The opinion of the court was delivered by: Crabtree
Plaintiffs seek review of a deficiency in gross income tax determined by defendant for tax year 1988 in the amount of $6,826, plus interest and penalty.
The issues in this case are (1) whether plaintiff's *fn1 share of partnership indebtedness released at the time of and as part of the consideration for the sale of plaintiff's interest in the partnership constitutes cancellation of indebtedness income, or part of the net gain, or income from the Disposition of property within the purview of N.J.S.A. 54A:5-1(c); (2) whether plaintiff's basis in his partnership interest should be the same for both federal and New Jersey income tax purposes; and (3) whether depreciation recapture income under the federal Internal Revenue Code is part of the net gain or income from the Disposition of property within the purview of N.J.S.A. 54A:5-1(c).
The facts have been fully stipulated pursuant to R. 8:8-1(b).
In 1983, plaintiff purchased a limited partnership interest in US Cable of Tri-County, Ltd. (the partnership), for $75,000 in cash. He also agreed to be personally liable for a portion of the partnership's indebtedness to a third party. As of December 31, 1987, and until the sale of his interest, the amount of plaintiff's liability was $136,895.
In 1988, in a single transaction, and pursuant to an Agreement for Sale of Partnership Interest, plaintiff sold his entire interest for (1) $125,000 in cash, (2) an additional constructive payment on his behalf of $143,161 that eliminated the deficit in his capital account, and (3) a release from creditors of the partnership of his personal liability for partnership debt. *fn2
On their 1988 federal income tax return, plaintiffs reported $268,161 of income with respect to the sale of the partnership interest. They reported $217,785 as capital gain and $50,376 as depreciation recapture income.
On their 1988 New Jersey gross income tax return, plaintiffs reported $50,000 of gain from the sale of plaintiff's partnership interest. This amount was the difference between the cash proceeds of $125,000 and the cash price paid for the interest.
Defendant determined that plaintiffs should have reported the same amount of gain for gross income tax purposes as they reported for federal income tax purposes and determined the deficiency at issue here.
The primary issue in this case, namely, whether the amount of indebtedness from which plaintiff was released at the time he sold his interest in the partnership is part of the net gain or income from the Disposition of property, or is income from the discharge of indebtedness, arises out of the disparate treatment accorded discharge of indebtedness income under the federal Internal Revenue Code and the New Jersey Gross Income Tax Act. Discharge of indebtedness income is subject to federal taxation pursuant to section 61 of the Code, which defines gross income as "all income from whatever source derived" and also, specifically includes income from discharge of indebtedness. Section 61(a)12. The New Jersey Gross Income Tax Act, on the other hand, only taxes expressly identified classes of income, in which discharge of indebtedness income is not included. This disparate treatment by federal and New Jersey law has been acknowledged by our Supreme Court, in Smith v. Director, Division of Taxation, 108 N.J. 19,32 (1987). See also Vasudev v. Taxation Div. Director, 13 L. Ed. 2d 223, 231 (Tax 1993).
If, however, the release by the partnership's creditors of plaintiff's personal liability for his share of partnership indebtedness at the time and as part of the sale of plaintiff's interest in the partnership constitutes part of the amount realized (a necessary element of net gain) by plaintiff in connection with the sale, then the amount of indebtedness so released is taxable as a net gain from the Disposition of property under N.J.S.A. 54A:5-1(c).
As different tax treatment has been historically accorded discharge of indebtedness income (taxable at ordinary rates) and capital gains (taxable at preferential rates) under federal law, it behooves the court to examine the provisions of the Internal Revenue Code dealing with the transfers of partnership interests and the treatment of partnership liabilities assumed by the transferees of such interests.
To begin with, Code section 741 provides that in the case of a sale or exchange of interest in a partnership, gain or loss shall be recognized to the transferor partner, and such gain or loss is considered as gain or loss upon the sale or exchange of a capital asset. Secondly, as to the treatment of partnership liabilities, section 752(a) declares that any increase in a partner's individual liabilities by reason of such partner's assumption of partnership liabilities is considered a contribution of money to the partnership. Conversely, section 752(b) provides that any decrease in a partner's share of partnership liabilities, or in a partner's assumed liabilities, is considered a distribution of money by the partnership.
Section 731(a)(1) provides that where money is distributed to a partner by the partnership, capital gain is recognized to the partner to the extent that the distribution exceeds the partner's basis in the partnership immediately prior to the distribution. Section 752(d) provides that in the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships.
Finally, section 1001(b) provides that the amount realized from the sale or other Disposition of property is the sum of money received, plus the fair market value of property (other than money) received. Treas. Reg. section 1.1001-2(a), interpreting Code section 1001(b), provides that the amount realized from a sale or other Disposition of property includes the amount of liabilities from which a seller is discharged as a result of the sale or other Disposition. The application of that principle is illustrated in Example (3) of Treas. Reg. section 1.1001-2(c), which postulates the sale of a partnership interest and concludes that the selling partner's ...