The opinion of the court was delivered by: Dougherty
The issue in the Complaint filed in this matter was whether Charles A. Sabino (Taxpayer) and Dolores C. Sabino (collectively, Taxpayers) were entitled to deduct certain items in the computation of their Gross Income Tax category "distributive share of partnership income". The term "distributive share of partnership income" is set out at N.J.S.A. 54A:5-1(k). *fn1
The items of deduction in question fall into two categories: the Direct Expenses, which consist of unreimbursed expenses of a partner; and the Contributions, which constitute a partner's share of payments characterized for Federal income tax purposes as deductible under the provisions of § 170 of the Internal Revenue Code of 1986 (IRC).
The facts underlying the original controversy were not complicated. During 1985, Charles A. Sabino was actively engaged in the business of accountancy as a partner of Peat Marwik Mitchell & Company (Peat Marwick). Peat Marwick was and continues to be a partnership formed and existing under the laws of the State of New York. Each of Peat Marwick's 1400 partners *fn2 was allocated a percentage share of partnership income and a percentage share of partnership expenses under the terms of the written agreement among them (Partnership Agreement).
Taxpayers have asserted that the Partnership Agreement also provided that certain expenses incurred individually by a partner in the conduct of partnership business would be paid directly by that partner and, in turn, that partner would be "allocated" any available income tax deduction for such direct expenditure. These expenses would not be reimbursed by Peat Marwick.
In 1985 Taxpayer incurred the following expenses, which it was claimed were incurred in the conduct of Peat Marwick's (i.e. the partners') business: (a) $3,513 of vehicle expenses; (b) $80 of parking expenses and tolls; (c) $600 of travel away from home expenses including meals, lodging, air travel, car rentals and taxi expenses; and (d) $8,509 for entertainment, gifts and other business expenses. Peat Marwick reimbursed a portion of these expenses, totalling $5,214. The balance of $7,488 (the Direct Expenses) were not reimbursed to Taxpayer.
For its 1985 tax year, Peat Marwick made payments (the Contributions) to a number of organizations which qualified as "charitable organizations" under the provisions of IRC § 501(c)(3), including various educational institutions and the Peat, Marwick, Mitchell Foundation. *fn3 Under the terms of the Partnership Agreement, Taxpayer's proportionate share of the Contributions was $3,315.
Taxpayers timely filed their 1985 NJ-1040 Resident Income Tax Return, and attached a copy of the Federal Schedule K-1 ("Partner's Share of Income, Credits, Deductions, etc.") Form 1065, issued by Peat Marwick (K-1), together with copies of various other State income tax returns filed by Taxpayers for tax year 1985, and their Schedule E ("Supplemental Income and Loss (From rental real estate, royalties, partnerships, estates, trusts, REMICs, etc)") to the Federal Form 1040 (the Individual income tax return).
The 1985 K-1 requires a partnership to set out, for information purposes, each partner's "distributive share item(s)" *fn4 of the following categories of income and deduction: (i) "Income (Loss", which includes items of "net" ordinary income (loss) of the partnership and requires the partnership to set out separately: Guaranteed Payments to the individual partners; Dividends qualifying for the (then) allowable exclusion from Federal gross income; Net short-term (and long-term) capital gain (loss); Net gain (loss) under IRC § 1231; *fn5 and any " other" income; (ii) "Deductions", including Charitable Contributions set out in accordance with the applicable percentage limitation categories of IRC § 170(b); IRC § 179 expense deductions (i.e. whereby a taxpayer takes an immediate expense deduction rather than a depreciation deduction); *fn6 IRA payments; 401(k) and Simplified Employee Pension Plan payments; and "Other" Deductions; (iii) "Credits", including Jobs Credits, Credit for Alcohol Used as Fuel, Credit for Income Tax Withheld and "Other" credits; (iv) "Net Earnings From Self Employment", in conjunction with the computation of the self employment tax; (v) "Tax Preference Items"; (vi) "Investment Interest expense items"; (vii) "Foreign Taxes"; (viii) "Other items and amounts not [previously] included . . . that are required to be reported separately . . ."; and (ix) "Investment Credit and Investment Credit Recapture Items". In general, the Schedule accommodates the requirements of IRC § 703(a)(1) that "[t]he taxable income of a partnership . . . be computed in the same manner as in the case of an individual [i.e, the netting process whereby the partnership's "ordinary income (loss)" is determined], except that . . . (1) the items described in section 702(a) shall be separately stated. . . ." The items set out in IRC § 702(a) are items which, if separately earned or incurred by the individual partner (i.e. not in his capacity as a partner), would result in an income tax liability for that partner different from the income tax liability which would result if the item had been netted with other partnership items and passed out as part of the partner's distributive share of the partnership's "ordinary income(loss)". *fn7 For example, Taxpayers' itemized deduction available under IRC § 170 for its share of the Contributions paid by Peat Marwick was entered on the 1985 Federal K-1 as a separately stated item. IRC § 170(b) would require Taxpayers to aggregate all Contributions, whether made by them individually, or by allocation from Peat Marwick or any other "pass through" entity in which they may have had an interest, in the taxable year and apply the percentage limitations of IRC § 170(b) to this total in order to determine the deduction allowable for the 1985 taxable year. *fn8 The 1985 K-1 therefore directs a taxpayer to the Instructions to Federal Form 1040 Schedule A to complete the calculation. Lumping the Contributions together with the "ordinary" income and expense items of the partnership at the entity level might lead to the avoidance of the IRC § 170(b) percentage limitations at the partner level, with a resultant distortion of Federal taxable income. In similar fashion, the 1985 K-1 required that items of capital gain and loss be passed through separately to the individual partners in order that the netting process and the limitation on deductibility of capital loss apply at the partner level. See IRC § 1201 et seq.
In computing their New Jersey Gross Income Tax liability (N.J.S.A. 54A:5-1, et seq.) Taxpayers deducted the $3,315 in Contributions set out on the Peat Marwick K-1 and the $7,488 in the (unreimbursed) Direct Expenses, reported on Taxpayers' Schedule E from the sum of the Schedule K-1 distributive share items of income.
The Director's Final Determination of Taxpayers' 1985 tax, issued on December 15, 1992, disallowed the deductions for both the Contributions and the Direct Expenses.
The parties agree that the Final Determination included no explanation of denial of the deduction for the Direct Expenses. As to the Contributions, it provided "(n)o deduction is allowed for charitable contributions which are not deductible directly by the partnership against ordinary income."
In March, 1994, Taxpayers filed a motion for summary judgment. That motion was brought on two bases: (1) that Director's failure to identify any legal or factual basis for the disallowance of the deductions was violative of the principles of equity, fairness and due process; and (2) that notwithstanding the absence of any basis for disallowance, the New Jersey Gross Income Tax Act, N.J.S.A. 54A:1-1 et seq., mandates that such deductions be allowed. The Director filed a cross-motion for summary judgment contending that the expenditures in question were not properly deductible in determining Taxpayers' "distributive share of partnership income" under the New Jersey Gross Income Tax Act. While Taxpayers' motion was pending, the Director articulated the following bases for disallowance of the deductions:
The Division disallowed the deduction claimed by Mr. and Mrs. Sabino in their Gross Income Tax category "net [sic] distributive share of partnership income" for $3,315 of Section 501(c)(3) Payments allocated to Mr. Sabino by Peat Marwick on Mr. Sabino's Schedule K-1 because (i) as a matter of law expenditures reported by Peat Marwick on its Partnership Return solely as charitable contributions are in all cases not deductible for purposes of determining the net distributive share of partnership income for New Jersey Gross Income Tax purposes of a partner therein, and (ii) even if the reason set forth in clause (i) does not provide a proper basis for the denial, Mr. and Mrs. Sabino have ...