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Although the state Supreme Court did not render any opinions in tax cases this past term, it did grant certification or is expected to do so in a number of cases of relevance to the tax bar, including one suit on deductibility of Keogh Plan contributions.< On March 20, the Court granted certification to review the Appellate Division decision in Reck v. Director, Division of Taxation,345 N.J. Super 443, (App. Div. 2001). In that case, the Appellate Division reversed the Tax Court and ruled that for gross income tax purposes, a partner was not entitled to deduct from his distributive share of partnership income contributions made on his behalf by the partnership to a qualified retirement plan under the federal Keogh Act. In upholding the appeal of the director of the Division of Taxation, the Appellate Division adopted the director’s argument that N.J.S.A. 54A:6-21 permits a deduction only for contributions to IRC �401(k) plans, not the Keogh plan involved in this case which qualified under IRC �401(a), but was not an approved plan under section 401(k). At the underlying Tax Court level, the plaintiff, a resident partner in Ernst & Young, was permitted to offset against New Jersey gross income his Keogh contributions set forth on the Schedule K-1 which had been issued to him. The holding was based on the Tax Court’s conclusion that the Supreme Court’s opinion in Koch v. Director, Division of Taxation, 157 N.J. 1 (1999) and N.J.S.A. 54A:5-1J and N.J.S.A. 54A:6-10 and 21 necessarily incorporated a determination that partnership contributions to Keogh plans on behalf of partners were deductible business expenses under N.J.S.A. 54A:5-16, which defines net profits from business. The Appellate Division rejected that reasoning and found the Kochcase distinguishable as not applying to a case involving retirement and pension plan contributions, but dealing with accounting principles regarding the cost basis of a partnership interest, and that N.J.S.A. 54A:6-21 controlled the issue presented for decision in the Reckcase. In reaching its decision to reverse the Tax Court, the Appellate Division relied upon the director’s regulation N.J.A.C. 18:35-1.14 (f) and found it reasonable for him to determine that contributions to Keogh plans made on behalf of a partner constitute a portion of the partnership’s profits otherwise distributable to the individual partner and therefore, not an ordinary business expense. For further support, the Appellate Division relied upon Mutch v. Director, Division of Taxation, 9 N.J. Tax 612 (Tax Ct. 1988), aff’d 11 N.J. Tax 87 (App. Div. 1989) where, in affirming the Tax Court, the Appellate Division ruled that employer contributions to a Simplified Employee Pension Plan were not deductible from the employee’s gross income because it was not included within IRC �401(a) plans. Finally, the Appellate Division opined that its recent affirmance of the Tax Court’s opinion in Sidman v. Director of Division of Taxation, 18 N.J. Tax 636 (Tax Ct. 2000), which had held that a taxpayer may not deduct interest on a loan, the proceeds of which were used to purchase shares in a New Jersey subchapter S corporation from his pro rata share of the S corporation’s income, compelled the reversal. In Sidman, Chief Judge Joseph Small distinguished the Kochcase and cited legislative history to support his conclusion that the express language of N.J.S.A. 54A:6-21 applies only to contributions made to a deferred compensation plan that qualified under IRC �401(k). In conclusion, practitioners should note that a taxpayer who has not offset Keogh contributions against partnership income may amend tax returns for open years. The Division of Taxation will reject such a claim for refund and a protest would then have to be filed, followed by a Tax Court complaint upon its rejection. Alternatively, in published Notice 9-22, the Division of Taxation is affording an expedited protest and appeal process that uses a closing agreement format, instead of an issuance of a final determination and Tax Court filing. To elect that process, however, a taxpayer is required to concede interest on the refund in the event the division ultimately loses the issue. Lastly, the division is only offering the closing agreement format to taxpayers who contributed to defined contribution plans and not to those who had contributed to deferred benefit plans. Another recent (June 17, 2002) and important personal income tax case where the Appellate Division reversed the Tax Court and which most probably will eventually be argued before the Supreme Court is Miller v. Director, Division of Taxation, 352 N.J. Super 98 (App. Div. 2002). In Miller, 19 N.J. Tax 522 (Tax 2001), the Tax Court held that where an S corporation sells substantially all of its business, the shareholder was not required to report the resulting gain as S corporation income for gross income tax purposes, but instead, as gain on the disposition of property, which in turn could be netted against the shareholder’s cost basis in the S corporation shares and against any capital losses recognized on the shareholder’s disposition of other properties. The subject dispute arose from two related transactions. First, Miller as the S corporation’s principal shareholder had the corporation sell all its assets to a third party for cash. In the second transaction, which occurred in the same tax year, Miller liquidated his stock in the corporation for the cash generated by the asset sale plus the balance of the corporation’s ordinary income. He treated the two transactions as one, reporting his gain under N.J.S.A. 54A:5-1(c) relating to net gains from disposition of property. Literally interpreting the applicable provisions of the gross income tax act, the director determined that under the act the net pro rata share of S corporation income as reported on a Schedule K-1, and the individual shareholder’s gain or loss on the liquidation of the S corporation shares, are two distinct transactions and are reportable in different categories of income. Thus, the director concluded that the cash generated by the first transaction had to be reported as Miller’s net pro rata share of subchapter S corporation income under N.J.S.A. 54A:5-1(p). That re-categorization increased Miller’s basis in his stock, and consequently, the director determined that Miller was entitled to report a loss with respect to the second transaction under subsection 5-1(c) which specifically governs the sale of subchapter S corporation stock. Although the Appellate Division reversed the Tax Court decision, it is important to note that it concurred in the Tax Court’s rejection of the director’s interpretation of the statute, but disagreed with its solution. Instead, the Appellate Division suggested an alternative interpretation; namely, treating the two transactions as one involving a sale of stock under that portion of N.J.S.A. 54A:5-1(c) specifically addressed to subchapter S corporations. Essentially, the Appellate Division agreed with the Tax Court’s rejection of the director’s literal interpretation and his refusal to treat these transactions as one transaction because it resulted in a tax on the return of capital which was inconsistent with the overall legislative purpose/intent not to tax capital at all which was acknowledged by the Supreme Court in Koch v. Director, Division of Taxation, 157 N.J. 1, (1999). The Appellate Division did find fault, however, with the Tax Court’s determination that N.J.S.A. 54a:5-1(p) did not include “income outside of the subchapter S corporation’s ordinary trade or business, such as capital gains for a corporation that is not in the business of investing or trading capital assets,” but instead should be taxed under the N.J.S.A. 54a:5-1(c) category of net gains from the disposition of property. Such a creation of a sub-category of income to be taxed was inconsistent with the clear language of N.J.S.A. 54A:5-1(p) and supportive legislative history. The author, a partner with Newark’s Sills Cummis Radin Tischman Epstein & Gross, represents taxpayers in civil and criminal tax controversies with the federal and state tax authorities.

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