The following articles describe recent judicial and administrative decisions impacting New Jersey taxpayers, as well as two ongoing voluntary disclosure programs being offered by the New Jersey Division of Taxation and possible changes to come based on Governor Christies's recent annual budget proposal.
New Jersey Tax Court Ruling Concerning the "Throw-Out Rule" Favors Taxpayers Having Nexus Without Physical Presence in New Jersey
The portion of a corporation’s income that is allocable to New Jersey is determined by an apportionment formula.[1] For tax periods beginning before January 1, 2014, the apportionment formula was determined by the use of sales, property and payroll fractions. The numerator of such fractions was sales, property or payroll (as applicable) attributable to New Jersey and the denominator was all sales, property and payroll (as applicable) within or without New Jersey of the taxpayer.[2]
For tax periods beginning before July 1, 2010, however, the amount of a taxpayer’s income apportioned to New Jersey could be significantly increased by New Jersey’s “throw-out rule.”[3] The throw-out rule provided that receipts of a taxpayer assigned to other jurisdictions that are not subject to tax by those jurisdictions are excluded from the denominator of the sales fraction in New Jersey’s apportionment formula.[4] This often resulted in a taxpayer having a higher sales fraction, thereby increasing the taxpayer’s New Jersey Corporation Business Tax (CBT) liability.
The New Jersey Supreme Court ruled in Lanco v. Director, Division of Taxation, 188 N.J. 380 (2006), that New Jersey may constitutionally subject a foreign corporation having no physical presence in New Jersey to the CBT if the corporation derives income through a licensing agreement with an entity that conducts a retail business in New Jersey. The New Jersey Division of Taxation has applied the throw-out rule to taxpayers similarly situated to the taxpayer in Lanco to exclude from the denominator of the sales fraction receipts that were not taxed by other jurisdictions, resulting in significant additional CBT liability for such taxpayers.
The Division’s application of the throw-out rule to a taxpayer having no physical presence in New Jersey was considered by the New Jersey Supreme Court in Whirlpool Properties v. Director, Division of Taxation, 208 N.J. 141 (2011). There, the Court held that the throw-out rule may only be applied to throw out receipts that are not taxed by another state because the taxpayer does not have sufficient contacts with the state under the U.S. Constitution or other federal law. In response to Whirlpool, the Division indicated that it will not throw out receipts assigned to Nevada, South Dakota and Wyoming since those states do not impose a corporate income tax or similar business activity tax.
The New Jersey Tax Court recently addressed the application of the throw-out rule post-Whirlpool to a taxpayer subject to the CBT that did not have any physical presence in New Jersey. Like the taxpayer in Lanco, the taxpayer in Lorillard Licensing Co. v. Director, Division of Taxation[5] had no physical presence in New Jersey. The taxpayer licensed certain trademarks and trade names to an entity having sales in all states, including New Jersey, and received a royalty payment based on sales in each state.
The court in Lorillard noted that, in Lanco, the New Jersey Supreme Court held that a state may constitutionally tax a company having no physical presence in the state by virtue of the receipt of royalty payments derived from sales in the state by its licensee. In addition, the court noted that the New Jersey Supreme Court in Whirlpool held that, where a taxpayer has contacts with a state that are constitutionally sufficient for the state to tax the receipts of such taxpayer, receipts assigned to such state may not be removed from the denominator of the sales fraction pursuant to the throw-out rule. The court held that since New Jersey could impose a tax on the taxpayer by virtue of Lanco, all other states could also constitutionally impose a tax on the taxpayer. Therefore, as mandated by Whirlpool, no receipts could be thrown out of the denominator of the sales fraction pursuant to the throw-out rule since the taxpayer derived royalties from sales made in all states. The Division has appealed the decision of the New Jersey Tax Court in Lorillard. That appeal is currently pending.
The decision in Lorillard represents an important victory for taxpayers that do not have any physical presence in New Jersey but are subject to the CBT by virtue of Lanco. Similarly situated taxpayers that reported additional New Jersey tax due to the throw-out rule should consider making a refund claim for open tax years. CBT refund claims must generally be made within four years of the later of the payment of the relevant tax or the filing of the final return for the relevant tax year.
[1] For tax years beginning before July 1, 2010, a corporation was required to have a regular place of business outside of New Jersey to allocate a portion of its income outside of New Jersey.
[2] For tax periods beginning prior to January 1, 2012, the apportionment formula consisted of the average of the sales fraction (which was double weighted), the property fraction and the payroll fraction. The apportionment formula is based solely on the sales fraction for tax years beginning on and after January 1, 2014, following a phase-in period that started in January 2012.
[3] The “throw-out rule” was eliminated for tax periods beginning on or after July 1, 2010.
[4] For purposes of the throw-out rule, a tax is only one on or measured by profits, income, business presence of business activities.
[5] The New Jersey Tax Court issued a bench opinion in Lorillard. The Division has appealed the decision. In response, the court issued a letter amplifying its prior bench opinion.
Making Sense of New Jersey’s Attempts to Tax Partnerships with Nonresident Partners
Entities that are treated as partnerships for federal and state income tax purposes, including most multi-member LLCs, traditionally do not pay income taxes. Rather, their partners pay tax on their distributive share of the partnership’s income. The New Jersey legislature, worried that nonresident partners of partnerships doing business in New Jersey might not file tax returns or pay taxes in New Jersey, established a nonresident partner tax in 2002. The tax requires partnerships to pay tax on amounts of partnership income that are allocable to nonresident partners. Partners may take the amount of tax paid by the partnership as a credit on the partners’ tax returns.
In BIS LP v. Director, Division of Taxation, 25 N.J. Tax 88 (Tax 2009), aff’d, 26 N.J. Tax 489 (App. Div. 2011), remanded to 27 N.J. Tax 58 (Tax 2012), the courts confronted a partnership with two partners: a 1% general partner and a 99% limited partner. The partnership contained the banking information solutions division, with business activity and income in New Jersey, of an information processing and technology outsourcing services business that was carried on by multiple related entities. The limited partner, which was incorporated in Delaware, did not control the partnership or directly engage in any business in New Jersey and did not own property or hire employees or agents in the state. Its sole income-producing asset was its limited partner interest in the partnership. The limi ted partner was a wholly owned subsidiary of the general partner, which managed the operations of the partnership. The Tax Court and the Appellate Division of the Superior Court held that the State did not have sufficient nexus to tax the limited partner. Accordingly, while the partnership was required to remit nonresident partner tax with respect to the limited partner’s distributive share of partnership income, the limited partner was entitled to a full refund of the remitted amount.
While BIS may limit the reach of the nonresident partner tax, it is not the end of that tax. In Village Super Market of PA v. Director, Division of Taxation, 27 N.J. Tax 394 (Tax 2013), the Tax Court considered another partnership doing business in New Jersey with a 1% general partner and a 99% limited partner incorporated in Pennsylvania. The partnership operates a number of grocery stores in New Jersey, while the limited partner operates one in Pennsylvania. Because the limited partner and the partnership “are in the same line of business,” “have common agents, managers, officers, and directors,” and “share a principal place of business in Springfield, New Jersey,” the court held that New Jersey does have sufficient nexus to tax the limited partner on its share of the partnership’s income.
Like BIS, Village Super Market is a Corporation Business Tax case involving a corporate nonresident limited partner. It is not clear whether and how the reasoning of these cases would apply to an individual nonresident limited partner.
Perhaps in response to these cases, the Division of Taxation is now encouraging partnerships to come forward and pay their unpaid nonresident partner taxes, without penalty, through May 15, 2014. More information about the Partnership Tax & Partner Fees Initiative, which supplements the Division’s existing voluntary disclosure program, is available at http://www.state.nj.us/treasury/taxation/Partnership.shtml. In his recent fiscal year 2015 budget proposal, Governor Chris Christie suggested “clarify[ing] the existing law to close a loophole that allows out-of-state partners in New Jersey partnerships to be eligible for tax refunds, even if they didn’t pay any taxes to begin with,” which would seem to indicate the possibility of legislation that would override BIS (if constitutionally permissible).
LLCs and other partnerships that have not been remitting nonresident partner tax or the $150 per partner fee should consider whether they are eligible for and should take advantage of the Partnership Tax & Partner Fees Initiative described above. As for nonresident limited partners that lack material New Jersey contacts, such as the taxpayer in BIS, they should consider filing refund claims with respect to their share of nonresident partner tax remitted by the partnership to New Jersey – even in cases where the partnership is availing itself of the Partnership Tax & Partner Fees Initiative –perhaps before this year’s budget legislation is enacted.
New Jersey Tax Court Highlights Limit on State’s Ability to Tax Income from Intangibles Owned by Out of State Taxpayers
In a recent letter opinion deciding certain motions in Whirlpool Properties v. Director, Division of Taxation, the New Jersey Tax Court discussed Lanco v. Director, Division of Taxation, 188 N.J. 380 (2006), and noted that Lanco simply holds that physical presence is not required to tax income from transactions involving intangible property that take place in New Jersey. Importantly, the court noted, “Lanco does not stand for the proposition that New Jersey may tax intangible income from transactions occurring outside the state of New Jersey, particularly if there is no constitutional basis to subject an entity to taxation.”
The taxpayers in both Lanco and Whirlpool did not have physical presence in New Jersey. Further, both taxpayers received royalties from the licensing of intangible property to affiliates. However, an important distinction between Lanco and Whirlpool is that the royalty paid to the taxpayer in Lanco was calculated based on the sales of goods bearing the licensed brand name (including sales in New Jersey), while the royalty paid to the taxpayer in Whirlpool was calculated based on a percentage of production costs of manufacturing products bearing the licensed brand name. While Whirlpool’s products were sold in all fifty states, none were produced in plants located in New Jersey. Because of this distinction, the court declined to decide whether the taxpayer in Whirlpool had sufficient nexus for New Jersey to impose tax on it, finding that certain material facts relevant to this determination were still in dispute.[1]
The decision in Whirlpool creates uncertainty as to whether the New Jersey Corporation Business Tax (CBT) may be imposed on taxpayers not having physical presence in New Jersey, and that receive income from intangibles arising from transactions occurring outside of New Jersey, if the products to which such intangibles relate are sold in New Jersey.
Perhaps in response to the decision in Whirlpool, which is still pending before the Tax Court, the New Jersey Division of Taxation has implemented an Intangible Asset Nexus Initiative, supplementing its existing voluntary disclosure program. The initiative runs through May 15, 2014 and applies to companies owning intangible assets that derive income from such assets in New Jersey. Taxpayers choosing to participate in the Initiative must file all required returns and pay CBT for tax periods beginning after July 1, 2010 or the date business commenced, whichever is later. All penalties would be waived. More information about the Initiative is available at http://www.state.nj.us/treasury/taxation/IntangibleAsset.shtml.
Companies that own intangible assets and derive income from the use of those assets in New Jersey should consider whether they are eligible for and should participate in the Intangible Asset Nexus Initiative. In addition, companies that do not have physical presence in New Jersey and do not derive income from intangible assets that is calculated based directly on sales in New Jersey, but whose intangibles are nevertheless used in goods or services sold in New Jersey, should consider participating in the Intangible Asset Nexus Initiative and then making a refund claim pending resolution of the Whirlpool case.
Further, based on the current state of the Whirlpool case, taxpayers that do not have physical presence in New Jersey and that have remitted CBT with respect to income from intangibles that does not arise from transactions occurring in New Jersey should consider making refund claims for all open tax years. CBT refund claims must generally be made within four years of the later of payment of the relevant tax or filing of the final return for the relevant tax year.
[1] The court in Whirlpool noted that whether the taxpayer exercised certain rights in New Jersey that perhaps established nexus, and whether the taxpayer earned income attributable to New Jersey, were questions of material fact that would be better resolved at trial.
New Jersey Division of Taxation Expands Already Broad Bulk Sale Rules
In many states, bulk sale statutes require buyers of an existing business’s assets to notify the state of the proposed sale. This gives the state the opportunity to collect any unpaid taxes (typically sales taxes) owed by the seller out of the sale proceeds, before the seller is left as an empty shell.
New Jersey’s bulk sale statute, N.J.S.A. 54:50-38, takes a more expansive approach. The State may use a bulk sale filing as an opportunity to collect any unpaid New Jersey tax of the seller, be it sales tax, income tax, or any other New Jersey tax administered or collected by the New Jersey Division of Taxation. Failure to make a complete and timely filing or to comply with the State’s escrow demands makes the buyer joint and severally liable for all of the seller’s unpaid New Jersey taxes and interest, penalties and other additions to tax.
The New Jersey Division of Taxation has yet to issue any regulations under this statute. The only administrative guidance on the subject is a brief technical bulletin, TB-60R, and “frequently asked questions” (FAQs) on the Division’s website, which are periodically updated: http://nj.gov/treasury/taxation/faqbulksale.shtml. See our prior alerts for a more complete discussion of the bulk sale law.[1]
Recent iterations of the FAQs continue to reveal not-so-obvious aspects of the Division’s interpretation of the bulk sale statute. Perhaps the most surprising aspect of the Division’s interpretation is this: the Division views the sale of equity interests as a transaction subject to the bulk sale rules if the seller is an entity and not an individual. So, for instance, if an entity transfers corporate stock, general or limited partnership interests or LLC membership interests, the Division would view that as a situation in which a bulk sale filing should be made, or else the transferee becomes joint and severally liable for the transferor’s New Jersey tax liabilities.
[1] E.g., https://riker.com/publications/doing-deals-with-new-jersey-taxpayers-buyer-beware-new-jersey-tax and https://riker.com/publications/corporate-alert#Bulk.
New Jersey’s Treatment of 338(h)(10) Elections May Soon Be Revised
Under federal tax law, when a corporation buys the stock of an S corporation or a member of a consolidated group of corporations, the buyer and sellers may jointly inform the IRS that they are making the election described in Section 338(h)(10) of the Internal Revenue Code with respect to the transaction. If the election is made, the fact that the sellers sold their stock to the buyer corporation is ignored for tax purposes, and the following two steps are deemed to have occurred instead: first, a sale of the target company’s assets; and second, a liquidation of the target company, with the sellers receiving the sale proceeds in exchange for their stock. The buyer takes a cost basis in the assets, which is often higher than their pre-sale tax basis, resulting in greater depreciation and amortization deductions over time. ; The sellers may recognize some ordinary income (or loss) on the sale of certain assets, compared to 100% capital gain (or capital loss) in the case of a stock sale, but the buyer will often “gross up” certain sellers for the extra tax costs, if any, resulting from this recharacterization.
When a 338(h)(10) election has been made for federal tax purposes, New Jersey generally gives effect to that election, and also views a sale of the target company’s assets as having occurred for state tax purposes. Whether and to what extent New Jersey may tax the gain from such a deemed asset sale was answered by the courts in McKesson Water Products Co. v. Director, Division of Taxation, 23 N.J. Tax 449 (Tax 2007), aff’d, 408 N.J. Super. 213 (App. Div.), certif. denied, 200 N.J. 502 (2009). There, the New Jersey courts held that gain arising from a deemed asset sale due to a 338(h)(10) election is generally nonoperational income. Unlike operational income, which is apportioned among the states where a corporation does business, nonoperational income is, by statute, allocated 100% to the state in which the corporation’s principal place of business is located. So, if – as in McKesson – the target company’s principal place of business is outside of New Jersey, the target company, if a C corporation, or nonresident shareholders of the target company, if an S corporation, should not incur any New Jersey tax on the transaction, regardless of the extent to which the target company owns property or does business in the state.
This “all or nothing” rule for 338(h)(10) elections may be in the Christie Administration’s crosshairs. In his recent fiscal year 2015 budget proposal, the governor announced forthcoming proposals that “would close loopholes to prevent the sheltering of business income from a ‘deemed asset sale.’” Does this mean that New Jersey will soon attempt to tax C corporations and nonresident shareholders of S corporations on their 338(h)(10) deemed asset sale gains, even if the corporation’s principal place of business is out of state? Stay tuned.
