No. 011704-2015

April 7, 2017 (Date Decided)

Judge Fiamingo

For plaintiff: David J. Shipley and Aliza Sherman (McCarter & English, LLP, attorneys).

For defendant: Michael J. Duffy (Christopher S. Porrino, Attorney General of New Jersey, attorney).

The issue was whether the gain from the deemed sale of assets of a New Jersey S corporation under Internal Revenue Code §338(h)(10) is sourced to New Jersey on the nonresident shareholders’ New Jersey Non-Resident Gross Income Tax returns.

Xylem Dewatering Solutions Inc., a New Jersey corporation, elected to be taxed as an S corporation. John Paz, a nonresident of New Jersey, was Xylem’s sole shareholder until Feb. 1, 2010, when Paz transferred 49 of the 350 shares of the corporation to three Grantor Retained Annuity Trusts. Shortly thereafter, the shareholders sold all of the shares of the corporation, electing to apply §338(h)(10) to the transaction. For federal income tax purposes, the sale of stock by the shareholders was disregarded and the transaction was treated as a sale of all of the assets of the corporation, followed immediately by liquidation.

As to New Jersey, the court found that Paz incorrectly sourced the income taxable to the shareholders on the liquidation of the corporation. In a substantially similar matter, McKesson Water Prods. Co. v Director, Div. of Taxation, 408 N.J. Super. 213 (App. Div. ), certif. denied, 200 N.J. 506 (2009), held that the gain on a deemed sale was nonoperational income under N.J.S.A. 54:10A-6.1, and therefore assignable to the corporate plaintiff’s principal place of business. Here, McKesson controls and the income from the deemed sale of assets by the corporation constituted nonoperational income. Deemed to be earned by the corporation, such income must be sourced with reference to the Corporation Business Tax and is assignable to New Jersey as the corporation’s principal place of business under N.J.S.A. 54:10A-6.1.

Defendant Division of Taxation’s assessment of gross income tax on the nonresident shareholders was affirmed. Plaintiffs’ motion to void the assessment for additional tax on the corporate plaintiff based on the income attributable to the Trust shareholders was granted. The retroactive election filed by the Trust shareholders cured the prior failure to elect to be consenting shareholders. Plaintiffs’ motion to abate underpayment penalties was granted; their position was reasonable due to the lack of certainty in the regulations and lack of guidance as to the sourcing of income in N.J.A.C. 18:35-1.5, the Director’s regulation at N.J.A.C. 18:7-8.12(g) apportioning the gain on an I.R.C. §338(h)(10) deemed sale, and the disparate treatment of sole proprietorships and partnerships in N.J.A.C. 18:35-1.1 and 1.3. The court denied plaintiffs’ demand for litigation costs.

No. 011704-2015

April 7, 2017 (Date Decided)

Judge Fiamingo

For plaintiff: David J. Shipley and Aliza Sherman ( McCarter & English, LLP , attorneys).

For defendant: Michael J. Duffy (Christopher S. Porrino, Attorney General of New Jersey, attorney).

The issue was whether the gain from the deemed sale of assets of a New Jersey S corporation under Internal Revenue Code §338(h)(10) is sourced to New Jersey on the nonresident shareholders’ New Jersey Non-Resident Gross Income Tax returns.

Xylem Dewatering Solutions Inc., a New Jersey corporation, elected to be taxed as an S corporation. John Paz, a nonresident of New Jersey, was Xylem’s sole shareholder until Feb. 1, 2010, when Paz transferred 49 of the 350 shares of the corporation to three Grantor Retained Annuity Trusts. Shortly thereafter, the shareholders sold all of the shares of the corporation, electing to apply §338(h)(10) to the transaction. For federal income tax purposes, the sale of stock by the shareholders was disregarded and the transaction was treated as a sale of all of the assets of the corporation, followed immediately by liquidation.

As to New Jersey, the court found that Paz incorrectly sourced the income taxable to the shareholders on the liquidation of the corporation. In a substantially similar matter, McKesson Water Prods. Co. v Director, Div. of Taxation, 408 N.J. Super. 213 (App. Div. ), certif. denied, 200 N.J. 506 ( 2009 ) , held that the gain on a deemed sale was nonoperational income under N.J.S.A. 54:10A-6.1 , and therefore assignable to the corporate plaintiff’s principal place of business. Here, McKesson controls and the income from the deemed sale of assets by the corporation constituted nonoperational income. Deemed to be earned by the corporation, such income must be sourced with reference to the Corporation Business Tax and is assignable to New Jersey as the corporation’s principal place of business under N.J.S.A. 54:10A-6.1 .

Defendant Division of Taxation’s assessment of gross income tax on the nonresident shareholders was affirmed. Plaintiffs’ motion to void the assessment for additional tax on the corporate plaintiff based on the income attributable to the Trust shareholders was granted. The retroactive election filed by the Trust shareholders cured the prior failure to elect to be consenting shareholders. Plaintiffs’ motion to abate underpayment penalties was granted; their position was reasonable due to the lack of certainty in the regulations and lack of guidance as to the sourcing of income in N.J.A.C. 18:35-1.5, the Director’s regulation at N.J.A.C. 18:7-8.12(g) apportioning the gain on an I.R.C. §338(h)(10) deemed sale, and the disparate treatment of sole proprietorships and partnerships in N.J.A.C. 18:35-1.1 and 1.3. The court denied plaintiffs’ demand for litigation costs.