Originally published on Forbes.com Sept 13th, 2013
State tax computations will quite often follow federal computations pretty closely. Not infrequently, though, there are nasty surprises. The recent decision in New Jersey Tax Court in the case of Constance Dinallo is an example. New Jersey apparently does not care for tax shelters. The numbers you enter on the Gross Income Tax return form designating the various categories of income must all be positive. If a category is negative, you enter zero. New Jersey only wants to partner with you when you are making money.
Coordinating this with your federal return is a little tricky. If you are a partner in a partnership your basis in your partnership interest is being reduced by losses. Someday, if you are lucky or good, your ship might come in. The positive number that flows through on your federal return might be larger due to those past losses that New Jersey did not give you credit for.
N.J.S.A. 54A:5-2 mandates that any losses in any category of income incurred in a given taxable year must be applied as a deduction against income in that same category in the same taxable year. Thus, losses may not be carried forward into taxable years in which they were not incurred.
So it seems like you are out of luck. There is a glimmer of hope though.
However, the New Jersey Supreme Court held that the Director cannot use a federal adjusted basis if it results in a taxpayer being taxed on a return of capital. In other words, a taxpayer can only be taxed on the economic gain resulting from a sale.
In 2004, Empire Ltd. flowed a $2,533,468 gain through to Ms. Dinallo. Following the logic above she offset the gain with losses from prior years of $1,749,716.
There was a problem :
In this case, Director contends that plaintiff could not offset losses from prior years for NJ GIT purposes in her tax year 2004 return as her interest in Empire continued through 2005 ( i.e. there was no sale, exchange or other disposition terminating plaintiff’s interest in Empire in 2004). On the other hand, plaintiff contends that she was able to offset the prior years’ losses because her interest in Empire was dissolved in the year 2004 with the sale of the partnership’s land.
Apparently the partners of Empire Ltd. kept the partnership open for several years after the land sale in 2004. New Jersey only allows the accumulated losses in the year when the partnership is totally disposed of. Since the big gain was recognized in 2004, when those losses are finally allowed for New Jersey purposes, they might do no good.
State Taxes – Nasty Surprises
It would not be at all unusual to keep a single purpose partnership alive for a year or two after its main assets have been sold. There will frequently be contingent liabilities or escrows and the like. Absent special circumstance (such as a transfer without a 754 election), the continued existence of the partnership will have little significance to the partners. They recognized income in the year the partnership earned it and as long as they get the bulk of their distributions, the remaining entity will not cause them any trouble for federal tax purposes. State taxes, at least in New Jersey, are a different story.
When it comes to New Jersey Gross Income Tax, keeping the partnership alive cost Ms. Dinallo $166,049 plus penalties and interest. I have written about worse outcomes. Robert Marshall invested about $150,000 in a partnership that invested in the iconic US Steel Tower in Pittsburgh, PA. He received about $6,000 in distributions over 20 years. When the deal unwound with no further distributions in 2005, he ended up with a Pennsylvania state income tax liability of $165,055.
In planning flow-through investments, it is important that you consider state income taxes, both in the state of operation and the state of residence of the investors. This is particularly important when dealing with states that have significant variations from federal principles in their computations.
Commentary From Another Jersey Boy
Bob Flach, the Wandering Tax Pro, like me is a New Jersey native, but he stayed a lot longer than I did and has much more experience with New Jersey returns than I do. So I asked him for his take on this case:
My former home state of New Jersey is indeed a unique one when it comes to state income taxes. It has a “Gross” Income Tax – and losses in one category of income cannot be applied against income in other categories of income.
Most states with income taxes follow the federal 1040. However when the NJ state income tax was created they decided to borrow from neighbor Pennsylvania rather than neighbor New York. Pennsylvania has a true gross state income tax, with losses from one category not being allowed against income from another category. NJ did make some adjustments just to be different – it allowed for personal exemptions and a couple of deductions (excess medical expenses and real estate tax).
For NJ Gross Income Tax purposes income from a sub-S corporation has been a different category of income than income from a partnership, which is a different category than income from a sole proprietorship. This is different from the PA state income tax, where all types of business income and losses (Schedule C, sub-S, and partnership) are combined in a single category. NJ has only recently decided to allow losses from one type of business activity to offset gains from another type of business activity, and is phasing in this change beginning with the 2012 Form NJ-1040
And, as Peter points out, NJ does not permit the carry forward of any net losses that are not allowed to be claimed in the current year. This is also true for capital losses from the federal Schedule D. So the NJ taxpayer is royally screwed (something he has become very used to).
Where I have seen this royal screwing most is with the sale of rental real estate. The federal basis must be used in the calculation of gain or loss, including the recapture of depreciation allowed or allowable on the federal Schedule E. So the NJ taxpayer, who received no state tax benefit from much if not all of the annual depreciation deductions when the property was being rented, because this deduction created a rental loss for the year, still has to reduce his basis for gain by the federal depreciation.
There is some relief if the annual depreciation by itself, without taking into consideration any other rental deductions, reduced the gross rental income below 0. In years when this was the case the depreciation deduction in excess of gross rents does not have to be recaptured when determining the NJ state tax basis of the property.
Peter’s take away from this post is very important – when doing tax planning you must always take into consideration the state tax implications of whatever actions you are considering. Or maybe more appropriately, don’t live in NJ.
You can follow me on twitter @peterreillycpa.