Andrews v. Commonwealth, 185 F.R. 2016
| Decision Date | 02 November 2018 |
| Docket Number | No. 212 F.R. 2016,No. 185 F.R. 2016,185 F.R. 2016,212 F.R. 2016 |
| Citation | 196 A.3d 1090 |
| Parties | Craig S. and Christine L. ANDREWS, Petitioners v. COMMONWEALTH of Pennsylvania, Respondent Commonwealth of Pennsylvania, Petitioner v. Craig S. and Christine L. Andrews, Respondents |
| Court | Pennsylvania Commonwealth Court |
Joseph C. Bright, Philadelphia, for petitioners Craig S. and Christine L. Andrews.
Matthew S. Salkowski, Deputy Attorney General, Harrisburg, for respondent Commonwealth of Pennsylvania.
BEFORE: HONORABLE MARY HANNAH LEAVITT, President Judge, HONORABLE RENÉE COHN JUBELIRER, Judge, HONORABLE P. KEVIN BROBSON, Judge, HONORABLE PATRICIA A. McCULLOUGH, Judge, HONORABLE ANNE E. COVEY, Judge, HONORABLE MICHAEL H. WOJCIK, Judge, HONORABLE ELLEN CEISLER, Judge
OPINION BY JUDGE BROBSON
This is one of several related matters, challenging the assessment of Pennsylvania personal income tax (PIT) liability on nonresident investors on account of the 2005 foreclosure of a commercial property located in the City of Pittsburgh (Property). We resolved the first round of appeals through en banc opinions and orders issued in 2012, which the Pennsylvania Supreme Court affirmed in Wirth v. Commonwealth , 626 Pa. 124, 95 A.3d 822 (2014), cert. denied sub nom. Houssels v. Pennsylvania , ––– U.S. ––––, 135 S.Ct. 1405, 191 L.Ed.2d 362 (2015).1 Petitioners Craig S. and Christine L. Andrews (Taxpayers), residents of the State of California, are among the second round of challengers.2
In a decision dated February 24, 2016, the Board of Finance and Revenue (Board) assessed Taxpayers' PIT liability on account of the foreclosure of the Property at $25,578, "plus appropriate interest, less any payments and credits to their account." Both Taxpayers and the Pennsylvania Department of Revenue (Department) challenge aspects of the Board's decision. We affirm.
600 Grant Street Associates Limited Partnership (Partnership), organized under Connecticut law, purchased the Property for $360 million. Of this $360 million purchase price, the Partnership financed $308 million with a Purchase Money Mortgage Note (PMM Note) secured only by the Property. The PMM Note was nonrecourse, meaning that the Partnership and the lender agreed that the lender's only recourse for nonpayment of the obligations under the PMM Note was to pursue foreclosure of the Property. As the name of the Partnership suggests, the Partnership's primary purpose was the ownership and management of the Property.
Interest on the PMM Note accrued on a monthly basis at a rate of 14.55%. If the monthly accrued interest exceeded the net operating income of the Partnership, the Partnership was not required to pay the excess (i.e. , the amount of monthly accrued interest less monthly net operating income). Instead, the accrued but unpaid excess would be deferred and, thereafter, compounded on an annual basis subject to the same interest rate as the principal amount of the PMM Note. The original maturity date of the PMM Note was November 1, 2001. In 1998, the lender and the Partnership amended the PMM Note to extend the maturity date to January 2, 2005.
Taxpayers purchased a limited partnership interest (¼ unit) in the Partnership on or about December 31, 1984, for $37,223. Their ¼ unit interest amounted to a 0.037820% interest in the Partnership. Taxpayers were passive investors. They never participated in the management of the Partnership or the Property.
Over the years, the Partnership's net income from operations did not keep pace with projections. The Partnership incurred losses from operations for financial accounting, federal income tax, and PIT purposes every year of its existence. For PIT purposes, the Partnership allocated its annual losses from operations to each partner, including Taxpayers. Taxpayers filed Pennsylvania PIT returns for tax years 1985 through 2005, reporting thereon their pass-through share4 of the Partnership losses "derived from or in the form of rents, royalties, patents and copyrights," which is one of eight separate classes of income subject to PIT under Section 303 of the Code.5 In these tax years, Taxpayers had no offsetting income of the same class.
Because of the Partnership's dismal operations, the Partnership paid less monthly interest on the PMM Note than it had projected. Under the terms of the PMM Note, this led to a greater amount of accrued but unpaid interest over the years. According to the comprehensive "Offering Memorandum" shared with investors, the Partnership projected accrued but unpaid interest on the PMM Note at maturity (November 1, 2001, later extended to January 2, 2005) to be approximately $300 million. It also projected that proceeds upon sale of the Property at maturity would be sufficient to pay off the principal and accrued interest on the PMM Note, with excess funds available to distribute to the partners as a return on their investment. At the date of foreclosure, the Partnership had an accrued but unpaid interest obligation of approximately $2.32 billion. The Partnership had used approximately $121,600,000 of this amount to offset its income from operations that would otherwise have been subject to PIT. Neither the Partnership nor Taxpayers derived any PIT benefit from the remainder.
The lender foreclosed on the Property on June 30, 2005. By that time, what began as a $308 million Partnership liability on the PMM Note had grown into a liability of more than $2.6 billion, of which only $308 million represented principal. Neither the Partnership nor its individual limited partners received any cash or other property as a result of the foreclosure. That same year, the Partnership terminated operations and liquidated. Taxpayers did not recover their capital investment in the Partnership at foreclosure or liquidation. Indeed, Taxpayers did not receive any cash or other property upon liquidation of the Partnership.
The Partnership reported a gain on foreclosure of the Property for tax year 2005 on federal Form 1065 and Pennsylvania Form PA-65 (information return), the overwhelming majority of which is attributable to the full amount of the PMM Note debt obligation (principal plus accrued but unpaid interest) discharged upon foreclosure. The Partnership reported to Taxpayers on Pennsylvania Schedule NRK-1 for tax year 2005 their pass-through share of the Partnership gain, $935,144, in the class of "[n]et gains or income from the disposition of property." Section 303(a)(3) of the Code.6 It also reported to Taxpayers their pass-through share of the Partnership's operating losses that year as Section 303(a)(4) class income.
In a Notice of Assessment dated April 29, 2008, the Department assessed Taxpayers $28,709 in PIT liability, plus penalties and interest of $9,932.03, for a total assessment of $38,641.03 (Assessment). In doing so, the Department determined that Taxpayers had a taxable gain from the foreclosure for PIT purposes in the amount of their pass-through share of the gain reported by the Partnership in its informational filing—$935,144. Taxpayers filed a petition for reassessment with the Department's Board of Appeals (BOA), challenging the Assessment. On August 21, 2015,7 BOA rejected the majority of Taxpayers' arguments. It, nonetheless, abated the assessed penalties in full and recalculated the amount of gain realized by the Partnership upon disposition of the Property, accounting for annual straight-line depreciation of the Property dating back to the year the Partnership acquired it.8 Taxpayers' pass-through share of the Partnership's revised gain was $903,286, thereby reducing Taxpayer's principal PIT liability from $28,709 to $27,730. The Department issued a Notice of Reassessment (Reassessment) consistent with BOA's determination.
Taxpayers appealed the Reassessment to the Board. Citing Wirth , Taxpayers contended that the tax benefit rule should be applied to exclude from the amount of the gain realized by the Partnership upon foreclosure that amount of prior year operating losses attributable to accrued but unpaid interest deductions for which the Partnership derived no tax benefit. Under Taxpayers' view, this would reduce the amount realized by the Partnership from $2.6 billion to just $429,600,000, reducing the taxable gain for the Partnership from $2,362,812,499 to just $163,914,948. Concomitantly, Taxpayers' PIT liability for their pass-through share of the Partnership's taxable gain would be reduced by approximately 93%.
Taxpayers also challenged BOA's determination that the Partnership was required to reduce its basis in the Property by straight-line depreciation dating back to the year that the Partnership acquired the Property. Section 303(a.2) was added to the Code by section 9 of Act 89 of 2002.9 Section 34 of Act 89 of 2002 provides that Section 303(a.2) of the Code "shall apply to taxable years beginning after December 31, 2000." Taxpayers argued that this language meant that the minimum straight-line depreciation provision should only be applied for tax years 2001 and thereafter and, therefore, did not mandate a minimum downward basis adjustment for straight-line depreciation in years preceding the 2001 tax year. The Department offered a competing interpretation. In its view, Section 303(a.2) of the Code relates to the calculation of income. In this case, the income in question is the gain on disposition of the Property, which occurred in 2005. Accordingly, because the income event occurred after the effective date of Section 303(a.2), the minimum straight-line depreciation provision applied to calculate the adjusted basis of the Property from inception through foreclosure and, consequently, any gain upon disposition.
Taxpayers also argued that Pennsylvania lacks the authority to impose PIT liability on Taxpayers in this case, because doing so would violate the Commerce Clause of the United States Constitution.10 Taxpayers also contended that, in reality, they did not experience a taxable gain in 2005...
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