New Jersey Denies Resident S-Corporation Shareholder Full Credit for Tax Paid to Pennsylvania

A New Jersey Tax Court opinion demonstrates that although resident individuals receive a credit for taxes paid to other states, the calculation of the credit can be subject to limitations.

By Alissa Graffius, SALT Senior Associate

Generally, states provide their residents an income tax credit for taxes paid to another state on income earned in that state.  Typically, that credit is equal to the lesser of (i) the amount of income tax paid to the non-resident state and (ii) the amount of income tax that would be paid to the resident state (i.e., at resident state rates) based on the amount of income earned in the non-resident state.  In other words, if a resident of State A (with a 7 percent tax rate) earns $100,000 of income in State B (with a 10 percent tax rate), State A will provide a credit of $7,000 (even though the taxpayer paid $10,000 to State B).  If State B’s tax rates was 5 percent, then the State A credit would be $5,000.  Therefore, depending on the rate difference, a taxpayer may not get a full tax credit for taxes paid to non-resident states.

However, each state’s specific method for calculating the amount of the credit, and any additional limitations thereon, must be analyzed carefully.  For example, on Aug. 17, 2018, the New Jersey Tax Court issued an opinion regarding the application of New Jersey’s income tax credit for taxes paid to other states with respect to an individual resident shareholders of an S-corporation that operates in multiple states.[1]

The taxpayers are residents of New Jersey, and they both own shares in a family business, David Weber Company, Inc. (the “company”), that is located in Philadelphia, Pennsylvania and incorporated under the laws of Pennsylvania. The shareholders elected for the company to be treated as an S-corporation for both federal and Pennsylvania purposes, meaning that the income passes through the company and is taxed as income of each individual shareholder.

The company filed S-corporate returns in Pennsylvania and New Jersey and the taxpayers filed personal income tax returns in those states for 2011, 2012 and 2013, the period for which New Jersey audited them.[2]  On the Pennsylvania return, the taxpayers reported $2,252,820 as their share of the S-corporation income as computed under Pennsylvania law.  To that amount, the taxpayers applied Pennsylvania’s apportionment factor of 81.7087 percent.  Based on the state’s flat income tax rate of 3.07 percent, the taxpayers paid $56,511 of Pennsylvania income tax and claimed a credit for that amount on their New Jersey gross income tax (“GIT”) return.[3]

However, the New Jersey Division of Taxation (“Division”) denied a portion of the credit based on a New Jersey law that limits the amount of credit in the case of a resident shareholder of an S corporation.  Specifically, the statute provides that “No credit shall be allowed against the tax otherwise due . . . for the amount of any income tax . . . imposed for the taxable year on S corporation income allocated to this State.”[4]  “S corporation income allocated to this State” is defined by reference to the New Jersey S-corporation income tax computation and allocation statutes.[5]

In other words, the amount of the credit is determined based on the amount of S-corporation income earned in Pennsylvania as computed under New Jersey’s statute.  There are two main differences among states with regard to the computation of income.  First, while both states begin with federal income, each state has different adjustments (i.e., addition and subtraction modifications from federal income).  As a result of these modification differences, the Division calculated the taxpayers’ share of S-corporation income to be $2,108,894 (instead of $2,252,820 as per the Pennsylvania return).

The second difference is with each state’s apportionment formula.  Using New Jersey’s apportionment formula, the Division calculated New Jersey’s apportionment percentage to be 30.4536 percent (and thus 69.5464 percent was the percentage of income earned in Pennsylvania per New Jersey’s rules, versus 81.7087 percent on the Pennsylvania return per Pennsylvania’s rules).

Applying these two differences, the Division calculated the taxpayers’ New Jersey income to be $642,234 ($2,108,894 times 30.4536 percent), and therefore, their Pennsylvania income to be $1,466,660 ($2,108,894 minus $642,234).  Accordingly, the maximum amount of tax credit that the taxpayers were allowed to claim was $45,026 ($1,466,660 times 3.07 percent), resulting in a deficiency of $11,484.

The Tax Court sided with the Division based on the plain language of New Jersey’s tax code and the intent of the legislature when it enacted this limitation.  This case demonstrates the importance of understanding the subtle, yet potentially significant, distinctions among state tax rules.

Aprio’s SALT team has experience with state income tax credit calculations, and we can assist taxpayers to ensure that they understand the state income tax impact of doing business in multiple states and do not receive unexpected tax assessments.  We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Alissa Graffius, SALT senior associate at alissa.graffius@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the September 2018 SALT Newsletter.

[1] Patricia A. Doherty and James Robert Doherty, Jr. Estate of v. Director, Div. of Taxation, Tax Court of New Jersey, Docket No. 011661-2016 (August 17, 2018).

[2] The opinion uses the 2012 numbers for purposes of its discussion and analysis, and those numbers will be used in this article as well.  The same analysis applied to 2011 and 2013.

[3] Pennsylvania’s 3.07% rate was much less than New Jersey’s top marginal rate of 8.97% for the years at issue.

[4] N.J. Rev. Stat. §54A:4-1(c) (emphasis added).

[5] N.J. Rev. Stat. §54A:5-10.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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