In Xylem Dewatering Solutions, Inc., et al. v. Director, Div. of Taxation (Xylem),¹ the New Jersey Tax Court (court) ruled that gain on the 2010 sale of S corporation stock that the buyer and the S corporation shareholders elected under IRC Section 338(h)(10) to treat as a deemed sale of the S corporation's assets should be allocated to New Jersey as non-operational income under its Gross Income Tax (GIT) (i.e., the tax New Jersey imposes on personal income). The court concluded that it was bound by the 2009 New Jersey Superior Court appellate decision in McKesson Water Products Co. v. Director, Div. of Taxation (McKesson)² (which in 2010 was binding precedent) in which the appellate court concluded that the income from the sale of S corporation stock for which an IRC Section 338(h)(10) election was made was non-operational income and must be sourced to the principal place of business of the S corporation, which was New Jersey. The court also interpreted the filing of a retroactive S corporation election to constitute the consent of non-original shareholders to taxation by New Jersey.

In Xylem, the nonresident sole shareholder of a New Jersey S corporation first transferred shares in 2010 to grantor retained annuity trusts (GRATs) that were also nonresidents of New Jersey. The shareholders (both old and new) later sold their shares but joined with the buyers in electing to treat the transaction as the deemed sale of the S corporation's assets (which were located both within and outside New Jersey), followed by a liquidation under IRC Section 338(h)(10). After an audit in 2014, the New Jersey Division of Taxation (Division) proposed assessing GIT, concluding that, under McKesson, all of the net long-term gain was non-operational income that must be solely allocated to New Jersey under the state's sourcing rules applicable to S corporations. The Division also proposed to assess the S corporation directly for GIT due on the income allocated to the GRATs because the GRATs had not consented to taxation in New Jersey. In arguing for direct assessment of the S corporation, the Division rejected a retroactive S corporation election filed in 2015 on which the GRATs consented to New Jersey taxation.

The court relied on McKesson for the proposition that income from a deemed sale of assets under IRC Section 338(h)(10) constituted non-operational income. Having so concluded, the court then found that, by applying the sourcing rules under the state's Corporation Business Tax, which applied to the sourcing of S corporation income, N.J.S.A. 54:10A-6.1 mandated sourcing that income to the S corporation's principal place of business, which was New Jersey (i.e., its commercial domicile). The taxpayers argued that New Jersey's regulations for sourcing partnership and sole proprietorship income, which would have sourced the gains on the sale of partnership or sole proprietor interests to where the underlying assets were located, applied to S corporations. In addition, the court rejected the taxpayers' constitutional-based arguments under the Due Process and dormant Commerce Clause, finding that the sourcing of income did not raise constitutional questions.

Further, the court broadly read N.J.A.C. 18:7-20.3 to mean that, when a corporation has already elected to be taxed as an S corporation, the filing of a retroactive S corporation election suffices to provide consent to taxation for shareholders that were not the original S corporation shareholders. Because the retroactive election was made in this case, the court ruled that the GRATs had consented to New Jersey taxation and the Division had no power to directly assess the corporation.

Implications

It is anticipated that the shareholders will appeal the sourcing portion of the court's decision, as well as its rejection of their constitutional arguments. If the court's decision stands, it will provide further guidance in the realm of S corporation sourcing, foreclosing attempts to source S corporation income based on sourcing for sole proprietorships, partnerships and LLCs. This is true even though McKesson has very limited applicability going forward as a result of an 2014 amendment to N.J.S.A. 54:10A-6.1 that re-characterizes income from the sale of a business under an IRC Section 338(h)(10) election as apportionable business income. In addition, the court's decision provides valuable guidance for S corporations with new shareholders that neglect to timely consent to New Jersey taxation. Under the court's decision, the S corporation can file a retroactive election, in order to provide consent of the later shareholders and avoid direction taxation of the corporation.

———————————————
ENDNOTES

¹ Xylem Dewatering Solutions, Inc. v. Director, Div. of Taxation, Dkt. Nos. 011704-2015, 000056-2016, 000057-2016 (N.J. Tax Ct. April 7, 2017) (slip op.).

² McKesson Water Prods. Co. v Director, Div. of Taxation, 408 N.J. Super. 213 (App. Div.), certif. denied, 200 N.J. 506 (2009).