On appeal from the Tax Court of New Jersey.
Before Judges King and Landau.
This is an appeal from the Tax Court's decision upholding the Director's assessment pursuant to the Corporation Business Tax (C.B.T.) Act, N.J.S.A. 54:10A-1 to -40 (the C.B.T. Act). The dispute focuses on the interpretation of I.R.C. § 291(a)(1) and whether the Tax Court correctly interpreted that section to hold the taxpayer liable for additional taxes under the C.B.T. Act.
Plaintiff-appellant Nine Franklin Corporation (Nine Franklin) filed a request on July 26, 1990 with the Director, Division of Taxation (Director), for a refund on its fiscal year 1988 C.B.T. Nine Franklin requested a refund in the amount of $1,649.84. In a final determination letter dated September 14, 1989, the Director denied a part of Nine Franklin's refund claim, asserting that its tax liability was greater than claimed because of the application of I.R.C. § 291.
On November 17, 1989 Nine Franklin filed a complaint with the Tax Court contesting the Director's final determination. The parties filed a stipulation of facts and briefs with the Tax Court. Judge Pizzuto heard oral argument on May 31, 1991 and upheld the Director's final determination.
These are the facts stipulated before the Tax Court. Nine Franklin was incorporated in New Jersey on August 23, 1960. The sole asset of the corporation was a commercial rental property, consisting of a building and land, located in Newark. The building and land were purchased on August 23, 1960 for $60,000 (building $44,000; land $16,000). The building was fully depreciated on a straight-line basis over ten years. On November 2, 1987 the shareholders adopted a plan for liquidation of the corporation under I.R.C. § 337, and filed Form 966 with the Internal Revenue Service indicating that the corporation would be dissolved within 12 months.
In June 1988, within the context of an I.R.C. § 337 liquidation, the assets of the corporation were distributed to Vera Goodman, the sole shareholder, as follows:
Land and Building 195,000.00
($40,000.00 cash and mortgage of
$155,000 (fair market value)).
Total Valuation $385,000.00
Vera Goodman sold the building and land on July 1, 1988 for $195,000.
Following the liquidation, Nine Franklin filed its final New Jersey C.B.T. return for the fiscal year September 1, 1987 through August 31, 1988. Nine Franklin did not file I.R.S. Form 4797, which reports I.R.C. § 291 gains, with its 1988 Form 4797 or with its final Form 1120 U.S. Corporation Income Tax return. Nine Franklin did not report any recaptured income on line 9 of Schedule A of its C.B.T. return or on line 9 of its Form 1120 U.S. Corporation Income Tax return.
On July 26, 1989 Nine Franklin filed a refund request with the Director seeking a refund of $1,649.84 on its 1988 C.B.T. return. The Director requested and received supplemental materials from Nine Franklin regarding the refund request. By final determination letter dated September 14, 1989, the Director denied $722 of Nine Franklin's refund request. The Director determined that Nine Franklin erroneously under-reported income by $8,800. The $8,800 represented 20% of the accumulated straight-line depreciation taken on Nine Franklin's real property which should have been reported on the C.B.T. return. The Director determined, pursuant to I.R.C. § 291, that Nine Franklin was required to recapture 20% of the $44,000 depreciation deductions taken on the property. ($44,000 x 20% = $8,800). The refund was reduced by $722, reflecting an application of the 9% corporation business tax rate applied to the $8,800.
As noted, on appeal Judge Pizzuto upheld the Director's determination. Judge Pizzuto phrased the issue as "whether nor not section 291 applies to every case where property of the kind described in section 1250 is disposed of or whether it only applies to a more limited category of Dispositions of property known as section 1250 property." Judge Pizzuto accepted the State's contention that I.R.C. § 291 applies whenever I.R.C. § 1250 property is disposed of and concluded that the property in issue fell within this category. The Judge concluded that the Director acted properly by (1) computing a I.R.C. § 291 ordinary income amount for the Disposition of the property, (2) applying the 9% corporation income tax to it, and (3) deducting $722 from the refund.
Several Conclusions were essential to the Judge's decision. He recognized that the case involves a corporate liquidation as opposed to a corporate sale of property. He felt this was significant because under federal tax law a corporation does not recognize taxable gain after a distribution of property to shareholders. I.R.C. § 291 is an exception to the non-recognition rule and requires the corporation to recognize an income gain that would be applicable to a sale other than one in the course of a dissolution.
The Judge next concluded that the property in issue is I.R.C. § 1250 property because it is real property. This was not dispositive, however, because I.R.C. § 291 results in a classification of gain as ordinary income and requires the taxpayer to calculate the gain as if the property was I.R.C. § 1245 property.
Judge Pizzuto explained that the gain should be computed under I.R.C. § 291(a)(1)(A) by: (1) determining the amount which would be treated as ordinary income if the property was I.R.C. § 1245 property (i.e., the full amount of depreciation recovered on the amount of the sale of property over the amount treated as ordinary income under I.R.C. § 1250); (2) determining the amount under I.R.C. § 291(a)(1)(B) (this amount would be zero despite its status as § 1250 property because there is no additional depreciation and no ordinary income under I.R.C. § 1250). The Judge concluded that the amount under I.R.C. § 291(a)(1)(B) would be zero, and the amount under I.R.C. § 291(a)(1)(A) should be computed "by simply applying the rules specified in section 1245 without regard to whether or not the given property is or is not section 1245 property." He found that there may be some property which is subject to I.R.C. § 1245 and some property which is subject to I.R.C. § 1250; however, the two sections do not apply simultaneously to the same property. I.R.C. § 291 calculates some I.R.C. § 1250 property as I.R.C. § 1245 property and requires the reclassification of all depreciation recovered as capital gain upon Disposition of the property to ordinary income.
Applying this analysis to the present case, the Judge concluded that the excess of I.R.C. § 291(a)(1)(A) over § 291(a)(1)(B) is the entire amount of the depreciation recovered on the sale ($44,000 taken in straight-line depreciation over ten years). I.R.C. § 291 then requires that 20% of that amount ($8,800) be treated as ordinary income under I.R.C. § 1250. He concluded that the Director acted properly by computing I.R.C. § 291 ordinary income for the Disposition of the property, in applying the 9% corporation income tax, and in deducting the resulting $722 from the refund due.
Judge Pizzuto also relied on the official instructions distributed by the Internal Revenue Service for Form 4797, line 26(f), which states:
The amount treated as ordinary income under section 291 is 20% of the excess, if any, of the amount which would be treated as ordinary income if such property were section 1245 property, over the amount treated as ordinary income under section 1250. If you used the straight line method of depreciation, the ordinary income under section 291 is 10% of the amount figured under section 1245.
Finally, the Judge indicated that even if an ambiguity exists in the interpretation of I.R.C. § 291, deference must be given to the interpretation of the Internal Revenue Service, the agency charged with its administration.
On this appeal, Nine Franklin contends that (1) no portion of the depreciation should be included in net income because (a) I.R.C. § 291 does not cause it to recognize income for federal income tax purposes and (b) New Jersey did not incorporate I.R.C. § 291 into the C.B.T. Act; and (2) even if the Tax Court correctly interpreted I.R.C. § 291, ...