Smith v. Director, Div. of Taxation

• Decision Date: 02 July 1987
• Citation: 108 N.J. 19,527 A.2d 843
• Parties: Layton F. and Joan SMITH, Plaintiffs-Respondents, v. DIRECTOR, DIVISION OF TAXATION, Defendant-Appellant. Roger and Lisa GEISSLER, Plaintiffs-Respondents, v. DIRECTOR, DIVISION OF TAXATION, Defendant-Appellant.
• Court: New Jersey Supreme Court

Page 19

108 N.J. 19

527 A.2d 843

Layton F. and Joan SMITH, Plaintiffs-Respondents, v. DIRECTOR, DIVISION OF TAXATION, Defendant-Appellant.

Roger and Lisa GEISSLER, Plaintiffs-Respondents, v. DIRECTOR, DIVISION OF TAXATION, Defendant-Appellant.

Supreme Court of New Jersey.

Argued Jan. 6, 1987.

Decided July 2, 1987.

Mary R. Hamill, Deputy Atty. Gen., for defendant-appellant (W. Cary Edwards, Atty. Gen., James J. Ciancia, Asst. Atty. Gen., attorney).

Jeffrey M. Schwartz, for plaintiffs-respondents (Clapp & Eisenberg, attorneys; Jeffrey Schartz and Arnold K. Mytelka, on the briefs).

The opinion of the Court was delivered by

GARIBALDI, J.

The issue in these cases is the proper method of taxing a partner on his or her "distributive share of partnership income" under the New Jersey Gross Income Tax Act, N.J.S.A. 54A:1-1 to 54A:10-12 (the "Act"). Specifically, we must determine whether all partnership income realized in the ordinary course of the business of a partnership actively engaged in the securities business is to be taxed to the partners on a net consolidated basis as a single category of income, i.e., "distributive share of partnership income" under N.J.S.A. 54A:5-1k, or whether, pursuant to N.J.A.C. 18:35-1.14(c)4, the taxpayer's partnership income is to be divided into three subcategories, one of which, "distributive share of partnership income," is to be taxed on a net basis, while the other two, "dividends" and "gains," are to be taxed on a gross basis. Practically, the question posed in these cases is whether a partner in a securities firm, in determining his "distributive share of partnership income," may deduct partnership business expenses against all types of partnership income, including dividends and capital gains, realized in the ordinary course of that partnership's business.

I

These cases arise from tax deficiencies assessed against Layton and Joan Smith for 1976 and against Roger and Lisa Geissler for 1978, ¹ 1979, and 1980. ² The facts are stipulated.

At all relevant times the Smiths and Geisslers were New Jersey residents. Layton Smith was a general partner in Salomon Brothers, a New York limited partnership actively engaged in the securities business. Roger Geissler was a general partner in Easton & Co., a New York limited partnership actively engaged in the securities and commodities businesses. In the ordinary course of their businesses, these partnerships generated various types of income, including commissions, investment advisory fees, underwriting and syndication fees, dealer profits, interest, dividends, and trading profits. The trading profits were capital gains realized by each partnership in the ordinary course of its business of trading securities. Likewise, in the ordinary course of their businesses, these partnerships incurred and paid business expenses, including salaries, rent, interest, and depreciation. These expenses were incurred in the production of all types of the partnerships' business income, including dividends and gains.

Each taxpayer computed his distributive share of partnership income by aggregating all the partnership's business income to which he was entitled, including dividends and gains, and deducting his share of the business expenses incurred by the partnership. ³ The taxpayers contend that business expenses in excess of partnership income other than dividends and gains may be applied against those two categories of income.

The Director agrees with the taxpayers that a "distributive share of partnership income" is a partner's share of the "[n]et income of the partnership," which is "determined and reported on the basis of accepted accounting principles ... after provision for all cost and expenses incurred in the conduct thereof." N.J.A.C. 18:35-1.14(c)2. The Director, however, does not agree that the "net income of a partnership" includes dividend and capital gains realized by a partnership in the ordinary course of its business. Instead, the Director, relying on N.J.A.C. 18:35-1.14(c)4, concludes that partnership income consists of three separate categories of income--"distributive share of partnership income," "dividend income," and "gain from the sale, exchange or other disposition of property." Under the Director's theory, partnership business expenses are deductible only against "distributive share of partnership income"; and business expenses exceeding that income are not deductible against income from dividends and capital gains, even where, as here, such income is realized in the ordinary course of business. The result is that not all business expenses incurred in producing partnership income in the ordinary course of business are deductible against partnership income realized in the ordinary course of business. The effects of the taxpayers' and the Director's methods of computation are illustrated in the following table, which uses figures proportionate to those involved in the Smith case:

Distributive share of partnership:

                                       Taxpayer   Director
                                       ________   ________
                Dividends              $  8             $  8
                Capital gains           211              211
                Interest                161      $161
                Other ordinary income   330       330
                Expenses               (684)     (684)
                                                 (193)   -0-
                                                        ----
                Partnership income
                  subject to tax       $  26            $219
                

The Tax Court concluded that " N.J.A.C. 18:35-1.14(c)4, as applied to a partnership in which dividend and capital-gain income are generated in the ordinary course of business, is plainly inconsistent with the statute and must be disregarded." Smith v. Director, Div. of Taxation, supra, 7 N.J.Tax at 207; see also Geissler v. Director, Division of Taxation, No. GI 0633-83 (March 8, 1985) (decided on the grounds expressed in Smith ). The Appellate Division affirmed, substantially for the reasons set forth by the Tax Court in its Smith opinion. 8 N.J. Tax 319 (App.Div.1986). We granted certification, 104 N.J. 448, 517 A.2d 436 (1986), and now affirm.

II

We start our analysis with a brief review of relevant statutory provisions. The Act does not tax partnerships as such. N.J.S.A. 54A:2-2. Instead, the Act provides that "[i]ndividuals carrying on business as partners shall be liable for the New Jersey Gross Income Tax only in their separate or individual capacities." N.J.S.A. 54A:2-2. Individuals are taxed on their New Jersey gross income, defined to consist of fourteen categories. N.J.S.A. 54A:5-1. ⁴ Some of these categories are taxed on a gross basis (i.e., without regard to associated costs)--e.g., salaries ( N.J.S.A. 54A:5-1a), interest ( N.J.S.A. 54A:5-1e), and dividends ( N.J.S.A. 54A:5-1f). Other types are taxed on a net basis (i.e., with regard to associated costs)-- e.g., net profits from business ( N.J.S.A. 54A:5-1b), net gains or income from disposition of property ( N.J.S.A. 54A:5-1c), and net gains or net income from rents, royalties, patents, and copyrights ( N.J.S.A. 54A:5-1d). N.J.S.A. 54A:5-2 provides that "[l]osses which occur within one category of gross income may be applied against other sources of gross income within the same category of gross income," but "a net loss in one category of gross income may not be applied against gross income in another category of gross income." (emphasis added.)

The term "distributive share of partnership income" is not defined anywhere in the New Jersey Gross Income Tax Act. The Director argues that N.J.A.C. 18:35-1.14(c)4 is a reasonable interpretation of N.J.S.A. 54A:5-1 and N.J.S.A. 54A:5-2 and hence, under well-recognized rules, is entitled to great deference.

Generally, we do give substantial deference to the interpretation an agency gives to a statute that the agency is charged with enforcing. See Matter of Board of Educ. of Town of Boonton, 99 N.J. 523, 534, 494 A.2d 279 (1985) ("an administrative agency's interpretation of a statute it is charged with enforcing is entitled to substantial weight"); Metromedia, Inc. v. Director, Div. of Taxation, 97 N.J. 313, 327, 478 A.2d 742 (1984) ("the agency's interpretation of the operative law is entitled to prevail, as long as it is not plainly unreasonable"); Peper v. Princeton Univ. Bd. of Trustees, 77 N.J. 55, 69, 389 A.2d 465 (1978) ("this Court places great weight on the interpretation of legislation by the administrative agency to whom its enforcement is entrusted").

Nevertheless, administrative regulations are not binding on the courts and a regulation will fall if a court finds that the rule is inconsistent with the statute it purports to interpret. See Airwork Serv. Div. v. Director, Div. of Taxation, 97 N.J. 290, 296, 478 A.2d 729 (1984) (when the court can identify a particular legislative intent, that intent cannot be "outweighed or overcome simply by a countervailing administrative practice"); Service Armament Co. v. Hyland, 70 N.J. 550, 563, 362 A.2d 13 (1976) ("an administrative interpretation which attempts to add to a statute something which is not there can furnish no sustenance to the enactment"); Kingsley v. Hawthorne Fabrics Inc., 41 N.J. 521, 528, 197 A.2d 673 (1964) (an "administrative agency may not under the guise of interpretation extend a statute to include persons not intended, nor may it give the statute any greater effect than its language allows."); Mayflower Sec. Co., Inc. v. Bureau of Sec., 64 N.J. 85, 93, 312 A.2d 497 (1973) (a court is "in no way bound by the agency's interpretation of a statute or its determination of a strictly legal issue"); Safeway Trails, Inc. v. Furman, 41 N.J. 467, 484, 197 A.2d 366 (1964) (quoting Burnet v. Chicago Portrait Co., 285 U.S. 1, 16, 52 S.Ct. 275, 281, 76 L.Ed. 587, 595 (1932)) (" 'The Court is not bound by an administrative construction, and if that construction is not uniform and consistent, it will be taken into account only to the extent that it is supported by valid reasons.' ").

III

In the...