What Are the Key Tax Issues Affecting Taxpayers in New York?

A substantive tax issue concerns the legal merits of whether income should be taxed, a deduction is allowable, or a credit applies, while a procedural defect relates to notice, filing, assessment, or collection mechanics. Substantive disputes often turn on statutory interpretation, the application of judicial precedent, and factual findings about the nature of income or the business purpose of an expense. Procedural defects can include improper notice of assessment, failure to follow administrative review processes, or violations of the statute of limitations. Courts and administrative bodies treat these categories differently; a procedural flaw may render an assessment invalid or unenforceable even if the underlying tax liability is correct on the merits.

The IRS and New York State have statutory authority to examine returns and determine tax liability based on a reasonable belief that underpayment or misreporting has occurred. The examination process is governed by IRC Section 7602 at the federal level and New York Tax Law Section 205 at the state level, which grant broad investigative authority. The tax authority bears the initial burden of producing evidence to support a proposed adjustment; however, once that burden is met, the taxpayer must substantiate claimed items through contemporaneous records, receipts, and documentation. In practice, the burden of proof allocation can shift depending on the issue type and whether the taxpayer maintains adequate records.

Income recognition disputes arise when a taxpayer excludes income from reporting or the tax authority asserts that additional income should have been reported. The IRC defines gross income broadly to include all income from whatever source derived, subject to specific statutory exclusions. Common disputes involve whether a payment is a gift (excluded from income under IRC Section 102) or compensation (taxable), whether barter transactions or cryptocurrency gains were properly reported, or whether forgiven debt constitutes taxable income under IRC Section 61(a)(12). The taxpayer bears the burden of proving that claimed exclusions apply through documentation, contemporaneous evidence, and legal characterization of the transaction. Courts apply a substance-over-form analysis to determine the true nature of a transaction rather than the label the parties assigned to it.

Deductions and credits are statutory allowances, not inherent rights; a taxpayer must substantiate them through adequate records and documentation. IRC Section 274 and Treasury Regulation Section 1.274-5 impose strict substantiation requirements for certain deductions, such as business meals and entertainment, travel, and vehicle expenses. The IRS applies a heightened standard for hobby loss deductions under IRC Section 183, which requires the taxpayer to demonstrate that an activity is engaged in for profit rather than personal enjoyment. Similarly, the Earned Income Tax Credit (EITC) and Child Tax Credit require proof of eligibility through filing status, dependent relationships, and earned income documentation. When records are incomplete or absent, the taxpayer may lose the entire deduction or credit, even if the underlying expense was incurred.

When the IRS issues a Notice of Deficiency, the taxpayer has 90 days to file a petition in the U.S. Tax Court without paying the assessed tax. Alternatively, the taxpayer may pay the tax and file a claim for refund with the IRS; if the IRS denies the claim or does not act within six months, the taxpayer may sue in federal District Court or the U.S. Court of Federal Claims. The choice of forum affects the burden of proof allocation, the availability of jury trial, and the precedential value of the decision. Tax Court proceedings are governed by the Tax Court Rules of Practice and Procedure and emphasize documentary evidence and expert testimony. In federal District Court or Court of Federal Claims, the taxpayer may use broader discovery but must comply with the Federal Rules of Civil Procedure. Documentation of the claim and timely filing are essential; missed deadlines often result in loss of the right to judicial review.

New York State taxpayers may file a protest with the Department of Taxation and Finance within 90 days of receiving a Notice of Deficiency. If the department denies the protest, the taxpayer may petition the Division of Tax Appeals, an independent administrative tribunal. The Division conducts a de novo review of the assessment and applies the preponderance of the evidence standard. The Division's determination may be appealed to Appellate Division, Third Department (which covers much of upstate New York) or to the Appellate Division, First Department (which covers New York City), depending on the taxpayer's residence. Administrative appeals must be exhausted before seeking judicial review in state court, and failure to file a timely protest can preclude further administrative and judicial relief. The procedural requirements are strict; incomplete or untimely filings often result in dismissal without reaching the merits.

Documentation is the foundation of tax dispute resolution. Contemporaneous written records, receipts, invoices, bank statements, and business logs are critical evidence in establishing the nature, amount, and business purpose of claimed deductions and income. The IRS applies the Cohan rule (named from Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930)), which permits a court to estimate deductions when records are incomplete but the taxpayer has substantiated the general reasonableness of the claimed amount; however, this doctrine is narrow and applies only when the taxpayer has made a credible showing that an expense was incurred. In practice, taxpayers who maintain organized records and can produce them promptly during examination are far more likely to resolve disputes favorably than those who reconstruct records or rely on memory. The burden of proof framework often hinges on whether the taxpayer has maintained records sufficient to meet the substantiation standard.

Before responding to an IRS examination notice or filing a protest with New York State, a taxpayer should compile all contemporaneous records related to the disputed items: bank statements, invoices, receipts, canceled checks, credit card statements, business logs, contracts, and correspondence with third parties. Organize these records chronologically and by category (income, deductions, credits) so they can be presented clearly to the tax authority or a court. If records are missing, document what happened to them and whether reconstructed records or third-party verification (such as bank records obtained from the financial institution) can substitute. A taxpayer should also preserve any email, memoranda, or contemporaneous notes that explain the business purpose or factual basis for claimed items. Early organization of records signals to the tax authority that the taxpayer takes compliance seriously and often facilitates settlement discussions.

A taxpayer should consider engaging counsel or a qualified tax professional as soon as they receive an examination notice, a notice of deficiency, or a collection notice. Tax disputes involve specialized knowledge of the Internal Revenue Code, Treasury Regulations, and procedural rules; errors in procedural compliance or substantiation strategy can be costly and irreversible. A tax professional can assess whether the taxpayer's records are adequate, identify potential legal defenses or alternative characterizations of disputed items, and advise on the forum most favorable to the taxpayer's position. For complex issues involving entity classification, transfer pricing, or substantial dollar amounts, early engagement of counsel is particularly important. Additionally, a taxpayer facing collection action may be eligible for relief through installment agreements, offers in compromise, or currently not collectible status; a tax professional can evaluate these options and help navigate the application process. Engagement should occur before the taxpayer responds to the tax authority, as statements made during examination can be used against the taxpayer in litigation.

In limited circumstances, a taxpayer may have access to specialized tax relief mechanisms. Annual gift tax exclusion planning allows a taxpayer to transfer assets to family members or others during life without incurring federal gift tax, provided the transfers comply with IRC Section 2503(b) requirements and are properly documented. This strategy can be useful for taxpayers seeking to reduce the size of their taxable estate or to transfer wealth tax-efficiently. In cases where a taxpayer's tax liability is substantial and cannot be resolved through normal administrative or judicial channels, bankruptcy for tax relief may offer a pathway to discharge or restructure tax debt under federal bankruptcy law. However, bankruptcy is a complex and consequential proceeding; it should be considered only after careful evaluation of the taxpayer's overall financial situation and the specific requirements for discharging tax debt in bankruptcy. A taxpayer should consult with counsel before pursuing any of these alternatives.

A taxpayer should begin by organizing all records related to the disputed items, identifying any procedural defects in the tax authority's notice or assessment, and determining the appropriate forum for appeal. If the dispute involves substantial amounts or complex legal issues, early consultation with a tax attorney is prudent. The taxpayer should also evaluate whether the nature of the dispute (income recognition, deduction substantiation, or penalty assessment) suggests a settlement opportunity or whether the legal position is strong enough to warrant litigation. Finally, the taxpayer should document all communications with the tax authority and preserve evidence of good faith compliance efforts, as these factors often influence both administrative settlements and judicial outcomes.