The opinion of the court was delivered by: Dougherty
On December 15, 1992 the Director, Division of Taxation (Director) issued a Final Determination of the 1985 Gross Income Tax liability of Charles A. Sabino (Taxpayer) and Dolores C. Sabino, husband and wife (Taxpayers). At issue in the audit of Taxpayers' 1985 Return were deductions in the computation of the Gross Income Tax category "distributive share of partnership income". *fn1 The items disallowed fell into two categories: the Direct Expenses, consisting of unreimbursed travel and entertainment expenses of a partner incurred in the conduct of the partnership's business; and the Contributions, consisting of a partner's share of payments characterized as charitable contributions for federal income tax purposes, deductible under § 170 of the Internal Revenue Code (IRC). Taxpayers appealed the disallowance.
Following cross motions for summary judgment, a written opinion was issued on March 1, 1995, Charles A. and Dolores C. Sabino, 14 N.J. Tax. 501 (Tax 1995). A Declaratory Judgment was entered on March 10, 1995. Defendant appealed. The Appellate Division reversed in part:
Thus, just as all business income does not mean all 'ordinary' business income, neither do all business expenses connote all 'ordinary' expenses. This qualification of what costs and expenses are deductible under N.J.S.A. 54A:5-1b in arriving at the net income of a business is implicit in the express provision that such costs and expenses are those 'incurred in the conduct' of the business. Facially, then, the Tax Court erred in its reading of Smith and, thus, in its interpretation of N.J.S.A. 54A:5-1b. 'All costs and expenses' are not deductible simply because the business incurred them. They must be 'ordinary' business expenses. That is precisely what the present regulation requires . . . What we do decide is that the Tax Court erred in its Conclusion that 'all costs and expenses' as used in N.J.S.A. 54A:5-1b means, virtually, any and all expenses of a business, whether related or unrelated to the conduct of that business.
[Charles A. and Dolores C. Sabino v. Dir. Div. of Taxation, 296 N.J. Super. 269, 275 (App. Div. 1996).]
The Appellate Division declined to address "whether 'ordinary' expenses within the meaning of Smith is the equivalent of 'ordinary and necessary'" under the Federal law standard set out in IRC § 162, and the regulations under that section. Id. It included that issue as one that might be reconsidered on remand.
We remand to the Tax Court the issues of whether 'ordinary' business expenses is the equivalent of 'ordinary and necessary', whether the proposed regulations are an appropriate exercise of the Director's rulemaking authority, and whether the Director may, as to charitable contributions, conclusively rely upon the federal return of the partnership . . . . In doing so, we observe that nothing we have here said would prevent the Tax Court from, on remand, declining to exercise further jurisdiction in light of the absence of any real dispute between the taxpayer and in light of the pendency of the [newly] proposed amendments to the critical regulatory provisions.
[Sabino, (supra) . 296 N.J. Super. at 278.]
On remand, all three issues raised by the Appellate Division were briefed and argued.
This Court's March 1, 1995 opinion held the standard for deductibility of a partnership item (i.e. a cost, expense, or loss) to be whether the item was paid or incurred in the conduct of the partnership's trade, business or other activity. Implicit in that holding (as in Smith and the Regulations) was the concept of a deductible expense being one incurred "in the ordinary course". The March 1, 1995 opinion also held that the ordinary and necessary standard of IRC § 162 does not apply for determining the income of a partner subject to tax under N.J.S.A. 54A:5-1b and 54A:5-1k.
Under Smith and in accordance with the plain and unambiguous language of N.J.S.A. 54A:5-1b, . . . the standard for deductibility of an expense of a partnership is whether the expense was paid or incurred in the conduct of the business, profession or other activity of the partnership. This Conclusion is fully consistent with N.J.A.C. 18:35-1.25(c) and (d) (2), which provide, as to a business, profession or other activity conducted as a sole proprietorship:
(c) A taxpayer's net profits from business shall be determined by taking into account all costs and expenses incurred in the conduct thereof, except no deduction shall be allowed for any expense or loss which is not incurred in the ordinary course of the conduct of taxpayer's trade or business.
(d) . . . (2) A taxpayer's net profits from business shall be determined by taking into account expenses or losses incurred in the conduct of the taxpayer's trade or business which are properly deductible in accordance with the taxpayer's method of accounting, even if such deductions relate to expenses incurred in earning business income exempt from taxation under the Gross Income Tax Act, or expenses which are partly or wholly nondeductible for Federal income tax purposes or expenses under rules which limit the deductibility of particular business expenses under the Internal Revenue Code.
[Sabino, (supra) , 14 N.J. Tax at 515-516, (emphasis added) (footnote omitted).]
On remand Taxpayers assert again that the Direct Expenses and the Contributions were ordinary expenses of a business enterprise. This assertion is not disputed by Director. The March 1, 1995 opinion concluded that the Direct Expenses and the Contributions were, consistent with the holding in Smith v. Director, Div. of Taxation, 108 N.J. 19 (1987), incurred in the regular business of the partnership. Sabino, (supra) . 14 N.J. Tax at 515. They were neither personal nor unrelated to the conduct of Peat Marwick's business. Taxpayers seek an affirmation of the March 1, 1995 holding that items paid [ i.e. by Cash Method taxpayers] or incurred [ i.e. by Accrual Method taxpayers] in the conduct of the business, profession or other activity of a partnership are deductible in determining a partner's "distributive share of partnership income" under the Gross Income Tax Act. Taxpayers do not dispute that the deductible cost, expense or loss will be one which is "ordinary" and paid or incurred in the "regular" or "ordinary" course of the conduct of business, provided that such an interpretation of N.J.S.A. 54A:5-1b does not preclude deduction of "extraordinary" or "one time" costs, expenses, or losses which are items incurred to produce income and are of the type unquestionably anticipated by the Legislature as being deductible. Costs, expenses, or losses which, although arising only infrequently, may, nonetheless be common, usual, normal, customary and legitimate; paid or incurred in the "ordinary course"; thus, deductible to determine "net profits from business". *fn2
The March 10, 1995 Declaratory Judgment provides (in part):
1. The standard for deductibility of a partnership expense is the standard set out in N.J.S.A. 54A:5-1b; that is, whether the expense was paid or incurred in the conduct of the business, profession or other activity of the partnership.
The March 1, 1995 opinion explains as follows:
As the Court in Smith, supra concluded that the Legislature did not intend to 'exclude income that would clearly fall into other categories if it were not earned in the regular course of a business ', from inclusion in a partner's distributive share of partnership income, 108 N.J. at 27, 527 A.2d 843, so . . . must conclude that the Legislature intended that partners, like sole proprietors, would deduct all costs and expenses incurred in the regular course of their business. The Court there articulated that the crucial inquiry for purposes of N.J.S.A. 54A:5-1b was whether the expense was incurred in the conduct of the ordinary (or regular) business, profession or other activity of the partnership.'
[Id. at 515 (emphasis added).]
The second issue raised by Director on remand is whether the federal income tax standard of "ordinary and necessary" (IRC § 162) may, as an appropriate exercise of the Director's rule making authority, be engrafted onto N.J.S.A. 54A:5-1b (and 54A:5-1k by implication) purely by reason of the language "determined either on a cash or accrual basis in accordance with the method of accounting allowed for federal income tax purposes". N.J.S.A. 54A:5-1b. This is a bootstrap argument. The interpretive gloss of "ordinary" cannot be used to hoist the standard of deductibility set out so clearly N.J.S.A. 54A:5-1b into IRC § 162. The argument here is substantially the argument rejected by the Tax Court in Smith, (supra) , and Estate of Guzzardi v. Director, Div. of Taxation, 15 N.J. Tax 395 (Tax 1995), aff'd per curiam, 298 N.J. Super. 568 (App. Div. 1996). It is also rejected here.
IRC Accounting Methods and § 162
The "ordinary" gloss opens, in the Director's view, the issue of whether the Legislature intended, by use of the phrase "determined either on a cash or accrual basis in accordance with the method of accounting allowed for federal income tax purposes" in N.J.S.A. 54A:5-1b, to
incorporate more of the federal tax structure than what ordinarily might be considered accounting methods, and whether it is a reasonable exercise of regulatory authority to so incorporate [federal law, beyond what are ordinarily considered 'accounting' provisions] in implementing the 'ordinary' business loss and expense provision of N.J.S.A. 54A:5-1b as construed by Smith.
[Sabino, (supra) , 296 N.J. Super. at 277].
I conclude that the Legislature did not intend to incorporate "more of the federal tax structure than what ordinarily might be considered accounting methods", Id. So that I need not consider Director's recently proposed regulations in terms of their being a reasonable exercise of regulatory authority.
A. Federal Methods Of Accounting In General
IRC §§ 441-483 constitute the statutory law governing the accounting periods and methods allowable for purposes of calculating income subject to federal income tax. These are substantive provisions prescribing the taxable year (the 12 month time period) in which income (loss) earned and allowable items of deduction paid or incurred will be recognized. The Regulations permit taxpayers great flexibility in accounting for taxable income, the objective being the "clear reflection of income"; the matching of income earned, with expenses incurred to produce it, within the appropriate tax year.
(2) No uniform method of accounting can be prescribed for all taxpayers. Each taxpayer shall adopt such forms and systems as are, in his judgment, best suited to . . . [its] needs. However, no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. A method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly ...