Pennsylvania Personal Income Tax; Like-kind exchange valuation: when the property is sold or when the exchange occurs?
Pearlstein v. Com., 291 A.3d 923 (Pa. Cmwlth. 2023) (en banc) (Pearlstein II), overruling exceptions to the Commonwealth Court’s opinion at 267 A.3d 593 (Pa. Cmwlth. 2021) (Pearlstein I), direct appeals, appeal dockets 21, 22 and 23 MAP 2023
These are direct appeals to the Supreme Court arise from the Commonwealth Court’s orders affirming the Board of Finance and Revenue’s (Board) decision that assessed personal income tax (PIT) against Taxpayers for net gains owed on like-kind exchanges of real property in tax years 2013 and 2014, the years in which the properties were exchanged. The Commonwealth Court issued its initial decision in 2021 in Pearlstein I, 267 A.3d 593, and overruled Taxpayers’ exceptions to that decision in 2023 in Pearlstein II, 291 A.3d 923.
Taxpayers, who use the Federal Income Tax (FIT) method of accounting, argue that for Pennsylvania PIT purposes, 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 when the exchanges occurred, because unlike IRC Section 1031, the Tax Reform Code of 1971 (TRC) 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.
On appeal, the Commonwealth Court concluded that because Pennsylvania’s TRC does not permit deferral, tax must be calculated on like-kind exchanges as of the years in which the properties were exchanged:
Based on the plain language of Section 303(a.1) of the TRC, we conclude that Taxpayers’ use of the FIT accounting method does not “clearly reflect income” for PIT purposes, because the TRC does not permit tax deferral on like-kind exchanges. We find both Taxpayers’ and the Department’s Experts’ statements describing the FIT accounting method to be credible, i.e., that Taxpayers used the FIT accounting method to prepare and conform their income and expenses to Federal tax rules and regulations, including tax deferral on like-kind exchanges pursuant to IRC § 1031. However, we also find to be credible the Department’s Expert’s statement that Taxpayers’ accounting method requires adjustments to “create state income financial data that is acceptable to the [Department].” Here, we conclude that Taxpayers must make the adjustments necessary to account for gain realized from their like-kind transactions at the time the transactions occurred, so that these gains may be subject to PIT under the TRC’s definition of income, which does not permit deferral.
Pearlstein I slip op. at 19-20.
The court likewise rejected the Taxpayers’ argument that they were entitled to rely on the Department of Revenue’s previous guidance on the issue:
We agree with Taxpayers that when the Department issued its Revised Bulletin in 2017, it deleted language from the earlier Bulletin regarding the use of accounting methods. However, both the Bulletin and the Revised Bulletin offer the same guidance, namely that IRC § 1031 tax deferral on gains from like-kind exchanges is not permitted under the TRC. Therefore, we cannot conclude that the Department abused its discretion when it issued the Revised Bulletin or other similar guidance, when the guidance remained consistent in its treatment of tax deferral on like-kind exchanges. Although we are mindful that the parties stipulated that Taxpayers relied on the Bulletin when preparing their PIT returns, JSOF ¶35, their reliance on this guidance, even if misleading, cannot prevent the Department from collecting a tax that is legally due. American Electric Power Service Corporation, 160 A.3d at 960. Further, Department regulations provide that revenue information including bulletins are for “informational purposes only” and “should not be relied upon in tax appeals.” 61 Pa. Code § 3.4. Finally, even if we found a conflict between PIT regulations and the Department’s revenue information, which we do not, Department regulations outline that the order of precedence shall be: (1) regulations; (2) statements of policy; (3) letter rulings; and (4) revenue information. 61 Pa. Code § 3.5.
Pearlstein I slip op. at 22-23.
On exceptions to Pearlstein I, the court reaffirmed its Pearlstein I holdings, and in addition addressed and rejected Taxpayers’ argument that the court failed to construe Section 303(a.1) of the TRC strictly in favor of Taxpayers:
Taxpayers correctly note that Section 1928(b)(3) and (5) of the Statutory Construction Act of 1972, 1 Pa. C.S. § 1928(b)(3) and (5), requires that statutes imposing taxes and statutes exempting persons or property from taxes should be “strictly construed.” Provisions imposing taxes must be strictly construed in favor of taxpayers. Greenwood Gaming and Entertainment, Inc., 90 A.3d at 707. Provisions exempting persons or property from taxation must be strictly construed against taxpayers. Id. In either instance, however, these principles apply only when the statutory language is ambiguous. Id. Here, we found no ambiguity in Section 303(a.1) of the TRC. Instead, we interpreted its plain language to permit the Department to assess PIT on net gains from Taxpayers’ like-kind exchanges when the exchanges were made, because the FIT method of accounting does not clearly reflect income as defined under the TRC. Pearlstein I, 267 A.3d at 604.
Pearlstein II slip op. at 4.
Dissenting in Pearlstein I, Judge Crompton took the position that the Taxpayers were entitled to follow the Department’s prior Bulletin and regulation on the issue, which were in effect at the time of the exchange and permitted valuation at the time the property is sold:
The Bulletin was published on the Department’s website and presented as guidance for construing the PIT regulations, including Section 101.2 of the Department’s regulations, 61 Pa. Code § 101.2. Relevant here, the Bulletin advised the public, including Taxpayers, that “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.” Joint Stip. of Facts, Ex. H (emphasis added). The non-recognition of the income at the time of the exchange was thus expressly permitted by the Department’s guidance provided the taxpayer utilized the accounting method on a consistent basis.
Taxpayers’ reporting of income on the 2013-14 PIT returns complied with the Bulletin to the letter. Notwithstanding Taxpayers’ compliance, however, the Department imposed tax liability, including interest since the date of the exchange, against Taxpayers for the non-realized income of the exchanges as though the income was recognized at the time of the exchange. I take issue with this result as it had the effect of penalizing Taxpayers for following the Department’s guidance and the example provided for purposes of filing returns. This is particularly troubling in these circumstances where Taxpayers consistently used the FIT method pursuant to the Bulletin, and previously completed like-kind exchanges and deferred the gains, i.e., did not then recognize income, on the prior exchanges on their federal and Pennsylvania returns without incident. Joint Stip. of Facts ¶36.
Pearlstein I, JAC at 3-4.
On exceptions in Pearlstein II, Judge McCullough adopted Judge Crompton’s reasoning. PAM 1-2.
The Supreme Court will hear argument on Taxpayers’ direct appeals, limited to the following issues:
1. Whether the Federal Income Tax (“FIT”) method of accounting is an accepted accounting principle, system, or practice or procedure where it is widely accepted by the accounting profession pursuant to its professional standards.
2. Whether the FIT method of accounting is consistent with Regulation Section 101.2, and therefore presumed to clearly reflect income, because it is widely accepted by and consistently applied by the accounting profession in the real estate business, was used consistently by the taxpayers in their real estate business, and was used by the taxpayers consistently for [FIT] purposes.
3. Whether the Department of Revenue (“Department”) expressly acknowledged in its original [Bulletin 2006-07], which was in effect during the 2013 and 2014 tax years, its acceptance of gain deferral on like-kind exchanges for Pennsylvania [p]ersonal [i]ncome [t]ax when a generally accepted method of accounting is used on a consistent basis from year to year.
4. Whether the [c]ourt erred in failing to hold that the authority in Section 303(a.1) to recompute income is limited by the mandated presumption in Regulation Section 101.2 that a calculation which meets the criteria of the regulation clearly reflects income.
5. Whether the [c]ourt erred in deferring to the Department’s limited discretion to recompute income under Section 303(a.1) without first following Regulation 101.2 and analyzing whether income computed consistently using the FIT method of accounting.
For more information, contact Kevin McKeon or Dennis Whitaker.