December 19, 2002
JOHN RECK AND BARBARA RECK, PLAINTIFFS-APPELLANTS,
DIRECTOR, DIVISION OF TAXATION, DEFENDANT-RESPONDENT.
On certification to the Superior Court, Appellate Division, whose opinion is reported at 345 N.J. Super. 443 (2001).
SYLLABUS BY THE COURT
(This syllabus is not part of the opinion of the Court. It has been prepared by the Office of the Clerk for the convenience of the reader. It has been neither reviewed nor approved by the Supreme Court. Please note that, in the interests of brevity, portions of any opinion may not have been summarized).
(NOTE: This Court wrote no full opinion in this case. Rather, the Court's affirmance of the judgment of the Appellate Division is based substantially on the reasons expressed in Judge Stern's opinion below.)
The question raised in this appeal is whether contributions made to a qualified retirement plan under the federal Keogh Act are deductible for purposes of the New Jersey State Gross Income Tax.
The matter was tried on stipulated facts, and the issue is purely one of law regarding whether Keogh Plan contributions are deductible from the "partner's distributive share of partnership income" (under N.J.S.A. 54A:5-1k) for purposes of the New Jersey Gross Income Tax Act, N.J.S.A. 54A:1-1 to 10-12. There is no dispute that the Keogh Plan involved in this case qualifies under Internal Revenue Code §401(a), but is not an approved plan under section 401(k). The Division's regulations permit deductibility of contributions on behalf of partners to qualified section 401(k) plans, but not to plans that do not qualify under section 401(k). The Director therefore assessed taxpayers for contributions to the Keogh Plan for the tax years 1992 and 1993.
The Tax Court rejected the Director's assessments, Reck v. Director, Div. of Taxation, 18 N.J. Tax 698 (Tax 2000). The Tax Court acknowledged that the Division's regulations do not permit deductibility of contributions on behalf of partners to plans which do not qualify under section 401(k). Nevertheless, it cited to the Supreme Court's opinion in Koch v. Director, Div. Of Taxation, 157 N.J. 1 (1999), which held that a taxpayer could rely on federal principles to calculate the cost basis of the taxpayer's partnership interest. The Tax Court held that Koch and applicable statutes required that partnership contributions to Keogh Plans on behalf of partners are deductible business expenses under N.J.S.A. 54A:5-1b, which defines net profits from business.
The Director appealed to the Appellate Division. In an opinion written by Judge Stern, the Appellate Division reversed. 345 N.J. Super. 443.
Like all administrative regulations, the Division's regulations are entitled to a presumption of reasonableness. A person challenging a regulation has to demonstrate that the rule is arbitrary, capricious or unreasonable. The Gross Income Tax Act (the Act) establishes a tax on New Jersey gross income reduced only by deductions, exemptions and credits expressly recognized by the Legislature. Taxation is the rule and exemption is the exception to the rule, and the legislative design to release one from some portion of the tax burden must be expressed in clear and unequivocal terms.
Partnerships, as such, are not subject to taxation under the Act. Rather, earnings are passed through to the partners, who are subject to income tax as individuals. Each partner's net profits from the operation of a partnership are included in each partner's individual gross income. Gross income is defined as "net income from the operation of a business, profession or other activity after provision for all costs and expenses incurred in the conduct thereof, 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. costs and expenses are not deductible simply because the business incurred them. A cost or expense must be incurred in the ordinary and regular course of the operation of the partnership's business to be deductible.
The Division's regulations, N.J.A.C. 18:35-1.14(f), explain that contributions by a partnership to a Keogh
Plan made on behalf of employees deductible as ordinary and necessary business expenses for federal income tax purposes are deductible for New Jersey Gross Income Tax purposes. However, contributions by a partnership to a Keogh Plan made on behalf of partners are not a deductible business expense. The Appellate Division determined that it was reasonable for the Director to conclude that contributions to Keogh Plans made on behalf of a partner constitute a portion of the partnership's profits otherwise distributable to the individual partner and thus, are not an ordinary business expense. This also is consistent with N.J.S.A. 54A:6-21, which provides:
Gross income shall not include amounts contributed by an employer on behalf of and at the election of an employee to a trust which is part of a qualified cash or deferred arrangement which meets the requirements of section 401(k) of the 1954 Internal Revenue Code.
Prior to its opinion in the present matter, the Tax Court interpreted N.J.S.A. 54A:6-21 narrowly and refused to permit deductions for purposes of the New Jersey Gross Income Tax even though the deductions are allowed under the Internal Revenue Code. In Sidman v. Director, Div. of Taxation, 18 N.J. Tax 636 (Tax 2000), Judge Small recently emphasized the significance of N.J.S.A. 54A:6-21, holding that a taxpayer may not deduct interest on a loan, the proceeds of which were used to purchase shares in a subchapter S corporation. Judge Small distinguished Koch, upon which the taxpayer and the Tax Court relied in this case. He quoted the fiscal note referred to in the Assembly Committee Statement to the bill which became N.J.S.A. 54A:6-21, which estimated that the bill may result in a $1 million loss in revenue. The note further stated: "The division commented that these types of plans are only one of many which, if in the future receive the same treatment, could result in revenue losses that could be quite substantial."
The Tax Court's judgment in Sidman was affirmed by the Appellate Division on November 14, 2001. Judge Stern, noting that Sidman and the Tax Court's opinion in this case post-dated Koch, explained that he did not read Koch, which dealt with accounting principles regarding the cost basis of a partnership interest, to involve a question relating to pension or retirement plan contributions.
The Supreme Court granted the taxpayers' petition for certification.
HELD: A partnership's contributions to a pension plan are deductible for purposes of the New Jersey Gross Income Tax only if the plan qualifies under section 401(k) of the Internal Revenue Code.
Judgment of the Appellate Division is AFFIRMED.
JUSTICES LONG and VERNIERO dissent, and would reverse the judgment of the Appellate Division substantially for the reasons expressed by the Tax Court, Reck v. Director, Div. of Taxation,
The opinion of the court was delivered by: Per Curiam
Argued December 2, 2002
The judgment is affirmed, substantially for the reasons expressed in Judge Stern's opinion of the Appellate Division, reported at 345 N.J. Super. 443 (2001).
CHIEF JUSTICE PORITZ and JUSTICES COLEMAN, LaVECCHIA, ZAZZALI and ALBIN join in this opinion. JUSTICES LONG and VERNIERO filed a separate dissenting opinion.
LONG and VERNIERO, JJ., dissenting,
We would reverse the judgment of the Appellate Division substantially for the reasons expressed in the opinion of the Tax Court. Reck v. Director, Div. of Taxation, 18 N.J. Tax 598 (Tax 2000).
Chief Justice Poritz PRESIDING
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