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Who Wants to be a Millionaire? | Cole Schotz P.C., Law Firm Focused on Your Goals
November 15, 2004Phillip S. Pepper | New Jersey Law JournalAttorney: Jeffrey H. Schechter
On June 28, the New Jersey legislature enacted the 2004 Homestead Property Tax Rebate Act (Tax Act of 2004). See N.J. P.L. 2004, c. 40. A key feature of the 2004 Tax Act is the “millionaires’ tax,” as this tax was often referred to by its proponents during the legislative process, which actually affects any taxpayer with income over $500,000, bringing new meaning to the term “fuzzy math.” The new law increased the highest marginal tax rate from 6.37 percent to 8.97 percent, and is retroactive beginning Jan. 1, 2004.
To illustrate the effect of the millionaires’ tax, assume that an unmarried individual earns $1 million of wage compensation and has no deductions. Prior to 2004, that individual’s New Jersey tax would have been $61,574, with is an effective tax rate of 6.16 percent. Beginning in 2004, however, that same individual’s New Jersey tax would be increased by $13,000 to $74,574, which is an effective tax rate of 7.46 percent, or an increase of more than 21 percent.
In absolute numbers, an 8.97 percent tax rate already ensures New Jersey’s place as the state with the fourth highest tax rate. The three states with higher tax rates include Iowa (at 8.98 percent), California (at 9.3 percent), and Vermont (at 9.5 percent). After considering the broad New Jersey tax base, however, the real measure of New Jersey’s tax burden is much greater than 8.97 percent. So who wants to be a millionaire? Or rather, who wants to pay a millionaire’s tax?
The millionaires’ tax is but one example of how New Jersey’s personal and corporate tax systems helped New Jersey earn a reputation among CFOs as one of the states with the worst business tax climate, according to a recent survey in CFO Magazine. See Tim Reason, “Stingers: the 2004 State Tax Survey,” CFO Magazine, Jan. 5, 2004. The CFOs perceived that New Jersey’s tax climate was one of the most unfair and aggressive among the 50 states.
The goal of this article is to analyze New Jersey’s tax system from a tax policy perspective, and to determine whether and what aspects of its tax system are unfair or inefficient. The authors conclude that legislative reform is necessary to increase fairness and efficiency.
Taxing Jurisdiction and Nexus
Taxing jurisdiction, known as “nexus,” refers to a state’s authority to impose tax on an individual, entity, or activity. Taxing jurisdiction may be compared and contrasted with due process and minimum contacts.
Minimum contacts is the due process threshold required for a court to obtain personal jurisdiction over a potential defendant. Minimum contacts may be established by physical presence, or activity which has an economic or tortious impact within a state. Several states may have personal jurisdiction simultaneously over a single defendant on the theory that the defendant’s actions put her on notice as to those potential claims in those states.
Taxing jurisdiction is an entirely different animal. Unlike personal jurisdiction, taxing jurisdiction is a zero-sum game, or at least it should be. If one state wins revenue, another state generally loses revenue. Thus, taxing jurisdiction posits that states should carve the “revenue” pie fairly, and should not “eat the same slice of pie.”
Just as minimum contacts is the threshold standard for due process, nexus is the constitutional threshold standard for taxing jurisdiction. The United States Supreme Court has not yet addressed nexus as to state income tax, but has addressed nexus as to state sales and excise taxes.
In Bellas Hess, the United States Supreme Court set forth a physical presence requirement for nexus under the Due Process Clause. See Nat’l Bellas Hess v. Comm’r, 87 S.Ct. 1389 (1967). Bellas Hess was a mail order company organized in Delaware and headquartered in Missouri. It solicited business by mailing catalogues to past and potential customers. Illinois sought to impose a use tax on Bellas Hess on sales to customers in Illinois, despite the fact that Bellas Hess had no office, no agents, no property, and no advertising in Illinois. Under a minimum contacts analysis, a court would probably conclude that Bellas Hess had “purposefully availed itself of the benefits of doing business in Illinois” due to its mail order marketing activities. Instead, the United States Supreme Court adopted a bright-line test, holding that due process required physical presence for Illinois to impose an excise tax on an out-of-state company.
Twenty-five years later, the United States Supreme Court revisited nexus in Quill, whose facts were nearly identical to those in Bellas Hess. See Quill v. North Dakota, 504 U.S. 298 (1992). The United States Supreme Court reached the same conclusion under a different rationale. The United States Supreme Court held that physical presence, while not necessary for nexus under the Due Process Clause, continued to be necessary for nexus under a Commerce Clause analysis.
The import of these United States Supreme Court cases is that a state cannot impose a sales or excise tax on an individual, entity or activity without a physical presence in-state. Further, only when a taxpayer has a physical presence in more than one state, should states apportion revenue based on other factors such as degree of economic activity or residency.
In October of 2003, the New Jersey Tax Court in Lanco addressed the nexus requirement as codified in N.J.S.A. § 54:10A-2 of the New Jersey’s Corporate Business Tax Act. See Lanco v. Division of Taxation, 21 N.J. Tax. 200 (Oct. 23, 2003). Among others, New Jersey’s nexus requirement is imposed on any corporation “engaging in contacts” within New Jersey, which includes any corporation with a physical presence or economic activity instate. In Lanco, New Jersey sought to impose the Corporate Business Tax on Lanco, a Delaware intangibles holding corporation, on passive income earned by its affiliate, Lane Bryant, which was organized and operated in New Jersey. Lanco had no physical presence in New Jersey, but under N.J.S.A. § 54:10A-2, was nonetheless technically subject to the Corporate Business Tax. The New Jersey Tax Court followed the United States Supreme Court’s holding in Quill and held that New Jersey could not impose a franchise tax on Lanco because it lacked a physical presence in New Jersey.
While New Jersey’s position on statutory nexus appears tenuous after Lanco, the Corporate Business Tax also incorporates the “throw-out” and “addback” rules which, like New Jersey’s broad statutory nexus, effectively impose tax on corporations with an economic nexus to New Jersey but with no physical presence.
The “throw-out” rule applies to a single corporation operating in multiple states. See N.J.S.A. § 54:10A-6. States generally use “formulary apportionment,” which allocates taxable income between in-state and out-of-state sources based on economic factors such as property, payroll, and sales. The “throw-out” rule permits New Jersey to impose a corporate tax on out-of-state economic activity, when it is not subject to an income or franchise tax by the primary taxing jurisdiction. This raises the specter of double-taxation, because the “throw-out” rule ignores out-of-state taxes based on net worth or gross receipts. Thus, not only could the “throw-out” rule apply to permit New Jersey to reach outside its borders to tax out-of-state economic activity, but it could result in double-taxation.
The “add-back” rule indirectly imposes a tax on out-of-state affiliate corporations without a physical presence in New Jersey. See N.J.S.A. § 54:10A-4.4. It does this by “blocking” certain inter-affiliate deductions, such as interest and royalty payments. By denying a deduction to the New Jersey corporation on actual economic payments to its out-of-state affiliates, New Jersey effectively imposes a franchise tax on out-of-state affiliates without a physical presence in-state. Said another way, the “add-back” rule taxes in-state corporations on “phantom income.”
The “add-back” rule was adopted in response to taxpayers employing intangible holding companies to shift income from high-tax to low-tax jurisdictions. What makes this rule particularly harsh, however, is that it applies as the default and not as an exception. Thus, corporations with legitimate out-of-state operations bear the burden of proving by clear and convincing evidence that the “add-back” rule is unreasonable as applied to their facts. Of course, such tax protests do not come without their own costs, which results in a lose-lose situation for many multistate corporations.
What distinguishes the “throw-out” and “add-back” rules from New Jersey’s statutory nexus that was successfully challenged in Lanco? Not much, as one could argue that these rules have the effect of circumventing the constitutional nexus requirement to impose a tax on out-of-state economic activity.
New Jersey’s Corporate Business Tax imposes a franchise tax on every domestic and foreign corporation with nexus to New Jersey. The tax imposed is the greater of three separate amounts: the tax on entire net income, the alternative minimum assessment tax, and the minimum tax.
The tax rate on entire net income is generally a flat 9 percent, except for small businesses earning less than $100,000 in gross income annually. Entire net income is based on federal taxable income with a number of special New Jersey adjustments. Entire net income disallows certain federal deductions including certain tax-free interest and dividend income, bonus depreciation, certain dividends received deductions, certain related-member payments, and certain deductions for civil and criminal penalties and fees.
For the 2002 and 2003 tax periods, net operating losses could not be used and were suspended. Under the recent legislation, for the 2004 and 2005 tax periods, net operating losses can be used, but only to the extent that they do not reduce entire net income more than 50 percent. See N.J. P.L. 2004, c. 47 (June 29, 2004).
The coup de grace of the Tax Act of 2002 is the Alternative Minimum Assessment. New Jersey’s AMA is imposed on a corporation’s gross receipts or gross profits. No other deductions, expenses, or credits are allowed in computing the tax base except that “gross profits” is defined as gross receipts less “cost of goods sold.” Since gross revenue and profits are both top-line income, most of the operating expenses, capital expenditures, and other costs of doing business are disallowed. The AMA, as a “gross” income tax, does not assess tax on a “level playing field” because it usually fails to impose the same tax burden on taxpayers in similar economic circumstances. For example, if a corporation earned gross revenue of $100 million, the AMA assumes it could afford to pay the same amount of tax whether its bottom-line profit was $10 million, $1 million, or it incurred a net loss.
The minimum tax is $500, unless the corporation is a member of an affiliated group with a payroll of $5,000,000 or more, in which case the minimum tax is $2,000. The minimum tax also applies to S corporations.
In addition to the AMA, there are two other significant tax burdens on businesses operating in New Jersey: the entity-level tax on pass-through entities, and the nonresident partner withholding tax.
New Jersey’s entity-level tax applies to pass-through entities, including partnerships and LLCs, and imposes a tax based on the number of partners or members, rather than on receipts or profits. The result is that this “head” tax bears no relation to the entity’s “ability-to-pay.” In contrast, federal tax law does not impose an entity-level tax on pass-through entities. Furthermore, corporations that operate in New Jersey as S corporations, which earn over $100,000 in net income annually, are also subject to a 1.33 percent tax on entire net income. This entity-level tax is phased out by July 1, 2007.
With limited exceptions, the withholding tax requires payments by a pass-through entity with respect to income allocable to a nonresident partner. The withholding amount is equal to such nonresident partner’s distributive share of income multiplied by 6.37 percent for noncorporate nonresident partners, and 9 percent for corporate nonresident partners. N.J.S.A. § 54:10A-15.11. This withholding tax creates a host of potential problems. First, partnerships and LLCs will be forced to treat resident and nonresident partners differently because constructive distributions of the tax are effectively made for the nonresident partners and not for the resident partners. This could violate agreements among the partners that either prohibit disproportionate distributions or do not authorize any distributions without requisite approval. It could also have an adverse impact on cash flow. Affected partnerships and LLCs should review their agreements regarding the effect of this provision and amend them if appropriate.
Thus, recent legislation, such as the AMA, does not treat corporations on a “level playing field.” Corporations subject to the AMA will incur a tax burden entirely unrelated to their actual bottom-line profit and “ability-to-pay.” The tax policy concerns raised by the AMA are exacerbated by the “head” tax on pass-through entities and the nonresident partner withholding tax.
New Jersey’s personal income tax system is, in most respects, a tax on gross, not net, income.
First, a single individual is only allowed a $1,000 personal exemption, a $1,500 exemption for dependents, and no standard deduction. These exemptions and deductions are below the national average. New Jersey only allows a deduction for certain expenses, including medical expenses, alimony and local property taxes. Other federal itemized deductions are disallowed.
Second, in measuring the fairness of New Jersey’s taxes, one must consider the overall effect of the tax burden after sales and property taxes. According to the most recent Census Bureau survey, New Jersey’s property tax is $1,720, per person, which ranks the highest in the nation. In addition, New Jersey imposes a 6 percent sales tax rate, which is above the national average, and levies “sin” taxes of $2.05 per pack of cigarettes (the highest in the country), and $4.40 per gallon of distilled alcohol (also above the national average). Property and excise taxes disproportionately affect lower-income individuals who consume a greater percentage of their disposal income.
Third, taxpayers are required to group their business and investment income into categories or “baskets,” which include business profit, gain from property dispositions, partnership income, S corporation income, rents and royalties, and gambling winnings. There is no carry back or carry forward for overall net losses, and if a taxpayer generates a net loss in one “basket,” that loss is permanently disallowed. The prohibition against utilizing net loss “baskets” to offset other income can significantly overstate a taxpayer’s actual increase in economic wealth. See N.J.S.A. § 54A:5-2. Taxpayers not entitled to utilize net losses, therefore, will bear a tax burden disproportionate to their disposable income or “ability-to-pay.”
Every taxpayer has different costs of living and costs of doing business, none of which is relevant to, or accounted for, by New Jersey’s gross income tax base. In this respect, New Jersey’s tax system does not impose tax on a “level playing field” by requiring individuals, in similar economic circumstances, to pay more or less than their fair share of tax.
New Jersey’s tax system imposes a tax burden among the highest in the nation on several different fronts, including corporate taxes, individual taxes, property taxes, and sales and excise taxes. According to an analysis by the National Association of State Budget Officers, New Jersey’s increases in taxes since 2002 have been the highest in the nation, rising an average of $417 per person. Also see Joe Donohue, “Jersey Leads Most of Nation in Raising Taxes Since ‘02,” The Star Ledger, Aug. 9, 2004. By way of comparison, New York raised taxes by an average of only $242 per person over the same period. New Jersey’s personal income tax, the Alternative Minimum Assessment, and the “head” tax on pass-through entities each raise significant fairness concerns as these taxes are, with few exceptions, imposed without regard to actual increases in “wealth.” Recent tax legislation, including the “millionaires’ tax,” have made a bad situation worse.
Since the passage of the millionaires’ tax, the authors have observed that several clients have inquired about relocating their residences and businesses outside of New Jersey to avoid being subject to tax in New Jersey. If New Jersey does not reverse the tax floodgate, one wonders whether there will be an exodus of individuals and businesses to states with friendlier tax climates. Without tax reform, this may be an indication of what the future has in store.