On certification to the Superior Court, Appellate Division.
For affirmance -- Chief Justice Wilentz, and Justices Clifford, Handler, Pollock, O'Hern and Garibaldi. For reversal -- None. The opinion of the Court was delivered by Garibaldi, J.
The issue in these cases is the proper method of taxing a partner on his or her "distributive share of partnership income" under the New Jersey Gross Income Tax Act, N.J.S.A. 54A:1-1 to 54A:10-12 (the "Act"). Specifically, we must determine whether all partnership income realized in the ordinary course of the business of a partnership actively engaged in the securities business is to be taxed to the partners on a net consolidated basis as a single category of income, i.e., "distributive share of partnership income" under N.J.S.A. 54A:5-1k, or whether, pursuant to N.J.A.C. 18:35-1.14(c)4, the taxpayer's partnership income is to be divided into three subcategories, one of which, "distributive share of partnership income," is to be taxed on a net basis, while the other two, "dividends" and "gains," are to be taxed on a gross basis. Practically, the question posed in these cases is whether a partner in a securities firm, in determining his "distributive share of partnership income," may deduct partnership business expenses against all types of partnership income, including dividends and capital gains, realized in the ordinary course of that partnership's business.
These cases arise from tax deficiencies assessed against Layton and Joan Smith for 1976 and against Roger and Lisa Geissler for 1978,*fn1 1979, and 1980.*fn2 The facts are stipulated.
At all relevant times the Smiths and Geisslers were New Jersey residents. Layton Smith was a general partner in Salomon Brothers, a New York limited partnership actively engaged in the securities business. Roger Geissler was a general partner in Easton & Co., a New York limited partnership
actively engaged in the securities and commodities businesses. In the ordinary course of their businesses, these partnerships generated various types of income, including commissions, investment advisory fees, underwriting and syndication fees, dealer profits, interest, dividends, and trading profits. The trading profits were capital gains realized by each partnership in the ordinary course of its business of trading securities. Likewise, in the ordinary course of their businesses, these partnerships incurred and paid business expenses, including salaries, rent, interest, and depreciation. These expenses were incurred in the production of all types of the partnerships' business income, including dividends and gains.
Each taxpayer computed his distributive share of partnership income by aggregating all the partnership's business income to which he was entitled, including dividends and gains, and deducting his share of the business expenses incurred by the partnership.*fn3 The taxpayers contend that business expenses in excess of partnership income other than dividends and gains may be applied against those two categories of income.
The Director agrees with the taxpayers that a "distributive share of partnership income" is a partner's share of the "[n]et income of the partnership," which is "determined and reported on the basis of accepted accounting principles . . . after provision for all cost and expenses incurred in the conduct thereof." N.J.A.C. 18:35-1.14(c)2. The Director, however, does not agree
that the "net income of a partnership" includes dividend and capital gains realized by a partnership in the ordinary course of its business. Instead, the Director, relying on N.J.A.C. 18:35-1.14(c)4, concludes that partnership income consists of three separate categories of income -- "distributive share of partnership income," "dividend income," and "gain from the sale, exchange or other disposition of property." Under the Director's theory, partnership business expenses are deductible only against "distributive share of partnership income"; and business expenses exceeding that income are not deductible against income from dividends and capital gains, even where, as here, such income is realized in the ordinary course of business. The result is that not all business expenses incurred in producing partnership income in the ordinary course of business are deductible against partnership income realized in the ordinary course of business. The effects of the taxpayers' and the Director's methods of computation are illustrated in the following table, which uses figures proportionate to those involved in the Smith case:
Other ordinary income 330 330