for taxpayers who consistently use GAAP principles of accounting. A taxpayer must use the method of accounting on a consistent basis and the method of accounting must clearly reflect his income.
JSOF Exhibit H at 3 (emphasis in original).
In December 2017, the Department issued and posted on its website a revised bulletin on like-kind exchanges (Revised Bulletin). JSOF ¶29. The Revised Bulletin, included as Exhibit I to the JSOF, eliminated the reference to accounting methods and states in relevant part: JSOF Exhibit I at unnumbered 3. There was no change in the TRC or PIT regulations that prompted the Bulletin revision. Id. ¶32. The Department prepared and published the instructions, revised instructions, Bulletin, and Revised Bulletin to serve as "general non-binding information for taxpayers’ review and use in preparing returns." Id. ¶30. The Department issued the Bulletin and Revised Bulletin to notify taxpayers of the Department's position on the taxation of like-kind exchanges. Id.
Taxpayers’ limited partnerships completed like-kind exchanges of real property in 2007 and 2008, and deferred the gains realized on these prior exchanges on both their federal and Pennsylvania tax returns. JSOF ¶36. Neither the Internal Revenue Service (IRS) nor the Department assessed tax on gains from these prior exchanges. Id. It is unknown whether the Department reviewed these prior exchanges. Id. The Department searched for private letter rulings regarding treatment of like-kind exchanges for PIT purposes. Id. ¶31. Although there may have been earlier private letter rulings the Department could not locate, the Department did locate a private letter ruling from 2005, included as Exhibit J to the JSOF. Id. Limited to the specific facts presented, the Department concluded that JSOF Exhibit J at unnumbered 1.
Taxpayers included as Exhibit M to the JSOF the expert report of certified public accountant Brian Duffy (Taxpayers’ Expert) in support of their position on deferral of gains from like-kind exchanges. JSOF ¶39. Taxpayers’ Expert is qualified to testify to matters relating to accounting rules, methods, and practices. Id. ¶40. The Department included as Exhibit P to the JSOF the expert report of certified public accountant Lisa Myers (Department's Expert) in support of its position that under Pennsylvania law, gains from like-kind exchanges must be reported in the year that the exchange was made. Id. ¶43. Department's Expert is also qualified to testify to matters relating to accounting rules, methods, and practices. Id. ¶44. Taxpayers and the Department stipulated that their respective experts were not qualified to provide a legal opinion on Pennsylvania law. Id. ¶¶40, 44. Neither Taxpayers nor the Department were asked to stipulate and did not stipulate to conclusions of law contained in the expert reports. Id. ¶¶39, 43.
The parties included as Exhibit K-1 to the JSOF the Board's decision dated August 23, 2017, relating to the PIT assessment for Taxpayers’ like-kind exchanges in 2013 and 2014.2 JSOF ¶37. In each decision, the Board struck all penalties and approved the reassessment plus interest of PIT for the gain Taxpayers realized on their like-kind exchanges for 2013 and 2014, based on its determination that Taxpayers’ gain from like-kind exchanges must be assessed at the time of the exchange. JSOF Exhibit K-1 at 4, Exhibit K-2 at 4, and Exhibit K-3 at 4. The Board concluded that gain from like-kind exchanges may be deferred under IRC § 1031, but could not be deferred under the TRC or PIT regulations. Id. The Board concluded that Taxpayers "cannot use the ‘[FIT] basis’ of accounting to incorporate wholesale federal tax principles into the [PIT], as federal tax principles are not incorporated into the [TRC]." Id. at p. 3. Taxpayers appealed the Board's decision to this Court, which functions as the trial court in finance and revenue matters.3
Taxpayers present two issues for review: (1) whether Section 303(a)(3) of the TRC4 and Section 101.2 of the PIT regulations authorize Taxpayers to report PIT income using the FIT method of accounting, when that method is based on accepted accounting principles, is widely used in...
To continue reading
Request your trial