STATE AND LOCAL TAXATION

By Harold J. Reiss

At an emergency session on July 2, the New Jersey Senate ended a fiscal standoff by adopting a $1.8 billion business tax package, known as the Business Tax Reform Act and signed into law by Governor McGreevey. The tax act contains provisions that affect both corporations and pass-through entities.

Increased Mimimum Tax

The minimum tax imposed on corporations has been increased from $200 to $500 annually for tax years 2002 and thereafter. Corporations that are members of affiliated or controlled groups with total payrolls of $5 million or more are subject to a minimum tax of $2,000.

Alternative Minimum Assessment

The new law implements an alternative minimum assessment (AMA) based on allocated gross receipts, or allocated gross profits (see the Exhibit). S corporations, professional corporations, investment companies, pass-through entities, and corporations operating as nonagricultural cooperatives under federal requirements will be exempt from the AMA. The law defines gross profits to mean gross receipts minus the cost of goods sold, adopting the federal definition of cost of goods sold. Once a taxpayer chooses between the gross receipts and gross profits method, it is bound by that choice for the next four years.

Entities subject to the Corporation Business Tax (CBT) will be required to compute the AMA and pay the greater of the CBT or the AMA. This provision sunsets for tax periods beginning after June 30, 2006.

The new law places a cap of $20 million on the AMA for affiliated groups of five or more taxpayers. The law restricts a taxpayer from breaking its AMA-subject entities into smaller units to take advantage of the lower rates by limiting the exclusion for all members of an affiliated or controlled group to $5 million of gross profits ($10 million of gross receipts), or five times the exclusion amount for the members of the group.

If a company’s AMA exceeds its CBT in one year, the new law allows the difference between the AMA and the CBT as a credit (that carries forward without limit through 2006) to reduce the company’s CBT liability in future years. In no event may the credit reduce the CBT by more than 50%, or below the $500/$2000 minimum tax.

Sales Allocation “Throwout Rule”

Under the apportionment formula used for determining the portion of a corporation’s total taxable income taxable by New Jersey, the sales fraction is double-weighted. Under the old rules, sales of tangible property shipped out of state were included in the denominator whether or not the corporation was subject to tax in those states. The new rules provide that goods shipped to states where the corporation is not subject to tax are “thrown out” of the denominator. It also places a $5 million limit on the amount of additional tax liability related to the throwout rule for affiliated groups.

Nonoperational Income

Income from tangible and intangible assets that do not constitute an integral part of the taxpayer’s trade or business is defined as nonoperational income. Previous rules allocated nonoperational income to the jurisdiction “where the nonoperational activity has nexus.” All income is presumed to be operational income unless demonstrated otherwise. Usually, therefore, these items would be apportioned to New Jersey according to the taxpayer’s New Jersey allocation percentage. Under the new rules, New Jersey will treat so-called nonoperational income as allocable to the jurisdiction in which the corporation is domiciled (i.e., where the seat of management exists). Accordingly, any New Jersey–based corporation will have 100% of its nonoperational income taxed in New Jersey.

Extending the Reach of the CBT

The new law extends the reach of the New Jersey CBT to a corporation that derives any income from New Jersey sources. Under the new law, the CBT is imposed upon a corporation “doing business,” employing or owning capital property, or maintaining an office in the state. The intent is to tax those corporations with a physical presence in New Jersey which were previously exempt from NJCBT under Federal Public Law 86-272, but the state may seek to extend the application to corporations without physical presence but which derive income from New Jersey sources.

Related-party deductions. The new law limits the ability of a taxpayer to deduct royalties and other intangible expenses and costs, as well as related interest when paid to affiliates. The provision addresses a tax avoidance device that allowed a corporation to deduct fees (royalties, for example) paid to an out-of-state affiliate. The new law also restricts the deductibility of interaffiliate interest expenses. Such deductions will be allowed in areas that are established as “non–tax avoidance” situations.

Presumptively, such expenditures are to be disallowed, and it is up to the taxpayer to meet its burden of proving that the add-back of an expense is unreasonable.

Additionally, the deduction will be allowed if the expense is paid, accrued, or incurred to a related member in a foreign nation with an income tax treaty with the United States. Also, the deduction will stand if the taxpayer establishes that the disallowance of the deduction is unreasonable. For example, the new law permits the deduction if the interest is ultimately paid to a third-party unrelated lender.

Foreign income taxes. The new law disallows a deduction for taxes paid to foreign nations or any political subdivisions thereof.

Clarification of research and development expense deduction. The new law disallows the deduction of certain research and development expenses that are used to claim the New Jersey research and development credit but are not used to claim a federal research and development credit. (Without this disallowance, a taxpayer would sometimes be able to claim both a deduction and a credit for the same expenditures.)

Investment company income. New Jersey defines an investment company as a business engaged in managing its own portfolio corporation whose business during the year consisted to the extent of at least 90% of holding, investing, and reinvesting in stocks, bonds, notes, mortgages, debentures, patents, patent rights, and other securities for its own account (with other restrictions and limitations). The prior CBT law taxed investment companies on 25% of their income at the applicable tax rate. The new law raises the proportion of entire net income subject to tax to 40%.

Dividends received from another corporation. The new law allows a 100% exclusion for subsidiaries in which the taxpayer has an ownership interest of 80% or more. Dividends from subsidiaries in which the parent owns between 50% and 80% are one-half excludable. Dividends received from a corporation in which the taxpayer has less than a 50% ownership interest are fully taxable.

Pass-Through Entities

Pass-through entity return processing fee. Effective for tax years beginning in 2002, a $150-per-owner processing fee is imposed on pass-through entities (e.g., partnerships, limited liability partnerships, companies having more than two members). The fee is capped at $250,000. Pass-through entities that have New Jersey–source income or New Jersey resident owners must file a New Jersey K-1 form annually, in which they must report their income and list their owners.

The new law also establishes a similar $150 filing fee per licensed professional (whether or not an owner) for professional corporations with more than two licensed professionals, also capped at $250,000 per corporation annually.

At the time of payment, three and a half months after the year-end, a 50% installment payment for the subsequent year is required.

Pass-through entity payment on behalf of owners. It is estimated that half of the K-1s filed in New Jersey list out-of-state residents that are involved in New Jersey pass-through entities with New Jersey–source income. Pass-through entities other than those listed on a national exchange must now make a payment on the share of the New Jersey income as defined of each nonresident (corporate, partnership, individual, trust, or estate) owner at a 9% rate for corporate owners and a 6.37% rate for individual owners. The payment, due on the 15th day of the fourth month following the end of the tax year, is credited to separate accounts for each owner, and will be credited against their respective tax liabilities.

Revenue Measures

NOL suspension. The use of net operating loss (NOL) deductions is suspended for tax years 2002 and 2003. The usual seven-year carry-forward (14 years for certain high-technology corporations) is extended for two years. This suspension does not apply to NOLs purchased through the high-technology incentive program. No estimated tax penalty may be imposed due to the suspension of the NOL carry-forwards.

S corporation phase-out suspended. Subchapter S corporation tax rates are in the second year of a three-year phase-out to zero. This new law resets the tax rate on S corporations with over $100,000 of entire net income to the 2001 tax year levels (1.33%) through tax year 2005, then resumes the phase-out thereafter.

Acceleration of estimated tax payments. The new law effectively accelerates the third-quarter estimated tax payment (due for most calendar-year taxpayers in September) into the second quarter (due in June) for taxpayers with gross receipts of $50 million or more. The accelerated schedule remains in effect for these taxpayers beginning in 2003 and thereafter.

The 2002 law also eliminates the estimated tax safe harbor of 100% of the prior year’s taxes and requires corporations to pay at least 25% of the actual year’s tax, including possible AMA, by the fifteenth day of the twelfth month (December 15 for calendar-year taxpayers). As a practical matter, estimating such an amount will be difficult for many corporations. Guidance will be required from the New Jersey Division of Taxation as to how prior year’s overpayments and estimated payments made in the first three quarters of 2002 will impact the new fourth-quarter payment obligation.

Decoupling from federal “bonus” depreciation. The federal deduction of the 30% “bonus” depreciation that is now allowed for certain property for federal tax purposes under the Job Creation and Worker Assistance Act of 2002 is not allowed for New Jersey purposes. The bonus depreciation is allowed for years beginning before January 1, 2002. New Jersey depreciation rules retain the prior methodology. New rules will be required to take into account the difference between federal and New Jersey bases in property.

Small Business Provisions

CBT reduction for small businesses. The new law reduces the CBT statutory rate from 7.5% to 6.5% for businesses with less than $50,000 of net taxable income.

Enhanced new jobs investment tax credit. The new law encourages job creation by doubling the value of the new jobs factor under the new jobs investment tax credit and increasing the eligibility caps, which allows mid-sized businesses to qualify for the credit.

Administrative Provisions

The following additional enforcement tools have been granted to the director of the division of taxation:

An affiliated group under federal rules may also elect to file a consolidated return in New Jersey. The election is binding for five years, and may be revoked with two years’ advance notice to the director.