A recent Pennsylvania Supreme Court decision could have broad, and unintended, consequences. The portion of the decision that permits the DOR to retroactively change its own positions could create a great deal of uncertainty among taxpayers.
In Pearlstein v. Commissioner,1 the Pennsylvania Supreme Court held that personal income taxpayers may not use gain deferral pursuant to IRC Section 1031 under the Federal Income Tax Method of Accounting prior to its express incorporation,2 thus settling a long-disputed Pennsylvania income tax issue. The decision may have broader implications because the court reasoned that the Department of Revenue (DOR) can use nonbinding guidance to advise taxpayers, but taxpayers cannot rely on that guidance when preparing their returns or in tax appeals. The portion of the court’s decision that permits the DOR to retroactively change a position through revenue information will likely create a great deal of uncertainty for taxpayers.
The Pearlsteins were Pennsylvania residents who were equal partners in various limited partnerships that managed and invested in real estate. Each limited partnership used the Federal Income Tax Method of Accounting to keep its books and records. In the 2013 and 2014 tax years, the limited partnerships engaged in like-kind exchanges of real property, which are tax-deferred exchanges for federal income tax purposes pursuant to IRC Section 1031. Relying on the DOR’s regulations and guidance in effect during those tax years, the Pearlsteins prepared their Pennsylvania personal income tax (PIT) returns reporting the partnership gains and losses on their Forms RK-1, thereby deferring the gains for PIT purposes.
Under the statute, taxpayers were required to calculate their taxable income for PIT purposes using accepted accounting principles and practices, and the legislature required that such accounting method was consistent with the standards of the accounting profession and the DOR’s regulations.3 The guidance at the time required the DOR to presume that the Federal Income Tax Method of Accounting clearly reflected income in certain circumstances,4 and a PIT Bulletin permitted gain deferral pursuant to IRC Section 1031.5
Even though the statute and corresponding regulation allowed for the deferral of gain under a method of accounting consistently applied, the DOR assessed the Pearlsteins’ PIT on the deferred gains. It argued that the PIT Code does not permit gain deferral because IRC Section 1031 had not been expressly incorporated at the time, and that the application of gain deferral would result in a recapitulation of federal taxable income for PIT purposes. The DOR also amended its PIT Bulletin 2006-07 midway through the appeal to say gain deferral was not permitted.
The Pennsylvania Supreme Court essentially adopted the position of the DOR with respect to gain deferral. It reasoned that an express incorporation of IRC Section 1031 was required, and it chose not to read the statutory requirement that each of the eight classes of income must be computed under a taxpayer’s regular method of accounting under 72 P.S. Section 7303(a.1) as a broad exception in the statute. The statute grants discretion to the DOR to incorporate gain deferral, which it did through Regulation Section 101.2. Moreover, under the court’s own recent analysis, the amendment to the statute to expressly incorporate Section 1031 should be treated as a clarification of existing law, not a change in the law.6
The court’s acceptance of the DOR’s position that adopting IRC Section 1031 results in a recapitulation of federal taxable income is deeply concerning. It is true that federal taxable income cannot be adopted wholesale as the tax base for PIT. Taxable income for PIT purposes is comprised of eight specific types of income, only one of which is net gains or income from disposition of property, to which gain -deferral applies, and none of which can be offset against each other type.7 Further, federal gain deferral only applies to business or investment income, and not every Pennsylvania taxpayer holds real property for business or investment purposes. Moreover, the legislature codified the applicability of IRC Section 1031 to the PIT Code,8 effective for transactions occurring in tax years beginning after Dec. 31, 2022, and the DOR never asserted that such codification had resulted in Pennsylvania taxpayers calculating PIT on their federal taxable income without any state-level adjustments.
The court’s position with respect to revenue information is likely more detrimental to taxpayers in the long term. In the course of litigation, the DOR changed a previously shared position with respect to gain deferral through a Bulletin. Bulletins are revenue information, which are published by the DOR “to call attention to Department procedures or to well-established interpretations or principles of tax law,” but do not carry precedential weight in tax appeals.9 In short, the DOR can use revenue information to communicate with taxpayers, but taxpayers cannot rely on that communication to defend their positions on their returns. This leaves taxpayers at a serious disadvantage because the primary way that the DOR communicates with taxpayers is through revenue information. For example, the 2023 Pennsylvania PIT return instructions contain 20 separate directions to taxpayers that refer to its Bulletins or the Pennsylvania Personal Income Tax Guide.
Consistency in tax administration is vital to a stable and predictable economy, and the Pearlstein case highlights concerns regarding the DOR and its own guidance. In this case, the DOR acknowledged that the Bulletin cited reflected its policy on the treatment of like-kind exchanges for PIT purposes at the time. The court unanimously found that the DOR did not follow the Bulletin and interpreted it differently in the appeal. As a result, questions have now been raised about the extent to which taxpayers can rely on the DOR’s published guidance. The potential for inconsistency will greatly increase uncertainty.
1 323 A.3d 716 (Pa. 2023).
2 72 P.S. Section 7303(a.5).
3 72 P.S. Section 7303(a.1).
4 61 Pa. Code Section 101.2.
5 PIT Bulletin 2006-7, p.3 (Oct. 20, 2006).
6 Synthes USA HQ Inc. v. Commonwealth, 289 A.3d 846, 878 (Pa. 2023).
7 61 Pa. Code Section 121.13.
8 72 P.S. Section 7303(a.5).
9 61 Pa. Code Section 3.4.
Dan Schulder is an equity partner at Cozen O’Connor in its Harrisburg office. Schulder focuses his practice on state and local tax matters. He can be reached at dschulder@cozen.com.
Heidi Schwartz is an associate in the Philadelphia office of Cozen O’Connor. Schwartz, too, focuses on state and local tax matters. She can be reached at hschwartz@cozen.com.
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