October 31, 2011
HARLAN W. WAKSAL AND CAROL WAKSAL, PLAINTIFFS-APPELLANTS,
DIRECTOR, DIVISION OF TAXATION, DEFENDANT-RESPONDENT.
On appeal from the Tax Court of New Jersey, Docket No. 1191-2009.
NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE APPELLATE DIVISION
Argued October 17, 2011
Before Judges Ashrafi and Fasciale.
Plaintiffs Harlan W. Waksal and Carol Waksal appeal from a July 30, 2010 order dismissing their complaint and granting summary judgment to defendant Director, Division of Taxation (the Director). Plaintiffs argue primarily that their nonbusiness bad debt is "a sale, exchange or other disposition of property" under N.J.S.A. 54A:5-1(c), and, as a result, they are allowed to report the loss on their New Jersey Gross Income Tax Return and offset capital gains. Because the New Jersey Gross Income Tax Act (the Act), N.J.S.A. 54A:1-1 to -10, does not permit such a deduction, we affirm.
In January 2002, Harlan loaned $14,769,320 to his brother, who signed a promissory note and agreed to repay the loan on or before January 31, 2004. His brother then defaulted on the loan. Subsequently, plaintiffs filed a 2004 United States Individual Income Tax Return, Form 1040, and reported a short term capital loss of $14,769,320, pursuant to I.R.C. § 166(d)(1)(B). They also filed a 2004 New Jersey Gross Income Tax Return and reported the same amount as a loss from the "sale, exchange or other disposition of property," pursuant to N.J.S.A. 54A:5-1(c). After using the loss to offset capital gains, they reported $6,644,022 as a net gain in their New Jersey tax return.
On September 15, 2008, the Director issued to plaintiffs a Notice of Deficiency for the 2004 tax year and disallowed the $14,769,320 loss they used to offset gains. Thus, the Director increased plaintiffs' net gain to $21,413,342 and assessed $2,001,602 in tax and late penalties. Plaintiffs did not file a protest with the Director within ninety days of the assessment. On March 4, 2009, plaintiffs filed a complaint in the tax court and challenged the Director's final assessment. Thereafter, both parties moved for summary judgment.
The judge conducted oral argument on January 22, 2010. Plaintiffs argued that federal methods of accounting applied to determine net gains and losses. They contended that the nonbusiness bad debt should be considered on their state tax return as a net loss derived from the "sale, exchange or other disposition of property," as it is on their federal tax return. The Director argued that New Jersey does not permit the deduction or offset of a personal loss, despite contrary federal treatment.
The judge issued an eleven-page written opinion granting the Director's motion. He relied on Walsh v. Director, Division of Taxation, 15 N.J. Tax 180 (App. Div. 1995), and King v. Director, Division of Taxation, 22 N.J. Tax 627 (App. Div. 2005), which held that a loss from a nonbusiness bad debt could not be used to offset gains "derived from the sale, exchange, or other disposition of property" under N.J.S.A. 54A:5-1(c). (Internal quotation marks omitted). He indicated that "net gains or income from disposition of property" is considered taxable income under N.J.S.A. 54A:5-1(c), which provides in part that New Jersey gross income consists of certain categories, including:
Net gains or net income, less net losses, derived from the sale, exchange or other disposition of property, including real or personal, whether tangible or intangible as determined in accordance with the method of accounting allowed for federal income tax purposes.. . . .
The term "net gains or income" shall not include gains or income from transactions to the extent to which non-recognition is allowed for federal income tax purposes.
The judge reasoned that the Act "does not mirror federal taxing statutes" and observed that the Supreme Court explained in Smith v. Director, Division of Taxation, 108 N.J. 19, 32 (1987), that:
Even a cursory comparison of the New Jersey Gross Income Tax and the Internal Revenue Code indicate [sic] that they are fundamentally disparate statutes. The federal income tax model was rejected by the Legislature in favor of a gross income tax to avoid the loopholes available under the Code.
The judge recognized that in Walsh we stated:
The Legislature determined that the New Jersey Gross Income Tax should contain fewer deductions from income than the federal income tax. This was seen as a way of making the Gross Income Tax fairer. The Legislature did not explicitly provide for a deduction of a nonbusiness bad debt. Thus, in view of the legislative history, it would appear that the Legislature did not intend for N.J.S.A. 54A:5-1c to be read broadly to include a deduction for nonbusiness bad debts. [Walsh, supra, 15 N.J. Tax at 185.]
The judge noted that in King, decided ten years after Walsh, we "flatly rejected the notion that a non-business bad debt constituted a loss that could be used to offset gains from the sale, exchange or other disposition of property under N.J.S.A. 54A:5-1c." The judge recognized that although "notes and accounts receivable resulting from a nonbusiness loan are capital assets under federal tax law," New Jersey "consciously refused to pattern its gross income tax on the federal code." King, supra, 22 N.J. Tax at 632. Quoting King, the judge stated:
New Jersey's divergence from federal treatment of nonbusiness bad debts also makes sense in light of the fact that, unlike federal tax law, New Jersey does not generally recognize discharge of indebtedness as income. Weintraub v. Dir., Div. of Tax[.], 19 N.J. Tax 65 (2000); see also I.R.C. § 61(a)(12). In other words, whereas federal law effectively offsets the deductions taken by creditors for bad debts by taxing the gains created on behalf of debtors as a result of a discharge, New Jersey does neither. [King, supra, 22 N.J. Tax at 633, n.1.]
The judge also rejected plaintiffs' argument that Koch v. Director, Division of Taxation, 157 N.J. 1 (1999), implicitly overruled Walsh and King. After observing that the King decision was issued six years after the holding in Koch, the judge remarked that [he could] divine no language in the Koch decision concerning nonbusiness bad debts or any holding suggesting that the "federal method of accounting" language of N.J.S.A. 54A:5-1c applies to any situation other than where a taxpayer has sold, exchanged or disposed of property. In Koch it was undisputed that the taxpayer had sold property. The question before the Court was how the gain from that sale was to be calculated. . . . . The "federal method of accounting" provision of N.J.S.A. 54A:5-1c can only apply once a taxpayer has sold, exchanged or disposed of property and triggered N.J.S.A. 54A:5-1c. That simply did not happen here.
In addition, the extent to which federal accounting methods are implicated under N.J.S.A. 54A:5-1c may well depend on the circumstances of the underlying transaction. Although plaintiffs here would like to apply federal tax concepts to transmogrify a worthless non-business debt into the disposition of property, in Koch a federal method of accounting capital gain -- use of the federal adjusted basis to determine gain from the sale of property -- was rejected by the Court as incompatible with the overall purpose of the [Act]. Koch, supra, 157 N.J. at 9-11. Nothing in the holding in Koch dictates the outcome in this case.
This appeal followed.
On appeal, plaintiffs contend that the decision of the judge conflicts with both N.J.S.A. 54A:5-1(c) and "the Supreme Court's clear direction to apply substantive federal tax rules to determine net gains and loses[.]" They argue that because the Court in Koch implicitly overruled Walsh and King, the judge erred by concluding that plaintiffs could not report their nonbusiness bad debt as a loss to offset capital gains on their New Jersey income tax return.
The parties agree that there are no genuine issues of material fact. The issue before the judge was purely a legal one. Generally, the Tax Court is afforded discretion due to its familiarity with such matters. Metromedia, Inc. v. Dir., Div. of Tax., 97 N.J. 313, 327 (1984); Reck v. Dir., Div. of Tax., 345 N.J. Super. 443, 446 (App. Div. 2001), aff'd o.b., 175 N.J. 54, 55 (2002). Because the parties' motions for summary judgment call for the disposition of a legal question, we conduct a de novo review. Pressler & Verniero, Current N.J. Court Rules, comment 3.2.1 on R. 2:10-2 (2012); see also Am. Fire & Cas. Co. v. Dir., Div. of Tax., 189 N.J. 65, 79 (2006).
After a review of the record and consideration of the controlling legal principles, we affirm for the reasons expressed by the judge in his thorough written opinion dated July 1, 2010. We add the following brief comments.
We reject plaintiffs' contention that because we omitted any reference in King to the holding in Koch, we "missed" the holding in Koch. King does not reference Koch because King differs from Koch factually. Walsh and King, on the other hand, are applicable.
In Walsh, the taxpayers sought to deduct a nonbusiness bad debt following a personal loan to a corporation in which they were also shareholders. Walsh, supra, 15 N.J. Tax. at 181. The corporation then transferred its assets to a second corporation, "but [the taxpayers] remained liable as . . . guarantor[s] on the bank loans." Id. at 181-82. After the second corporation defaulted on the bank loans that the taxpayers guaranteed, the taxpayers paid off the debt and deducted the losses on their New Jersey Gross Income Tax return. Ibid.
Quoting the tax court, we held that the "worthless debt, although treated as a loss from the sale or exchange of a capital asset held for not more than one year . . . under § 166(d)(1)(b) of the Internal Revenue Code, 'does not fit the statutory rubric of "sale, exchange or other disposition of property" found in N.J.S.A. 54A:5-1(c).'" Id. at 182-83 (quoting Vinnik v. Dir., Div. of Tax., 12 N.J. Tax 450, 454 (Tax 1992)). We noted that the taxpayers' debt was not a "disposition of property" because "the ejusdem generis rule of statutory construction, which provides that when general words follow specifically named things of a particular class, the general words should be understood as limited to things of the same class or at least of the same general character."*fn1 Ibid.
In King, the taxpayer entered into a personal loan that was only partially repaid. King, supra, 22 N.J. Tax at 628-30. The taxpayer used the loss to "offset her other gains from the disposition of property." Id. at 630. Citing legislative history, the court held she was not entitled to a deduction under the Act. Id. at 632.
In Koch, however, it was undisputed that the taxpayer was involved in a "sale, exchange or other disposition of property" under the meaning of N.J.S.A. 54A:5-1(c). Koch, supra, 157 N.J. at 3-5. The taxpayer purchased a partnership interest and then later sold it. Id. at 3, 4. The Court focused on how to calculate the cost basis for his partnership interest. Id. at 5-6. The taxpayer's "amount realized" was greater on his federal tax return than on his state tax return, as the former return allowed him to deduct losses from prior years and the latter did not. Id. at 5.
In Koch, the Director argued that the state tax return should have been identical to the taxpayer's federal return because N.J.S.A. 54A:5-1(c) provided for the application of "the federal adjusted basis," id. at 6, and the taxpayer believed that he did not have to "use the federal adjusted basis of his partnership interest in calculating the gain from the sale of that interest" because "the Act does not require a taxpayer to reduce the basis of his partnership interest by partnership losses that are not deductible under the Act." Id. at 5. The Court stated that "[the taxpayer's] economic gain . . . constitutes a tax on amounts that represent neither economic gain nor recovery of a past tax benefit. Instead, it represents a tax on a return of capital. Such a [tax] was not intended by the Legislature." Id. at 9. In the context of calculating the cost basis on the sale of a partnership interest, the Court reasoned that "[t]he Director's position ignore[d] the [other] federal accounting and non-recognition provisions of [N.J.S.A. 54A:5-1(c)]," the result of which would lead to a tax "on fictitious income" where the taxpayer "has gained no tax benefit." Id. at 9-10, 14.
Here, the focus is on whether plaintiffs' nonbusiness bad debt is considered a "sale, exchange or other disposition of property," just as in Walsh and King, rather than how to calculate income once a sale of property has, in fact, occurred, as in Koch.
Because plaintiffs' loss from their nonbusiness bad debt cannot be used to offset gains derived from the "sale, exchange or other disposition of property" under N.J.S.A. 54A:5-1(c), the judge correctly concluded that plaintiffs could not report the loss to offset capital gains on their New Jersey income tax return.