Before Judges Keefe, P.g. Levy and Wecker.
The opinion of the court was delivered by: Keefe, J.A.D.
On appeal from the Tax Court of New Jersey.
The issue to be decided is whether a resident New Jersey taxpayer who receives a distribution from a New York subchapter S corporation of which he is the sole stockholder is entitled to a tax credit on his 1991 New Jersey Gross Income Tax (GIT) return for taxes paid to New York by the corporation.
The Director of the New Jersey Division of Taxation (Director) gave the taxpayer, Ernest H. Sutkowski (taxpayer), a partial credit. *fn1 The taxpayer disagreed with the Director's final determination and filed a complaint in the Tax Court, challenging the Director's methodology and seeking an order declaring that the entire amount of the 1991 S corporation distribution was available for computation of the tax credit. The matter was submitted to the Tax Court Judge on stipulated facts. The issue on which the parties submitted briefs focused on the question of whether the Director's or the taxpayer's methodology for treating subchapter S distributions was correct. There were ancillary issues concerning computation of the credit once the methodology was determined.
In a reported opinion, the Tax Court Judge disagreed with both methodologies. Sutkowski v. Director, 16 N.J. Tax 231 (Tax 1996). The judge concluded that the taxpayer was not entitled to any credit because the distribution by the New York S corporation was not taxed in New York so as to make it eligible for the credit. The taxpayer appeals from the Tax Court judgment. We reverse the judgment under review for the reasons stated herein and direct the Division of Taxation to give the taxpayer full credit for the 1991 New York S corporation distribution and remand the matter to the Division for computation of the credit.
Taxpayer is an employee and sole stockholder of The Westchester Business Institute (WBI), a New York corporation that elected subchapter S treatment for New York and federal income tax purposes. For federal and New York tax purposes, earnings and losses from S corporations are passed through to shareholders to be reported on their individual tax returns in the tax years those items accrue to the corporation, regardless of whether the net profits are actually distributed. I.R.C. § 1366; N.Y. Tax Law § 617(b).
New Jersey taxes gross income which is defined in the GIT Act. N.J.S.A. 54A:5-1. Prior to 1993, New Jersey did not recognize S corporations. *fn2 Accordingly, for the tax year in question, income from S corporations was not taxed under the GIT Act until distributed to a New Jersey resident shareholder. Thus, distributions from S corporations were treated in the same manner as dividends from regular corporations (C corporations). Laurite v. Director, Div. of Taxation, 12 N.J. Tax 483, 489 (Tax 1992), aff'd, 14 N.J. Tax 166 (App. Div. 1993), certif. denied, 135 N.J. 301 (1994). Dividends are considered a form of gross income and were then defined as "any distribution in cash or property made by a corporation, association or business trust, (1) out of accumulated earnings and profits, or (2) out of earnings and profits of the year in which such dividend is paid." N.J.S.A. 54A:5-1(f).
The GIT Act also provides New Jersey residents with a credit for income tax paid to other states. N.J.S.A. 54A:4-1 then provided in relevant part:
(a) A resident taxpayer shall be allowed a credit against the tax otherwise due under this act for the amount of any income tax or wage tax imposed for the taxable year by another state of the United States . . . with respect to income which is also subject to tax under this act. (b) The credit provided under this section shall not exceed the proportion of the tax otherwise due under this act that the amount of the taxpayer's income subject to tax by the other jurisdiction bears to his entire New Jersey income. The purpose of the resident income tax credit is to minimize or avoid double taxation of New Jersey residents' gross income that is also subject to tax in the same year in another state. Ambrose v. Director, Div. of Taxation, 198 N.J Super. 546, 552 (App. Div. 1985). The formula for calculating the credit is expressed as a fraction.
New Jersey income subject to Tax by another State X Tax due under New Jersey Credit income = Entire New Jersey Tax
[Id. at 550; see also N.J.S.A. 54A:4-1(b).]
The parties to this litigation agree on the amount of the denominator of the fraction; the tax due under the GIT if no credit is due; and a portion of the numerator of the fraction. They also agree that the distribution to the taxpayer from the S corporation in 1991 was a "dividend" for GIT purposes and should be a part of the denominator. The disagreement, at least between the Director and the taxpayer, is how much of the dividend distribution should be included in the numerator.
The dispute before the Tax Court centered on the differing methodologies employed by the Director and the taxpayer in determining how much of the distribution was subject to New York income tax in 1991. The taxpayer contended that, in determining the source of the dividends paid by the S corporation to him in 1991, the Director should have looked to WBI's earnings for 1991. Those earnings were sufficient to cover the distribution paid to the taxpayer in the same year, and, therefore, the taxpayer contended that the dividend distribution (income) represented the same money taxed by New York as earnings (income), albeit under a different label. This method has been referred to as the last-in, first-out rule, or "LIFO." This is the same methodology used to trace the source of dividends under federal tax principles. I.R.C. §§ 301, 316, 1368. If this method is applied, the taxpayer is entitled to a credit for tax paid to New York, and the entire dividend distribution is part of the numerator. The Director, on the other hand, took the position that, if, in the year of distribution, the distributing corporation had both current earnings from the tax year in which the distribution was made, as well as earnings accumulated from prior years, the dividend is deemed by the Division to have been made first from accumulated earnings. The Director's method has been referred to as the first-in, first-out rule, or "FIFO." Employment of this method reduces the amount of the numerator and decreases the tax credit. *fn3
With this background, we now put the dispute into numbers in accord with the stipulation of the parties as submitted to the Tax Court. Because the taxpayer was the sole owner of WBI stock, his share of WBI's 1991 income subject to New York tax was 100%. WBI's total taxable New York income in 1991, on which tax was in fact paid, was $1,184,500. It consisted of $1,132,654 of S corporation trade or business income and $51,846 of S corporation passive interest income.
The taxpayer received four distributions from WBI during the course of 1991 totaling $1,031,065. Those distributions were reported by the taxpayer on his GIT return as dividend income because they were distributions made out of WBI's earnings and profits. N.J.S.A. 54A:5-1f. In addition to the dividends, the taxpayer reported his wages from WBI of $682,246, interest income of $116,092, and other dividends of $29,342, for a total of $1,858,745. *fn4 This latter number, by stipulation, became the denominator of the fraction in the above mentioned formula. The taxpayer's GIT liability without reference to any credit for taxes paid to New York was $126,267. The ...