Wirth v. Commonwealth

• Decision Date: 17 June 2014
• Citation: 95 A.3d 822
• Parties: Ernest & Beverly WIRTH, Appellants v. COMMONWEALTH of Pennsylvania, Appellee. John K. Houssels, Jr., Appellant v. Commonwealth of Pennsylvania, Appellee. Thomas Shaker, Appellant v. Commonwealth of Pennsylvania, Appellee. Robert J. Marshall, Jr., Appellant v. Commonwealth of Pennsylvania, Appellee.
• Court: Pennsylvania Supreme Court

95 A.3d 822

Ernest & Beverly WIRTH, Appellants

v.COMMONWEALTH of Pennsylvania, Appellee.

John K. Houssels, Jr., Appellant

v.Commonwealth of Pennsylvania, Appellee.

Thomas Shaker, Appellant

v.Commonwealth of Pennsylvania, Appellee.

Robert J. Marshall, Jr., Appellant

v.Commonwealth of Pennsylvania, Appellee.

Supreme Court of Pennsylvania.

Submitted Aug. 19, 2013.

Decided June 17, 2014.

Christopher Andrews Jones, Esq., Ballard Spahr Andrews & Ingersoll, L.L.P., Philadelphia, for Ernest Wirth and Beverly Wirth.

Wendi Lynn Lotzen, Esq., Ballard Spahr Andrews & Ingersoll, L.L.P., for Ernest Wirth.

Kevin A. Moury, Esq., Claudia M. Tesoro, Esq., Carol L. Weitzel, Esq., PA Office of Attorney General, for Commonwealth of Pennsylvania.

Joseph C. Bright, Esq., Cheryl Ann Upham, Esq., Cozen O'Connor, Philadelphia, for Thomas Shaker, John K. Houssels, Jr. and Robert J. Marshall, Jr.

BEFORE: CASTILLE, C.J., SAYLOR, EAKIN, BAER, TODD, McCAFFERY, STEVENS, JJ.

OPINION

Justice BAER.

In this direct appeal, we examine a decision by the Commonwealth Court, sitting en banc, which considered the application of Pennsylvania personal income tax (PIT) to various nonresidents, who invested as limited partners in a Connecticut limited partnership, which existed for the sole purpose of owning and operating a skyscraper in the City of Pittsburgh, which ultimately went into foreclosure in 2005. The Commonwealth Court held that the partnership was subject to PIT commensurate with the total debt discharged as a result of the foreclosure, and therefore the nonresident limited partners were liable for PIT in an amount proportionate with their shares in the partnership. In this case that presents several issues of first impression, for the reasons that follow, we affirm.

I. BACKGROUND

In late 1984–early 1985, the five Appellants in this case, a married couple (Ernest and Beverly Wirth) and three individuals (John Houssels, Jr., Thomas Shaker, and Robert Marshall, Jr.), all purchased various interests in a limited partnership known as 600 Grant Street Associates Limited Partnership (Partnership). Appellants' interests in the Partnership ranged from one-quarter of a unit to one unit.¹ All Appellants were non-Pennsylvania residents. The sole purpose of the Partnership, which was organized pursuant to Connecticut law, was the purchase and management of the property located at 600 Grant Street in the downtown section of the City of Pittsburgh, commonly known as the U.S. Steel Building (the Property). In all, 735 limited partners, only 25 of whom were Pennsylvania residents, comprised the Partnership. All of the limited partners were passive investors; none took an active role in managing the Property.

Investment in the Partnership began when the general partner made a comprehensive “Offering Memorandum” available to potential investors. The memorandum stated that while the Partnership would likely incur economic and tax losses for the first several years of its existence, due to expected growth in the Pittsburgh commercial real estate market, eventually the limited partners would be allocated a substantial gain upon the anticipated sale of the Property. The memorandum further specified that each investor could be subject to negative tax consequences, both under federal and Pennsylvania tax laws. The memorandum also indicated that these tax consequences would be determined primarily based on the financial liquidity of the Property when the mortgage on the Property matured.

With the Partnership in place, it proceeded to purchase the Property in 1985 for $360 million. Of that, $52 million was paid in cash, and the Partnership pledged the Property as collateral to secure a nonrecourse Purchase Money Mortgage Note (PMM Note), with an initial principal balance of the remaining $308 million.² Interest on the PMM Note was payable on a monthly basis, at a rate of 14.55% per annum. The PMM Note contained an important caveat, however: should the monthly interest amount exceed the Partnership's net operating income from the Property, the excess did not have to be paid, and instead would defer and compound on an annual basis, subject to the same 14.55% rate. The PMM Note originally delineated the maturity date as November 1, 2001; the parties subsequently extended that date to January 2, 2005.

As the years progressed, the Partnership's net income from operations did not meet the projections of the general partner. Indeed, it incurred net operating losses for accounting, federal tax, and PIT purposes in every year of its existence. Relevant to this case, for PIT purposes, the Partnership allocated those losses to Appellants (and all of the other limited partners) and, because Appellants had no Pennsylvania-based income for 1985–2004, they did not file Pennsylvania PIT returns for those years. Moreover, because the net operating income was less than the monthly interest on the PMM Note, the Partnership did not pay the interest and therefore deferred it as noted above. By June 30, 2005, the compounded, accrued interest totaled $2.32 billion, thus making the total liability on the PMM Note more than $2.6 billion.³

When the PMM Note matured on January 2, 2005, given the insurmountable debt that had accrued, the Partnership was unable to sell the Property. Accordingly, on June 30, 2005, the lender foreclosed, and, because the Partnership no longer owned the Property (which was the sole reason for the Partnership's existence), the Partnership soon after liquidated. None of the limited partners, including Appellants, received any proceeds from the Property's foreclosure or the Partnership's liquidation, and therefore lost their entire investments in the Partnership.

Following the Property's foreclosure, but prior to the Partnership's liquidation, the Partnership reported a gain as a result of the foreclosure on its federal and state tax filings that consisted of the unpaid balance of the PMM Note's principal and the accrued, compounded interest, totaling $2,628,491,551. Accord Commissioner v. Tufts, 461 U.S. 300, 103 S.Ct. 1826, 75 L.Ed.2d 863 (1983) (holding, as will be explained in greater detail, infra Part III(A), that foreclosures on nonrecourse mortgage notes constitute the disposition of property and therefore result in the realization of income or gain for federal tax purposes equal to the amount of the discharged debt). Concomitantly, the Partnership reported each individual limited partner's respective share of that gain. Therefore, and despite their individual investment losses, the Pennsylvania Department of Revenue (the Department) assessed PIT against Appellants, plus interest and penalties, related to the foreclosure on the Property for tax year 2005. The PIT equaled each limited partner's distributive share of the gain associated with the foreclosure, multiplied by the Pennsylvania PIT rate of 3.07%. See72 P.S. § 7306. ⁴ Appellants unsuccessfully challenged the assessments in the Department's Board of Appeals and, subsequently, in the Board of Finance and Revenue. Timely appeals to the Commonwealth Court followed.⁵

On January 3, 2013, in four separate decisions, an en banc panel of the Commonwealth Court affirmed the Board in part, vacated in part, and remanded. ⁶ The court began its analysis by examining as a threshold matter whether taxing Appellants in the first instance violated the Commerce and Due Process Clauses of the United States Constitution,⁷ under the theory that none of them as nonresidents could be subject to the Pennsylvania Tax Reform Code (the Code). While recognizing that in taxation cases, Commerce and Due Process Clause arguments are interrelated, the court opined that “the two should not be intermingled” because, accordingto the United States Supreme Court, they “are analytically distinct.” Marshall v. Commonwealth, 41 A.3d 67, 73 (Pa.Cmwlth.2012) ( en banc) (quoting Quill Corp. v. N. Dakota, 504 U.S. 298, 305–06, 112 S.Ct. 1904, 119 L.Ed.2d 91 (1992)). The court concluded that Appellants only disputed whether minimum contacts existed to permit Pennsylvania to tax them, and a minimum contacts analysis only implicates due process. Accordingly, the court concluded that Appellants waived the Commerce Clause claim.⁸

Turning to the due process claim, the court determined that a reasonable, definitive connection between Appellants and Pennsylvania existed because the primary purpose of the Partnership was the ownership and management of real estate within the Commonwealth's borders. While it ultimately failed, the Partnership's sole objective was to return a profit on the building, and therefore the Partnership and its limited partners purposely established contacts with Pennsylvania for that purpose. Thus, the court found that subjecting Appellants to PIT did not violate due process. Id. at 74 (citing, e.g., Kulko v. Superior Court of California, 436 U.S. 84, 92, 98 S.Ct. 1690, 56 L.Ed.2d 132 (1978) (whether minimum contacts exists for purposes of due process is fact specific and “must be weighed to determine whether the requisite ‘affiliating circumstances' are present”)).

The court next turned its attention to whether the foreclosure upon the Property, and therefore the discharge of the nonrecourse debt associated with it, constituted a taxable event for purposes of PIT. In Pennsylvania, the imposition of PIT is governed by Section 302 of the Code, which provides as follows:

(a) Every resident individual, estate or trust shall be subject to, and shall pay for the privilege of receiving each of the classes of income hereinafter enumerated in section 303, a tax upon each dollar of income received by that resident during that resident's taxable year at the rate of three and seven hundredths per cent.

(b) Every nonresident individual, estate or trust shall be subject to, and shall pay for the privilege of receiving each of the classes of income hereinafter enumerated in section 303 from sources within this Commonwealth, a tax...