New Jersey ~ Corporate, Personal Income Taxes: Gain from Deemed Sale of an S Corporation’s Assets Sourced to New Jersey

CCH Tax Day Report

Finding for the Division of Taxation on the main issue, the New Jersey Tax Court stated that the correct method of sourcing the income on the deemed sale of a New Jersey S corporations’s assets was with reference to the Corporation Business Tax (CBT) statutes. All the income had to be allocated to New Jersey as the S corporation’s (taxpayer) state of domicile. Thus, the division’s assessment of gross (personal) income tax (GIT) on the non-resident shareholders was affirmed. However, the Tax Court granted the taxpayer’s motion to void an additional assessment on the taxpayer based on the income attributable to trust shareholders. The Tax Court found that the retroactive S corporation election filed by the trust shareholders had cured their prior failure to elect to be consenting shareholders.

The taxpayer was a New Jersey corporation that had elected in 1997 to be taxed as an S corporation for both federal and New Jersey tax purposes. It was owned until February 2010 by a non-resident of New Jersey who was its sole shareholder (Paz). Around February 1, 2010, Paz transferred 49 of its 350 issued and outstanding shares to three Grantor Retained Annuity Trusts (GRATs) established by him as the grantor. These GRATs and Paz were the taxpayer’s only shareholders. About August 3, 2010, the shareholders sold all of the shares of the taxpayer. The parties elected to apply Internal Revenue Code (IRC) Sec. 338(h)(10) to the transaction. For federal income tax purposes, the election caused the sale of stock by the shareholders to be disregarded and the transaction treated as a sale of all the assets of the corporation followed immediately by the liquidation of the corporation. The division audited the taxpayer and eventually issued a notice of assessment on December 16, 2015. However, on January 8, 2015 the taxpayer had filed a retroactive S election application that included a consent by the GRATs to New Jersey’s jurisdiction. Most of the additional tax assessed by the division was a result of the characterization of gain on the IRC Sec. 338(h)(10) deemed asset sale as nonoperational income of the taxpayer allocable to New Jersey under the CBT act and includable in the shareholders’ non-resident gross GIT calculations as New Jersey source income.

Retroactive S Corporation Election

To be a New Jersey S corporation, a corporation and its shareholders must on the date of the election (the “initial shareholders”) consent to the election and to New Jersey’s jurisdictional requirements. These includes the state’s right to tax and collect the tax on the shareholder’s income and to collect the tax directly from the corporation, if a shareholder (other than an initial shareholder) fails to consent to the state’s jurisdiction. For shareholders that are not initial shareholders, the S corporation must either deliver the consent or make payments to the director of the amount of tax on the subsequent shareholder’s pro rata share of the S corporation’s income calculated at the highest rate of tax under the GIT. The taxpayer elected in 1997 to be a New Jersey S corporation. The director argued that the GRATs were not initial shareholders and their consent was required once they had become shareholders. Because the consents were not timely filed, the director further argued that the state could collect the tax directly from the taxpayer. The taxpayer argued that the GRATs were “grantor trusts” and all of the income otherwise allocable to the trusts was includable in Paz’s personal return. Also the taxpayer argued the regulation requiring the S corporation election be filed by the trustee of a grantor trust that becomes a shareholder was invalid because it was contrary to the income tax definition of “shareholder” and was inconsistent with the GIT treatment of a grantor trust as a disregarded entity. The regulation provided that a grantor trust be treated as a shareholder which was not an initial shareholder and required a New Jersey S corporation election form be filed. The Tax Court upheld the regulation finding that it was consistent with the plain language and probable intent of N.J.S.A. 54:10A-5.22(b), the statute requiring each initial shareholders and the corporation to consent to jurisdiction.

New Jersey’s regulations allowed for the filing of a retroactive S corporation election. However, they did not address consents for non-initial shareholders. The division argued that the retroactive election was only meant to benefit corporations that had filed S corporation returns but had failed to timely file the New Jersey S corporation election. Under this interpretation, since the taxpayer had neither the executed consents from that GRATs at the appropriate time nor paid the required tax it could not be granted relief. The Tax Court stated that to adopt the director’s interpretation would mean that any time a taxpayer contested the action of the director without first paying the tax alleged to be due, the taxpayer would not be afforded the remedy of a retroactive election. This interpretation would have a chilling effect on the ability of a corporation and its shareholders to legitimately contest an assessment. Thus, the Tax Court found that the failure of the GRATs to file the necessary consents was cured by the filing of the retroactive S election. Although the amount of income required to be included in the shareholders’ returns had not be determined, the tax due from all shareholders had been paid by Paz.

GIT Sourcing an S Corporation’s Income from a Deemed Sale of Assets

The GIT regulations governing the complete liquidation of an S corporation provided that” if the adopted Federal plan of liquidation requires the S corporation, and ultimately the shareholders(s), to recognize a gain or loss from the deemed sale of its assets, the gain or loss from the deemed sale is reported by the shareholder(s) for gross income tax purposes.” The regulations also stated that the income from these sales should be reported by the shareholder in the category “net gains or income for the disposition of property”. However, the regulations did not precisely address sourcing rules. This contrasted with the GIT regulations for sole proprietorship and partnerships, which did contain sourcing rules for business activities carried on both inside and outside New Jersey.

The director argued that McKesson Water Products Company v. Division of Taxation, ¶401-306. Tax Court of New Jersey, No. 000156-2004, August 13, 2007; New Jersey Superior Court, No. A-5423-06T3, July 16, 2009, aff’d., ¶401-452, conclusively established that gains from an IRC Sec. 338(h)(10) deemed sale are nonoperational income assignable to the domiciliary state of the corporation. Applying that holding to the facts of the taxpayer’s case, the gain on the taxpayer’s deemed asset sale would be assigned to New Jersey and would constitute New Jersey income to Paz and the GRATs. The taxpayer argued that there was no statutory cross reference to the CBT for determining the portion of net gains or income from the disposition of property that should be sourced to New Jersey and that the CBT principles apply only to source S corporation income under N.J.S.A. 54A:5-1(p) (net pro rata share of S corporation income). The taxpayer then argued that the principles of McKesson were inapplicable and the methodology of the regulations for sourcing the gain on the sale of assets disposed of in the complete liquidation of the businesses of sole proprietorships and partnerships should instead control. The Tax Court concluded that applying the CBT sourcing rules to the deemed gain on sale of assets under IRC Sec. 338(h)(10) was wholly consistent with the taxation of such income as net gains from the disposition of property under the GIT.

Allocation of Nonoperational Income

The Tax Court stated that McKesson was binding and that there was no discernible difference between the transaction in McKesson and the taxpayer’s case. Further, the Tax Court stated that McKesson was not distinguishable. As McKesson was controlling, the income from the deemed sale of assets by the taxpayer constituted nonoperational income. Further, the Tax Court concluded that the income, having been deemed to be earned by the taxpayer, must be sourced with reference to the CBT and was assignable to New Jersey as the principal place of business of the taxpayer under N.J.S.A. 54:10A-6.1. McKesson controlled to allocate the income to New Jersey as the taxpayer’s domiciliary state.

The taxpayer argued that sourcing the entire gain from the deemed asset sale was a violation of the fair apportionment requirement of the Due Process Clause and the Commerce Clause of the U.S. Constitution because sourcing the entire gain to New Jersey would be out of all proportion to the business activities conducted in the state by the taxpayer. This issue was not addressed by McKesson, where the court resolved the issue before them on purely statutory grounds and did not reach the constitutional issues implicated in the unitary business principle.

The Tax Court stated the definitions of operation and nonoperational income in N.J.S.A. 54:10A-6.1 have their origin in the Uniform Division of Income for Tax Purposes Act (UDITPA) definitions of business and nonbusiness income. Under UDITPA business income of a unitary business is apportioned and nonbusiness income is allocated. The income at issue arose from the deemed sale of assets in connection with a complete liquidation of the taxpayer. That income, the Tax Court stated, was clearly nonoperational income under McKesson, by which precedent the Tax Court was bound. There was no constitutional requirement that such income be apportioned and it was appropriately allocated to the domiciliary state, New Jersey.

The Tax Court also abated the penalty imposed on Paz for the incorrect sourcing of income, but denied the taxpayer’s request for litigation costs.

Xylem Dewatering Solutions, Inc. et al. v. Director, Division of Taxation, New Jersey Tax Court, Nos. 011704-2015, 000056-2016, 000057-2016, April 7, 2017, ¶402-067

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CCHTaxGroup

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