In a decision released today, the Tax Court of New Jersey ruled in Preserve II, Inc. v. Division of Taxation that a limited partner's interest in a partnership doing business in New Jersey created nexus for corporation business tax (CBT) purposes.1 (A copy of the decision can be found at the Tax Court's website). The decision creates uncertainty for taxpayers that had been relying on BIS LP, Inc. v. Division of Taxation,2 a 2011 decision issued by New Jersey's appellate court. Both cases raised similar issues and had similar facts, yet the Tax Court ruled against the limited partner in Preserve II.
Numerous appeals are pending for other, similarly situated taxpayers at the administrative level and in the courts. Those taxpayers will need to re-examine their strategy in the wake of today's decision.
The case involved an out-of-state limited partner (Preserve) with a 99% interest in two partnerships that conducted homebuilding activities in New Jersey. The partnership agreements gave general partners (not Preserve) "full, exclusive and absolute" authority to manage and control the partnerships. But Preserve and the general partners shared corporate officers, accounting and tax services, banking facilities, and other functions. The limited partner, general partners, and the underlying partnerships were indirectly owned by the same corporate parent.
Preserve argued that it lacked income tax nexus with New Jersey because it was merely a passive investor in the partnerships. The Division countered that Preserve and the partnerships were unitary because of the close relationship and shared functions between Preserve and the general partners. Judge Sundar heard oral argument in March 2016.
Prior Nexus Guidance for Limited Partners
The Division's regulation provides that a limited partner has nexus with New Jersey if the limited partner: is also a general partner; takes an active part in the control of the partnership; has property in New Jersey; has payroll in New Jersey; or is integrally related with the business of the partnership.3 The New Jersey courts analyzed this regulation in BIS LP, Inc.4 Like Preserve II, the BIS LP case involved a corporate limited partner whose only connection to New Jersey was a 99% interest in a partnership doing business in the state. But the Division had stipulated that the limited partner in BIS LP didn't have the right to participate in the management of the partnership, and that the limited partner and partnership were not in the same line of business. Accordingly, BIS LP held that the corporate partner was merely a passive investor and lacked nexus with New Jersey.5
More recently, in Village Super Market,6 the Division adopted a different litigation strategy. Rather than stipulate to the facts, the taxpayer was forced to participate in a multi-day trial. After a lengthy examination of the facts, the court determined that the corporate lines between the limited partner and partnership were so blurred, that the limited partner had physical presence in New Jersey. After its success in Village Super Market, the Division followed a similar strategy in Preserve II.
Tax Court's Decision in Preserve II
In Preserve II, the Tax Court distinguished prior New Jersey precedent concerning out-of-state limited partners. In an opinion that included a lengthy discussion of the facts, Judge Sundar noted that the limited partner and the general partners had overlapping officers and key management personnel. She further noted that the limited partner had made a capital contribution of only $9,900, and found no credible evidence that the officers acted for the partner in a completely passive role of watching that contribution grow. A finding that some of the individual officers didn't even know of the limited partner's separate existence helped to sow further doubt.
In the absence of any evidence of finite lines between the limited partner and the partnerships' home building operations, the court concluded that Preserve was not a mere passive investor with no nexus with New Jersey.
What's Next for Taxpayers with Related Claims?
There are a number of takeaways from the Tax Court's decision in Preserve II, and the impact of the decision extends beyond the facts of the case.
Out-of-state limited partners: tax years before 2014. The Division has now won two straight cases on the issue of whether an out-of-state limited partner has nexus with New Jersey. But this does not mean that other taxpayers should necessarily abandon their refund claims. If a limited partner is limited in name only and is closely affiliated with the general partner, it will clearly have a difficult time convincing the Division or a court that it lacks nexus with New Jersey. If, however, the partner is truly a passive investor or is unrelated to the other partners, it should be able to distinguish its situation from the facts in Preserve II.
Out-of-state limited partners: 2014 and forward. Effective in 2014, the New Jersey legislature amended the CBT partnership statute. A partnership with non-resident partners must pay tax on behalf of those partners. The tax paid is credited to the partners, but only a partner that concedes nexus is entitled to claim the credit. If a non-resident partner lacks nexus, the statute does not permit the partner to obtain a refund. In effect, the statute imposes an entity-level tax on partnerships—but only on partnerships with out-of-state partners. Because of this clear discrimination, partnerships with non-resident partners should consider challenging the rule. Although the Division may try to defend this discriminatory treatment based on the compensatory tax doctrine, the Division would have a difficult time prevailing with such an argument.7
New Jersey's unitary business test. In BIS LP, the appellate court affirmed a taxpayer-friendly application of the unitary-business test. Like Preserve II, the BIS LP case involved a 99% limited partner. But in BIS LP, the court ruled that the partner and partnership were non-unitary because they conducted different businesses: the partner was a holding company, whereas the partnership was an IT company. Although Preserve II addresses the unitary-business test, it provides little analysis concerning its application. Therefore, taxpayers can still rely on the appellate court's guidance in BIS LP. This is significant. Even if a corporate partner has nexus with New Jersey, there is significant flexibility concerning whether to flow-up partnership income and factors, or to compute the tax due using separate accounting.
Expansion of nexus standard? The Tax Court noted that in 2002, the legislature extended the reach of the CBT statute to corporations that derived receipts from New Jersey sources.8 Based on this standard, the court concluded that Preserve is "undoubtedly subject" to CBT. The court's application of this nexus standard could embolden the Division to assert economic nexus in other situations where an out-of-state company has investments in New Jersey.
Special apportionment for investment companies. The Tax Court's decision may make it more difficult for a holding company to qualify for special apportionment as an investment company. If a company limits its activities to investing in corporate stocks, limited partnership interests, debt, patents, or other securities, the CBT statue provides a 60% tax reduction. Based on the court's decision in a prior case,9 many taxpayers believed that limited partners automatically qualified for this special treatment. But after Preserve II, a limited partner won't qualify unless it can show that it is truly a passive investor. The 60% tax reduction was designed to apply only to New Jersey-based holding companies. But there are obvious constitutional problems with this. If your out-of-state holding company is taxable in New Jersey, and would otherwise qualify as an investment company, it should reduce its tax by 60% so that it's treated the same as a New Jersey-based taxpayer.
Effective date of regulations. This
decision marks the second time a court has criticized the Division
for making a regulation effective on a particular date (rather than
as of a particular tax year, which is the approach used by the
legislature for new or amended statutes). The court observed that
this could lead to absurd results, explaining that "taxpayers
in identical situations will be disparately treated simply because
of the date they each chose to file their tax
returns."10 Earlier this year, the Division
promulgated a number of new CBT regulatory provisions with an
effective date of May 18, 2017.11 If your company is
adversely affected by any of the new provisions, the Tax
Court's decision in Preserve II provides another basis for
Reed Smith will be addressing these issues in detail in an upcoming webinar. In the meantime, please contact one of the authors of this alert if you have any questions about how Preserve II might impact pending appeals or positions you're considering on upcoming returns.
1 The decision encompassed three docketed cases. One docket involved the limited partner: Preserve II, Inc. v. Director, Division of Taxation, Docket No. 010921–2013 (N.J. Tax Oct. 4, 2017). The other two dockets involved the underlying partnerships: Docket Nos. 010920–2013 and 010922–2013.
2 26 N.J. Tax 489 (N.J. Super. Ct. App. Div. 2011). After deciding that the limited partner in BIS lacked nexus, the appellate court remanded the case back to the Tax Court to decide whether the limited partner was entitled to a refund of tax paid on its behalf. The Tax Court ruled that the limited partner was entitled to a refund and the appellate court affirmed. BIS LP, Inc. v. Division of Taxation, 27 N.J. Tax 58 (N.J. Tax 2012), affirmed 28 N.J. Tax 269 (N.J. Super. Ct. App. Div. 2014).
3 See N.J.A.C. 18:7–7.6(c).
4 25 N.J. Tax 88 (N.J. Tax 2009), affirmed 26 N.J. Tax 489 (N.J. Super. Ct. App. Div. 2011).
5 See id. at 102–03.
6 See Village Super Market of PA, Inc. v. Director, Division of Taxation, 27 N.J. Tax 394 (N.J. Tax 2013), affirmed 2015 WL 998622 (March 9, 2015).
7 David J. Gutowski, et al., The BIS Case: A Big Shift in New Jersey's Unitary Business Rule and the Taxation of Corporate Partners, 22 J. of Multistate Tax. 7 (2012), available here.
8 See L. 2002, c. 40, § 1 (amending N.J.S.A. 54:10A–2 to impose CBT on "the privilege of deriving receipts from sources within this State").
9 See Manheim N.J. Invest. Inc. v. Director, Division of Taxation, 30 N.J. Tax 18, 30 n.5 (N.J. Tax 2017) (Andresini, J.T.C.).
10 See Preserve II, supra.
11 See generally 49 N.J.R. 52(b).
This article is presented for informational purposes only and is not intended to constitute legal advice.