New Jersey Supreme Court Decision May Create Refund Opportunities
The New Jersey Supreme Court has held that under the New Jersey Gross Income Tax Act (N.J.S.A. 54A:1-1 to 10-12), New Jersey's tax is limited to the gain realized by a partner on a sale of a partnership interest based upon the original cost basis of the partnership interest, not on the federal adjusted basis. Because New Jersey did not give the taxpayer the benefit of deducting the partnership losses that had reduced the federal basis of the partnership interest, the Court concluded the original cost basis should not be reduced in measuring the New Jersey taxable gain. The Supreme Court thus ruled against the New Jersey Director of the Division of Taxation, and reversed both the Tax Court's and the Appellate Division's findings that federal adjusted basis was the starting point for computing the gain on the sale of a partnership interest.
In Koch v. Director, Division of Taxation, (decided January 14, 1999) the taxpayer had purchased a partnership interest for $75,000 in cash, and had also assumed personal liability for a portion of the partnership's debts, thus permitting those debts to be includible in basis. Over the years, the partnership passed through to the taxpayers losses aggregating $218,161, of which they claimed $211,895, leaving them with a "negative" federal tax basis of $136,895. The New Jersey Gross Income Tax Act does not permit the deduction of partnership losses, and therefore the taxpayers never received any New Jersey tax benefit from the losses that reduced their federal tax basis.
Koch eventually sold his partnership interest for $125,000, triggering a federal gain of $217,785, but netting a "profit" of only $50,000. Koch reported New Jersey gain of $50,000.
The Director of New Jersey's Division of Taxation argued that, notwithstanding the New Jersey tax law's denial of a deduction for partnership losses and elimination of the tax benefits available under federal tax law arising from those losses, New Jersey could still compute the gain on the sale of the partnership interest using the federal adjusted basis rather than original cost. The Director thus sought tax on the full $217,785 of federal gain.
The Supreme Court held that since the taxpayer had received no New Jersey tax benefit for the partnership losses, it was improper to calculate his gain by reference to the federal adjusted basis that reflected the federal tax benefit received. The Court said that the taxpayer should "be taxed on his actual economic gain and not on fictitious income."
Those New Jersey taxpayers who have sold partnership interests and paid tax on the gain calculated by using federal adjusted basis should review their returns to see if refunds may be available. Generally, refunds may be claimed within three years after tax returns have been filed.