Title: Koch v. Director, Division of Taxation
Citation: N/A
Docket Number: a-135-97
State: new-jersey
Issuer: new-jersey Supreme Court
Date: January 14, 1999

(This syllabus is not part of the opinion of the Court. It has been prepared by the Office of the Clerk for the convenience of the reader. It has been neither reviewed nor approved by the Supreme Court. Please note that, in the interests of brevity, portions of any opinion may not have been summarized). GARIBALDI, J., writing for a unanimous Court. This appeal involves the tax treatment under the New Jersey Gross Income Tax Act (the Act) of the taxpayer's gain realized from the sale of his partnership interest. The question is whether the cost basis of that interest should be the purchase price or the federal adjusted basis (purchase price less losses deducted on federal income tax returns). The deducted losses provided the taxpayer with a federal income tax benefit. However, because the losses were not deductible on the taxpayer's New Jersey gross income tax returns, they provided no tax benefit under the Act. Koch purchased a limited partnership interest in US Cable in 1988 for $75,000 in cash. He also agreed to be personally liable for a portion of US Cable's indebtedness to a third party. Koch was allocated $218,161 of US Cable's losses for 1983 through 1987. He deducted $211,895 of those losses on his federal income tax returns (reducing his capital account from $75,000 to a negative $136,895). Thus, Koch's federal income tax basis for his interest in US Cable was reduced to zero. Koch sold his interest in 1988 for $125,000 in cash, an additional constructive payment to eliminate the $143,161 deficit in his capital account, and a release from the creditors of US Cable for his personal liability for partnership debt. On his federal income tax return, Koch reported the amount realized as $268,161, computed by adding the cash received ($125,000) and the reversal of his negative capital account ($143,161). Due to the losses deducted for prior years, Koch had no basis in the partnership for federal income tax purposes. Thus, the entire amount realized on the sale of the partnership was taxable income, $217,785 of which was reported as capital gain and $50,376 as depreciation recapture income. On his 1988 New Jersey gross income tax return, Koch reported $50,000 as net gain from the sale of the partnership. This amount was the difference between the sale proceeds of $125,000 and the $75,000 price paid. Koch did not reduce the initial cost basis of his partnership interest by the losses allocated to him because they were not deductible under the Act. The Director of the Division of Taxation redetermined Koch's tax liability, and concluded that Koch's basis in the partnership was the same as his basis for federal income tax purposes. Thus, Koch was required to report and pay State taxes on the same amount of gain he reported for federal income tax purposes. Koch filed a complaint with the Tax Court, asserting that the Act does not require a taxpayer to reduce the basis of his partnership interest by losses that are not deductible under the Act. The Tax Court disagreed and concluded that, in determining gain or loss under the Act, adjusted basis for federal income tax purposes must be used and no exception is permitted even where the taxpayer was unable to deduct partnership losses. Koch v. Director, Dir. of Taxation, 15 N.J. Tax 387, 395 (Tax Ct. 1995). The Appellate Division affirmed in an unpublished, per curiam opinion substantially for the reasons stated by the Tax Court. The Supreme Court granted certification. HELD: In calculating taxable income from the disposition of property under the Act, the basis cannot be the federal adjusted basis where that basis has been reduced by losses that are not deductible under the Act. Any income tax imposed on an amount greater than the taxpayer's economic gain (in this instance, sale price less purchase price) represents a tax on a return of capital, a result not intended by the Legislature. 1. N.J.S.A. 54A:5-1c sets forth three federal income tax concepts to be applied in calculating net gain from the disposition of property: (1) the method of accounting used for federal income tax purposes, (2) the use of the federal adjusted basis, and (3) the exclusion of gains to the extent federal rules require nonrecognition. Koch asserts that by limiting his focus to the adjusted basis provision, the Director fails to recognize and apply the other provisions. When there is a conflict among different parts of a legislative provision, the provision should be read in a manner which harmonizes those parts and does justice to the provision's overall meaning. (pp. 6-9) 2. An examination of the statutory scheme discloses that with respect to section 5-1c income, the Legislature intended to tax only income and not a return on capital. Koch purchased his partnership interest for $75,000 and sold it for $125,000, resulting in an economic gain of $50,000. Any tax on an amount greater than the gain of $50,000 represents a tax on amounts that are neither economic gain nor recovery of a past tax benefit. Instead, it represents a tax on a return of capital. (pp. 9-11) 3. The Director's position ignores the federal accounting and nonrecognition provisions of section 5-1c. By including reference to federal methods of accounting or nonrecognition provisions of the Internal Revenue Code, the Legislature explicitly intended to incorporate federal income tax concepts. Further, Koch's calculation of gain conforms to section 5-1c's directive to use methods of accounting allowed for federal income tax purposes to determine gain or loss for New Jersey gross income tax purposes. Under the federal method of accounting, losses not passed through to a partner would not reduce the partner's basis, and gain would be determined simply by computing the difference between a partner's cost basis (unreduced by partnership losses) and proceeds received from the sale. Accordingly, the accounting method allowed for federal income tax purposes does not require the use of Koch's federal adjusted basis to compute his gain. (pp. 11-14) 4. The Court rejects the various other assertions of the Director. The Court does agree with the Director that the Legislature did not intend to incorporate tax shelter provisions in the Act. However, there is no evidence that the Legislature intended to penalize a New Jersey taxpayer for investing in a tax shelter for federal income tax purposes. The Court believes that its interpretation harmonizes the three basic concepts of section 5-1c and effectuates the Legislature's plan that the return of capital not be taxed. (pp. 14-19) CHIEF JUSTICE PORITZ and JUSTICES HANDLER, POLLOCK, O'HERN, STEIN and COLEMAN join in JUSTICE GARIBALDI'S opinion. SIDNEY KOCH and DOROTHY KOCH, Plaintiffs-Appellants, v. DIRECTOR, DIVISION OF TAXATION, Defendant-Respondent. Argued September 15, 1998 -- Decided January 14, 1999 On certification to the Superior Court, Appellate Division. Howard M. Soloman and Harold Leib argued the cause for appellants (Harold Leib &amp; Associates, attorneys; Mr. Leib, Mr. Soloman, Elisa Leib and Robert C. Hess, on the briefs). Patrick DeAlmeida, Deputy Attorney General, argued the cause for respondent (Peter Verniero, Attorney General of New Jersey, attorney; Joseph L. Yannotti, Assistant Attorney General, of counsel; Joseph W. Fogelson, Deputy Attorney General, on the brief). Robert J. Holtz, a member of the Pennsylvania bar, argued the cause for amici curiae The National Realty Committee, The New Jersey Apartment Association and The New Jersey Chapter of the National Association of Industrial and Office Properties (Archer &amp; Greiner, attorneys; Mr. Holtz, John C. Connell and Steven K. Mignogna, on the brief). The opinion of the Court was delivered by GARIBALDI, J. This appeal involves the tax treatment under the New Jersey Gross Income Tax Act, N.J.S.A. 54A:1-1 to 10-12 (the "Act"), of a taxpayer's gain realized from the sale of his partnership interest. The primary issue concerns the proper method for calculating a taxpayer's cost basis for a partnership interest and, specifically, whether that cost basis should be the purchase price or the taxpayer's federal adjusted basis (his purchase price less the losses deducted on his federal income tax returns). In addition to reducing taxpayer's federal adjusted basis, those losses also provided the taxpayer with a federal income tax benefit. However, because those losses were not deductible on the taxpayer's New Jersey gross income tax returns, they provided taxpayer with no tax benefit under the Act. * * * . . . The term "net gain or income" shall not include gains or income from transactions to the extent to which nonrecognition is allowed for federal income tax purposes. Thus, section 5-1c sets forth three federal income tax concepts that are to be applied in calculating net gain: (1) the method of accounting used for federal income tax purposes, (2) the use of the federal adjusted basis, and (3) the exclusion of gains to the extent federal rules require nonrecognition. Walsh v. Director, Div. of Taxation, 10 N.J. Tax 447, 459 (Tax Ct. 1989), aff'd per curiam, 240 N.J. Super. 42 (App. Div. 1990). Koch asserts that by improperly limiting his focus to the adjusted basis provision, the Director fails to recognize and apply the other provisions, thereby failing to harmonize the three provisions. [Zimmerman v. Municipal Clerk of Tp. of Berkeley, 201 N.J. Super. 363, 368 (App. Div. 1985) (citing Alexander v. New Jersey Power &amp; Light Co., 21 N.J. 373 (1956).] Finally, "whatever be the rule of [statutory] construction, it is subordinate to the goal of effectuating the legislative plan as it may be gathered from the enactment read in full light of its history, purpose and context." State v. Haliski, 140 N.J. 1, 9 (1995) (quoting State v. Gill, 47 N.J. 441, 444 (1966)). In this case, Koch purchased his partnership interest for $75,000 and sold it for $125,000, resulting in an economic gain of $50,000. Any income tax imposed on an amount greater than Koch's economic gain of $50,000 constitutes a tax on amounts that represent neither economic gain nor recovery of a past tax benefit. Instead, it represents a tax on a return of capital. Such a result was not intended by the Legislature. But see Vasudev v. Director, Div. of Taxation, 13 N.J. Tax 223 (Tax Ct. 1993); Spinella v. Director, Div. of Taxation, 13 N.J. Tax 305 (Tax Ct. 1993) (distinguishing Walsh by concluding that adjustment to basis was made in Walsh because Subchapter S corporations were not recognized as matter of New Jersey law but acknowledging that their cases involved sales of partnership property, rather than sale of partnership interests, did not involve returns of capital). Similarly, we do not find that the Legislature's 1993 Subchapter S corporation legislation, L. 1993, c. 173, codified at N.J.S.A. 54:10A-4 (the "1993 Legislation"), indicated that the Legislature did not believe a Walsh-type adjustment was required in the case of partnerships. The 1993 Legislation recognized Subchapter S corporations and provided for their tax treatment. Aside from the Legislature's express endorsement of Walsh in the legislative history, see Assembly Appropriations Committee Statement accompanying L. 1993, c. 173, codified at N.J.S.A. 54:10A-4, the 1993 legislation is of little relevance to this matter. Because the purpose of the 1993 legislation was to recognize Subchapter S corporations and the issue of basis adjustments for partnership interests was not before the Legislature or the courts at the time, there was no reason for the Legislature to consider an adjustment to the basis of a interest in a partnership. We understand that there is presently pending in the Legislature Senate Bill 71, which proposes that a taxpayer's basis in a partnership interest shall be computed in a manner similar to the computation of a taxpayer's basis in shares of a Subchapter S corporation. Pending legislation, however, is of little value in determining legislative intent. In re Adoption of N.J.A.C. 5:25A-1.1, 266 N.J. Super. 625, 633 n.1 (App. Div. 1993); Pickett v. Lloyds, 252 N.J. Super. 477, 489 (App. Div. 1991), aff'd 131 N.J. 457 (1993); cf. Hammock v. Hoffman-LaRoche, 142 N.J. 356, 378 (1995) (placing little value on standard proposed by legislation "not enacted into law"). CHIEF JUSTICE PORITZ and JUSTICES HANDLER, POLLOCK, O'HERN, STEIN and COLEMAN join in JUSTICE GARIBALDI's opinion. NO. A-135 SIDNEY KOCH and DOROTHY KOCH, Plaintiffs-Appellants, v. DIRECTOR, DIVISION OF TAXATION, Defendant-Respondent. DECIDED