Waksal v. Director, Division of Taxation, A-103 September Term 2011; Supreme Court; opinion by Patterson, J.; decided August 13, 2013. On certification to the Appellate Division. [Sat below: Judges Ashrafi and Fasciale in the Appellate Division.] DDS No. 35-1-0992 [26 pp.]

In 2002, Harlan Waksal made a $14,769,320 loan to his brother, Samuel. Samuel made no payments on the loan. Consequently, on their 2004 joint federal income tax return, Harlan and Carol Waksal reported a $14,769,320 short-term capital loss from the loan pursuant to 26 U.S.C.A. § 166(d)(1)(B), under which losses from worthless nonbusiness debts are treated as short-term capital losses. That provision has no direct counterpart in New Jersey tax law.

In the absence of a provision expressly authorizing the deduction they sought, the Waksals invoked N.J.S.A. 54A:5-1c, which taxes "net gains or net income, less net losses, derived from the sale, exchange or other disposition of property … as determined in accordance with the method of accounting allowed for federal income tax purposes. Relying on Koch v. Director, Division of Taxation, 157 N.J. 1 (1999), they claimed that § 5-1c's language incorporates 26 U.S.C.A. § 166(d)(1)(B) as a method of accounting recognized in federal law. They therefore reported a $14,769,320 loss on their New Jersey income tax return and used it to offset capital gains realized from the disposition of other property.

The Division of Taxation disallowed the loss and the Waksals were advised that there was an outstanding balance on their 2004 New Jersey income tax obligation.

They filed a complaint in the Tax Court, which granted summary judgment in favor of the director. The Appellate Division affirmed. The Waksals' petition for certification was granted. They maintain that § 5-1c authorizes their claimed deduction of a worthless nonbusiness debt by incorporating the Internal Revenue Code's treatment of such debts into New Jersey's tax law.

Held: Based on the plain language of N.J.S.A. 54A:5-1c, the worthless nonbusiness debt at issue is not a "sale, exchange or other disposition of property" under that provision. Further, § 5-1c does not integrate into the Gross Income Tax Act every provision of the Internal Revenue Code governing capital gains and losses. Title 26 U.S.C.A. § 166(d)(1)(B) is not a federal "method of accounting" for purposes of this case. Therefore, plaintiffs cannot offset their capital gains with their worthless nonbusiness debt pursuant to 54A:5-1c on their state return.

The court says that under the Internal Revenue Code, the Waksals' loss due to Harlan's worthless nonbusiness loan is treated as a short-term capital loss and the Waksals were entitled to report the loan as a loss on their 2004 federal income tax return. However, New Jersey's act does not mirror the Internal Revenue Code's treatment of deductions for capital losses. In contrast to the Internal Revenue Code, the New Jersey Tax Act is a tax on gross income reduced only by certain limited deductions and credits. There is no provision in the act expressly authorizing a deduction for worthless nonbusiness debts.

The court therefore considers whether the loan was "derived from the sale, exchange or other disposition of property" within the meaning of § 5-1c.

The Waksals argue that the loss was derived from a "disposition" of real or personal property. The court disagrees, finding persuasive prior case law that addressed this issue.

Applying the plain language of the statute, the court says plaintiffs' inability to collect on the loan does not give rise to a "disposition" of real or personal property for purposes of § 5-1c. The loan was memorialized in a promissory note, which remained with the lender at all relevant times, and a disposition did not occur when it was effectively abandoned because it was worthless. The record reveals no change in the legal status of the loan other than plaintiffs' reporting of a short-term capital loss on their returns. Thus, there was no "disposition" of this asset within the meaning of § 5-1c and that provision does not govern this case.

Despite its determination that § 5-1c is not implicated in this case, the court opts to consider the extent to which its reference to "the method of accounting allowed for federal income tax purposes" effectively incorporates into New Jersey law 26 U.S.C.A. § 166(d)(1)(B)'s approach to worthless nonbusiness debt losses.

The court rejects plaintiffs' reliance on Koch, which considered "federal methods of accounting" in § 5-1c and its application to the calculation of the taxpayer's basis in the partnership interest that he sold, finding that the absence of a sale, exchange or other disposition distinguishes Koch. The court says Koch was not concerned with the applicability in New Jersey of a deduction recognized by the Internal Revenue Code, but with the potential conflict among three competing federal tax concepts explicitly mentioned in § 5-1c: the use of federal accounting methods; the use of the federal adjusted basis; and the use of federal nonrecognition principles.

No reported case after Koch construes § 5-1c to incorporate federal tax provisions that authorize deductions not expressly permitted by New Jersey's act. Rather, they construe § 5-1c cautiously, recognizing the fundamental distinctions between the federal and New Jersey income tax laws.

The court says neither § 5-1c nor Koch mandates application of 26 U.S.C.A. § 166(d)(1)(B) to the debt at issue. Section 5-1c must not be construed so as to erode the important distinctions between the Internal Revenue Code's approach to deductions and that of the act.

Chief Justice Rabner, Justices LaVecchia, Albin and Hoens and Judges Rodriguez and Cuff, both temporarily assigned, join in Justice Patterson's opinion.

For appellants — R. James Kravitz (Fox Rothschild; Jonathan D. Weiner, Steven C. Levitt, Wendy Wolff Herbert and Abbey True Harris on the briefs). For respondent — Lewis A. Scheindlin, Assistant Attorney General (Jeffrey S. Chiesa, Attorney General; Ramanjit K. Chawla, Deputy Attorney General, on the letter briefs).