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BY JOHN GENZ CPA, MST
STATE & LOCAL TAX SERVICES GROUP

New Jersey Governor James E. McGreevey signed into law a $1.8 billion business tax package, known as the Business Tax Reform Act.  The bill includes several changes; overhauling the Corporate Business Tax ("CBT") intended to close loopholes, imposing an Alternative Minimum Assessment ("AMA"), and assessing a processing fee on limited liability partnerships. The bill has numerous provisions, some of which effect businesses that currently do not pay CBT, which we have summarized below. The Governor also signed bills increasing the cigarette tax and decoupling the state estate tax from the federal estate tax.

The Business Tax Reform Act is effective immediately for taxable years beginning on or after January 1, 2002, unless otherwise noted.

Full text of legislation: http://www.njleg.state.nj.us/2002/Bills/A3000/2501_R2.HTM

Corporate Business Tax Q & A Prepared by the State Treasurer: http://www.state.nj.us/treasury/news/2002/p20702b.html

Alternative Minimum Assessment.

S-corporations, professional corporations, investment companies, pass-through entities, and corporations operating as cooperative under federal requirements will be exempt from the AMA.

The AMA also assures a fair measure of support from out-of-state companies that are exempt from a tax like the CBT. This reform will effectively capture the value of the activities in New Jersey of out-of-state companies that currently pay no corporate income taxes in New Jersey.

Companies will make a five-year election to assess their AMA liability with a formula that uses either allocated (New Jersey) gross receipts or allocated (New Jersey) gross profits as a determining factor.  The bill defines gross profits to mean gross receipts minus the cost of goods sold, and the bill adopts the federal definition of cost of goods.

By permitting companies to use their gross profits to calculate their AMA, the bill protects high volume, low margin industries such as retailers, food stores, car dealers and others that are so vital to the state’s economy from bearing a disproportionate burden.  The bill gives the Director of the Division of Taxation the authority to expand or adjust the definition of "cost of goods sold" if justified to achieve a more equitable result among the various types of businesses subject to the alternative calculation.  This is similar to the Director’s ability to adjust a corporation’s apportionment factor to achieve a more equitable result.

Corporations subject to the CBT (now all corporations deriving income from New Jersey sources, see below) will be required to compute the AMA and pay the greater of the CBT or the AMA. Businesses with gross profits of less than $1 million are not subject to the AMA. Businesses with gross profits of between $1 million and $10 million are subject to AMA at a rate of .0025 times the amount of gross profits over $1 million multiplied by 1.11111 (which has the effect of phasing out the $1 million exclusion between $1 million and $10 million). For businesses with more than $10 million in gross profits, the AMA is based on a rising rate multiplied by total gross profits, ranging from .0035 times profits between $10 million and $15 million to .008 times gross profits above $37.5 million. The AMA is not based on graduated rates, accordingly corporations with high gross profits will not benefit from the lower brackets.

For example, a company with $40 million in gross profits is in the 0.8% AMA bracket and will be subject to an AMA of $320,000, calculated as follows:

($9,000,000 x 0.008 x 1.11111 = $80,000) + ($5,000,000 x 0.008 = $40,000) + ($10,000,000 x 0.008 = $80,000) + ($12,500,000 x 0.008 = $100,000) + ($2,500,000 x 0.008 = $20,000)

A 50% reduced rate is applied to gross receipts. For gross receipts of $2 million or less, there is no assessment. For gross receipts between $2 million and $20 million, the rate is .00125 times (with a similar phase-out of the exclusion). Between $20 million and $30 million, the calculation is .00175 times total gross receipts, rising to a high of .004 times gross receipts for gross receipts of more than $75 million.  The AMA is not based on graduated rates, accordingly corporations with high gross receipts will not benefit from the lower brackets.

For example, a company with $40 million in gross receipts is in the 0.3% AMA bracket and will be subject to an AMA of $ 120,000 calculated as follows:

($18,000,000 x 0.003 x 1.11111 = $60,000) + ($10,000,000 x 0.003 = $30,000) + ($10,000,000 x 0.003 = $30,000)

The bill places a cap of $20 million on the AMA tax for affiliated groups of five or more taxpayers but does not place this same cap on single corporations.

A provision of the bill restricts the opportunities for a taxpayer to break its AMA-subject entities into smaller units so as to take advantage of the lower range ($1 million exclusion only) of the graduated scale on the AMA 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.

The bill sunsets the AMA for privilege periods beginning after June 30, 2006, except for taxpayers exempt from the CBT pursuant to federal Public Law 86-272. To avoid any claim of discriminatory treatment by such businesses, based on a claim that CBT payers might be subject to lower liabilities than out-of-state businesses covered by Pub L. 86-272, the amendment provides such out-of-state businesses with the option of consenting annually to the jurisdiction of the State to impose the CBT.

Furthermore, if a company’s AMA exceeds its CBT in one year, the bill allows the difference between the AMA and the CBT as a credit (that carries forward without limit) to reduce the company’s CBT liability in a future year. The bill limits the credit applied in any one year to an amount that does not reduce the CBT liability to less than 50 percent of the CBT otherwise due or less than the minimum franchise tax (increased to $500, see below) for the privilege period, which puts the AMA credit in line with the operation of other tax credits under the corporation business tax.  

"Loophole Closers" and Tax Base Changes.

Disallowance of deduction of intangibles expenses paid to a related party:  
The bill limits the ability of a taxpayer to deduct royalties and other intangible expenses and costs and related interest when paid to affiliates. The bill continues to allow such deductions in areas that are established as "non-tax avoidance" situations.

The bill gives the Director of the Division of Taxation authority to determine: (1) whether a taxpayer has met its evidentiary burden of establishing by clear and convincing evidence that the add-back of an expense is unreasonable, or (2) that it is appropriate to enter into agreements or compromises with the taxpayer to produce an equitable level of taxation. The disallowance of the deduction is the general rule that has the effect of requiring the taxpayer to secure prior approval (through general regulation or case-by-case determination) for the deduction before departing from the general rule.

Another exception provided to the general rule of disallowance is for interest and intangible expenses directly or indirectly paid, accrued or incurred to a related member in a foreign nation with a comprehensive income tax treaty with the United States. The director may require the disclosure of such information, as the director deems necessary to determine that the taxpayer’s situation falls within the exception.

The deduction may also be permitted upon a showing that the arrangement involves an unrelated third party.

Disallowance of deduction of interest paid to a related party:
The bill also restricts deductibility of inter-affiliate interest expenses. However, the bill again continues to allow such deductions in areas that are established as "non-tax avoidance" situations.

The first exception is intended to avoid unfairly duplicative taxation, and sets the following criteria for determining whether such a situation exists: (1) the principal purpose of the transaction was not to avoid taxes; (2) the interest was paid at an arm’s length rate pursuant to an arm’s length contract; and (3) the transaction was already subject to tax at levels approximating New Jersey’s corporation business tax as determined by (a) the fact that the related member was subject to tax on income or receipts by another state or national entity, (b) a measure of the tax included the interest received from the related member, and (c) the foreign tax on the interest was within at least three percentage points (3%) of the tax rate that would have been applied to the interest income if it were taxable in this State.

The second exception is permitted when the taxpayer establishes that the disallowance of the deduction is unreasonable. For example, the bill permits a taxpayer to keep the deduction if the interest paid is ultimately paid to a third-party unrelated lender, as evidenced by a guarantee provided by the taxpayer to the outside lender.  Again, the taxpayer is required to secure prior approval from the director (through general regulation or case-by-case determination) before departing from the general rule of non-deductibility.

The third exception permits the deduction if the taxpayer establishes, by a preponderance of the evidence as determined by the director, that the interest payment involves a related entity in a foreign nation with a comprehensive income tax treaty with the United States, so long as the taxpayer fully discloses the transaction on its return as prescribed by the director.

A fourth exception, noted above, is intended to cover the situation where debt is "pushed down" from a corporate parent to a subsidiary but involves a regular, market-rate loan from an outside lender. This exception permits the deduction if the transaction involves an independent lender, and the taxpayer taking the deduction guarantees the debt on which the interest is required.

Throwout Rule:
Some sales are made in states where the corporation is not subject to tax because the corporation has no operations in those states. These sales are typically referred to as "nowhere sales" because they result in income being assigned so that it is taxed nowhere. The bill closes this loophole by "throwing out" the "nowhere sales" from the denominator of the sales fraction, which causes more of the income of the corporation to be assigned to states where the corporation actually has operations.  It is worth noting that this provision does not extend to non-CBT taxpayers (i.e. partnerships, LLC, etc.).

For example, assume a corporation has total sales of $10,000, sales to New Jersey destinations of $1,000, sales to other states where the corporation is subject to income tax of $2,000.  "Nowhere sales" are $7,000.  The New Jersey sales factor is calculated as follows:

Old Rule…$1,000 / $10,000 x 2 (double weighted) = 20%

New Throwout Rule…$1,000 / $3,000 ($10,000 - $7,000 "nowhere sales") x 2 = 66.7%

The bill limits tax liability resulting to the throwout rule for affiliated groups to prevent exceptionally large impacts on tax burden to $5 million making it important to track the CBT with and without the throwout rule, but does not limit the liability resulting from the throwout rule for single corporations.  The director is given authority to assign a single corporation within the group to act as key-corporation for any adjustment as the director may prescribe.

The "statutory office" requirement has not been eliminated providing no relief to corporations currently not able to apportion out of New Jersey.

Extending the reach of the CBT to Constitutional limits:
The bill extends the reach of the New Jersey CBT to an out-of-state corporation that derives any income from New Jersey sources and to an out-of-state corporation engaging contacts within New Jersey (i.e. solicitation of sales).

Non-operational income fully taxed:
The bill requires that 100 percent assignment of "non-operational income" (non-business income that is unrelated to the usual operations of the corporation, usually headquarters-managed investment income) be assigned to the headquarters state to the extent permitted by law, disallowing the apportionment of "non-operational income" out of the headquarters state.

Disallow deduction for income taxes paid to foreign nations:
The bill disallows a deduction for taxes paid to foreign nations. This disallowance parallels the disallowance adopted in 1992 for any kind of business taxes paid to other states.

Clarification of research and development expense deduction:
The bill 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 New Jersey deduction and a New Jersey credit based on the same expenses.)

Investment company income:
The CBT currently defines the taxable income of such companies as 25 percent of their entire net income. The bill raises the proportion of net entire net income subject to tax to 40 percent.

Savings Institutions:
In view of federal law changes that modernize the powers and treatment of savings banks, building and loan associations and savings and loan associations, the bill subjects these institutions to the CBT imposed on competing depository and credit institutions.

Deduction for dividends received from another corporation:
Current law excludes 100 percent of dividends received from companies in which the taxpayer has an ownership interest of 80 percent or more; and excludes 50 percent of all other dividends received. The bill disallows the 50 percent deduction for dividends received from a corporation in which the taxpayer has less than a 50 percent ownership interest.

Locating the receipts from financial services:
The bill provides that for the purpose of determining the sales fraction for allocating New Jersey receipts of broker/dealers and asset management firms, the sales occur where the customers receive the services (primary residence), as opposed to where the services are performed as under current rules.

Codification of Net Operating Loss Rule:
(Retroactively effective for all tax years ending after June 30, 1984):

The bill codifies (incorporates in the law) the New Jersey regulations governing the carry forward of net operating losses ("NOL"s) with the goal of foreclosing further challenges to them.  

Pass-through Entities.

Pass-through entity return processing fee:
The bill institutes a $150 per-partner processing fee on the partners of pass-through entities, having more than two partners (i.e. partnerships, limited liability partnerships, and limited liability companies, etc)

For pass-through entities that have income from New Jersey sources and more than two members, the bill establishes an annual $150 per owner filing fee, capped at $250,000 per entity annually.

The bill establishes a similar filing fee of $150 per licensed professional for professional corporations with more than two licensed professionals, also capped at $250,000 per corporation annually. The bill treats these fees as payments under the State Uniform Tax Procedure Law for purposes of penalties, interest and other administrative functions

Pass-through entity payment on behalf of owners:
Pass-through entities, which include partnerships, limited liability corporations, and limited liability partnerships, other than those listed on a national exchange must make a payment on the share of the income of each nonresident partner (corporate, partnership, individual, trust or estate) at a 9% rate for corporate partners and a 6.37% rate for individual partners. The payment is credited to separate accounts for each partner, and may be credited against their respective tax liabilities.  

Revenue Measures.

Two year NOL suspension:
The bill suspends the application of net operating loss (NOL) deductions for tax years 2002 and 2003. The usual seven-year carry forward (14 years for certain high-technology corporations) is extended for two years for all disallowed NOL carryovers. This suspension does not apply to the NOLs purchased through the high-technology incentive program.

Subchapter S-corporation phase-out freeze:
This bill resets the tax rate on S-corporations to the 2001 tax year levels through tax year 2005, and then resumes the phase-out thereafter.  Accordingly, the CBT rate applicable to the regular income of S-corporations with annual income over $100,000 is phased out, as follows: 1.33 percent for tax periods ending on or after July 1, 2001; 0.67 percent for tax periods ending on or after July 1, 2006; and 0 percent for tax periods ending on or after July 1, 2007.

Acceleration of fourth quarter payments for substantial taxpayers:
(Effective for tax periods beginning on or after January 1, 2003)

The bill, in effect, accelerates the third quarter estimated tax payment into the second quarter for taxpayers with gross receipts of $50 million or more in the prior tax year.  In other words, for calendar year taxpayers, 25 percent will be due on April 15th; 50 percent on June 15th; and 25 percent on December 15th.

Decoupling from federal "bonus" depreciation:
The bill disallows the deduction of the 30% "bonus" depreciation that was allowed for certain property for federal tax purposes under the federal "Job Creation and Worker Assistance Act of 2002." The bill returns the New Jersey depreciation rules to New Jersey law as it stood before the enactment of the federal law, and gives the Director of the Division of Taxation authority to formulate rules and regulations to carry out the decoupling from federal law, including the necessary basis adjustments.  The law is not retroactive to the 2001 tax year, accordingly amended 2001 New Jersey CBT returns will not be required to reflect this disallowance.  Internal Revenue Code Section 179 deductions remain consistent with federal law.

Increased minimum tax:
The bill increases the minimum tax from $210 annually to $500 annually for tax year 2002 and thereafter, except for corporations that are members of affiliated or controlled groups with total payrolls of $5 million or more, whose minimum tax will be to $2,000 per corporation. Single corporations with payroll of $5 million or more are not subject to the $2,000 minimum tax.

Small business provisions.

CBT tax rate reduction for small business:
The bill reduces the statutory rate from 7.5 percent to 6.5 percent for businesses with less than $50,000 of net taxable income

Enhanced New Jobs Investment Tax Credit:
The bill doubles the value of the new jobs factor under the New Jobs Investment Tax Credit, and increases the eligibility caps allowing the qualification of mid-sized businesses for the credit.  Mid-sized business taxpayer means a taxpayer that has an annual payroll of $5 million or less and annual and annual gross receipts of not more than $10 million.

Administrative Provisions.

Disclosure of inter-affiliate transactions:
The bill allows the director to require the disclosure of inter-affiliate transactions, including transactions with related businesses that are not themselves CBT taxpayers, including management fees, rents and charges for other services. Disclosure is required only upon request of the director, and the taxpayer has 90 days to comply. Noncompliance is treated as a failure to file a complete return, subject to the normal penalties under the State Uniform Tax Procedure Law.

Mandatory consolidated filing:
The bill requires taxpayers to determine their taxes after eliminating all inter-affiliate payments in excess of fair compensation. The bill also provides that if a taxpayer cannot demonstrate by clear and convincing evidence that it has accurately reported its true earnings in such a manner, the director may compel consolidated filing.

NOL suspension hold-harmless:
The bill forbids the imposition of any penalty for the underpayment of an estimated payment that is due to the two-year suspension of the application of NOL carry forwards.

Fourth Quarter 2002 25% estimated payment:
For the fourth quarter estimated payment for the 2002 tax year, and only that payment, the bill suspends the usual forgiveness provisions that apply to estimated tax payments and requires the fourth quarter payment to be 25% of the total liability for 2002, calculated under the provisions of the bill.  The first quarter payment for 2003 based on total 2002 liability will be due at the usual time, as will the full "catch-up" amount due under the new rules for 2002 in the fourth month following the close of the privilege period.

Statute of limitations extension for tax court complaints filed:
The filing of a complaint by a taxpayer in the tax court shall suspend the running of the statute of limitations for the contested issue or issues for all subsequent tax periods.  

Air Carriers.

Air carrier AMA credit:
The bill allows an air carrier that contributes more than 25% of the total amortization for capital improvement projects at Newark International Airport paid through rates and charges to take a credit of 50% of its amortization payment for the privilege period against its calculation of AMA, so long as the credit does not reduce the AMA to less than the CBT statutory minimum. An air carrier that takes this credit for a privilege period is not allowed the AMA credit against the CBT for AMA paid in that privilege period.

Air carrier consolidated return election:  
The bill allows an air carrier to file a consolidated return with its affiliated group.   

Other Revenue Raising Legislation.

Cigarette tax increase:
Bill A-2504 increases the cigarette tax from 80¢ per pack to $1.50 per pack, effective July 1, 2002. Wholesale tobacco products will be taxed at 48% (formerly, 30%) on the sale, use or distribution of the product throughout New Jersey, except that the rate on the wholesale price of the sale, use or distribution of cigars, little cigars or cigarillos remains 30%.  Distributors and wholesalers subject to the compensating use tax on tobacco products will see an increased rate of 48%, except on cigars, little cigars or cigarillos, which will remain at 30%.

Estate tax:
Bill A-2302 keeps the estate tax exclusion starting at $675,000 instead of rising lock-step with the federal estate tax.  The federal Economic Growth and Tax Relief Reconciliation Act of 2001 phases out the federal estate tax over 10 years and raises the exclusion to $1 million for estates of those dying in 2002 and 2003. New Jersey has elected to decouple the state estate tax from the federal estate tax by maintaining the $675,000 exclusion. This bill is effective for resident decedents dying after December 31, 2001.

Proposed Legislation.

Litter Tax:
The litter control tax terminated on December 31, 2000. There has been no litter control tax in effect for the 2001 tax year. The Division of Taxation, therefore, did not mail 2001 LT-5 litter control tax returns to all sellers of litter generating products in January as in prior years. All litter control tax liabilities owed prior to the December 31, 2000 expiration date, of course, remain in effect and must be paid.

However, two litter control tax bills have been introduced in the new legislative session. S-862, introduced in the Senate on February 11, 2002, would extend the litter control tax until December 31, 2005. This bill's effective date for the tax would be retroactive to December 30, 2000. A-2069, introduced in the Assembly on March 18, 2002, would make the litter control tax a permanent tax with no expiration date and also has a retroactive effective date for the litter control tax of December 30, 2000. If either bill is enacted in its present form and signed into law, the litter control tax would be imposed for the 2001 tax year. All taxpayers eligible for the litter control tax would be notified and sent tax returns and instructions at that time.