Schulmann v. Director, Div. of Tax'n: New Jersey Court Holds Payments from Personal Income Cannot Be Deducted as Business Expense

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By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, DC

In Schulmann v. Director, Div. of Tax'n, No. A-2089-10T3 (N.J. Super. Ct. App. Div. 12/6/11), the New Jersey Superior Court held that the sole shareholder of two S corporations who paid commissions owed by the S corporations could not deduct the commission payments as business expenses from his gross income on his individual New Jersey income tax return. Unlike the federal income tax system imposed under the Internal Revenue Code of 1986, as amended (the "Code"), the New Jersey Gross Income Tax Act separates income into specified categories and then permits few deductions and does not allow losses from one category to be used to offset income in a different category. The mismatch between the Code and the New Jersey Gross Income Tax can trap an unwary taxpayer, and this case serves as an important reminder that practitioners cannot assume that federal law is the same as state law, especially with respect to pass-through entities.

Taxpayer, the owner of several karate schools, set up two S corporations to provide management services and franchise services to his business. Taxpayer encouraged his trained students to become instructors at a new school, which would be incorporated as an S corporation listing Taxpayer as 51% owner and the trained student as 49% owner. The trained student would be the instructor in the new school and, in such capacity would be treated as an employee of the school and entitled to salary/bonus income in addition to any net profits as a part-owner of the school. As an additional incentive, the instructor was entitled to certain commissions if a student he or she trained, in turn, became an instructor in a separately incorporated karate school.

Taxpayer paid the commissions that the two S corporations owed to the students from his personal funds and then deducted the expenses on his personal income tax return. The New Jersey Division of Taxation issued a deficiency for 2000 through 2002, on the grounds that the payments were nondeductible personal expenses.  Taxpayer filed an administrative protest claiming he was acting as an agent for the two S corporations of which he was the 100% owner, and thus the commission payments were expenses that could be used to offset his S corporation income.

Upon review, the Director of the Division of Taxation upheld the deficiency, concluding that, although the commission payments were ordinary corporate business expenses, the commissions could not be used to offset S corporation income when paid by Taxpayer directly.

On appeal to New Jersey Tax Court, Taxpayer argued that, as the sole shareholder of the two S corporations, he was contractually obligated to pay the commissions, and therefore, when he made payments on behalf of the S corporations they were business expenses. The New Jersey Tax Court, however, rejected Taxpayer's argument that the pass-through nature of an S corporation allowed for a "merging of identities of the entity and its members," noting that, unlike a partnership, an S corporation has a corporate-level tax which separates it from its members.

The New Jersey Tax Court also rejected Taxpayer's argument that he should be allowed a deduction on the grounds that because New Jersey law does not permit "inter-category netting," a business loss cannot be offset against a shareholder's pro rata share of S corporation income. The New Jersey Tax Court noted that having chosen to make the commission payments out of personal rather than business funds, Taxpayer could not then avoid the structure when it resulted in unfavorable tax consequences. Finally, the New Jersey Tax Court rejected Taxpayer's argument that he was allowed a deduction for the payments under §162 of the Code on the grounds that, because the state tax was not based on the Code, the federal deduction was not allowable against New Jersey state income tax.

Upon appeal, the New Jersey Superior Court affirmed the holding of the New Jersey Tax Court. The New Jersey Superior Court noted that the New Jersey Gross Income Tax Act established separate and distinct categories of income, and, by establishing taxes on a category-by-category basis, cross-netting of losses and income from different categories was expressly prohibited. The New Jersey Superior Court further agreed that Taxpayer could not disregard the corporate form to take personal deductions for corporate expenses.

Because of the mismatch between the Code and the New Jersey Gross Income Tax Act, New Jersey taxpayers need to be particularly mindful not just of the federal income tax ramifications of how they organize their affairs, but also the state income tax ramifications. In this instance, if Taxpayer had paid the commissions from the S corporations, then each S corporation could have taken New Jersey state income tax deductions for the payments. Accordingly, with a little care, Taxpayer could have structured his affairs to achieve the tax consequences he desired. There was no discussion in the case of characterizing the payment as a contribution to capital followed by a payment by the S Corporation. This case is important because practitioners cannot assume that federal law is the same as state law, especially with respect to pass through entities.

 For more information, in the Tax Management Portfolios, see Maule, 505 T.M., Trade or Business Expenses and For-Profit Activity Deductions,  and in Tax Practice Series, see ¶2110, Trade or Business Expenses - General Requirements.