Friday, November 25, 2011

New Jersey Couple Scores a Victory Against Bernie Madoff and the Division of Taxation

The New Jersey Tax Court recently held that a married couple was entitled to recover the Gross Income Tax (GIT) paid on dividends and capital gains reported as earned through their investments with Bernie Madoff. The taxpayers filed a claim for refund of gross income taxes paid by them for the tax years 2005, 2006 and 2007 with respect to capital gains and dividend income reported as earned through their investments with Madoff. They learned in 2008, that, in fact there had been no earnings, and that Madoff’s report to them of various security transactions and income earned from those transactions were fictitious. The Division of Taxation denied their refund claims.

The Division refused to stipulate to the facts surrounding the operation of the Madoff Ponzi scheme, however, the Director implicitly accepted the factual underpinnings of the plaintiff’s case in his official pronouncements with respect to the Madoff scheme; the court concluded that those facts constituted stipulated facts.

The taxpayers argued that they were entitled to refund of taxes paid on their factitious income. They also argued that their election to treat the loss as a theft loss on their federal income tax return did not preclude them from claiming refunds under the GIT Act. The Division of Taxation contended that the dividends and capital gains income were taxable because the taxpayers constructively received the income. They also argued that pursuant to its April 15, 2010 notice, victims of the Madoff fraud may only report a capital loss in 2008, the year in which the fraud was discovered and in accordance with the federal procedures for theft losses.

The Tax Court held that the taxpayers were entitled to income tax refunds because the dividends and capital gain income reported on their tax returns simply did not exist. The Tax Court found that there was never any sale, exchange or other disposition of property because the transactions reported by Madoff sent to the taxpayers never took place. The court then held that the Division of Taxation’s position that the only relief available to the taxpayers was to claim a capital loss in accordance with federal procedures was unreasonable. It found that there was no principal reason why the taxpayer should be required to use a federal procedure that relies upon federal tax code concepts that are not recognized by the Gross Income Tax Act. The court then found in favor of the taxpayers allowing the theft losses against the taxpayers gross income tax.

Tuesday, November 15, 2011


The Tax Relief Act of 2010 made significant changes to the gift, estate and generation-skipping transfer tax regimes by increasing the amount each individual can give without incurring tax from $1 million to $5 million.  The increase was not permanent however, and rumor has it that it may be in jeopardy.  To avoid any risk, those who have decided to use their full exemptions should do so no later than December 31, 2011, and, if feasible, November 22.

The Rumors

Rumors circulating recently within the financial and estate-planning communities have suggested the $5 million exemptions may be in immediate jeopardy.  Democratic staff on the U.S. House Committee on Ways and Means recently proposed decreasing the $5 million gift, generation-skipping transfer tax and estate tax exemptions to $3.5 million, effective January 1, 2012.  There also are rumors the Joint Select Committee on Deficit Reduction (the Super Committee) may recommend a drop down in the gift tax exemption to $1 million, effective at year end, or possibly as early as November 23, 2011, when its recommendations are scheduled to be released, though there is no confirmation this rumor is true.

As we all know "everything" is on the table before the super-committee (although they would not admit it), I would caution you to advise your clients of these developments and act sooner rather than later.

Wednesday, November 9, 2011

Unlike the Federal Tax Treatment of Bad Debts, New Jersey Taxpayers Are Not Entitled to a Bad Debt Deduction

The New Jersey Appellate Division in Waksal v. Director, Division Of Taxation determined that a New Jersey couple could not report losses to offset capital gains on their New Jersey income tax return.

In January 2002, Harlan W. Waksal loaned $14,769,320 to his brother, who signed a promissory note and agreed to repay the loan on or before January 31, 2004. His brother then defaulted on the loan. Subsequently, plaintiffs filed a 2004 Federal Individual Income Tax Return and reported a short term capital loss of $14,769,320. They also filed a 2004 New Jersey Gross Income Tax Return and reported the same amount as a loss from the "sale, exchange or other disposition of property," pursuant to N.J.S.A. 54A:5-1(c). After using the loss to offset capital gains, they reported $6,644,022 as a net gain in their New Jersey tax return.

The New Jersey Appellate Court affirmed the summary judgment granted to the Director, Division of Taxation. The Waksals argue primarily that their nonbusiness bad debt was "a sale, exchange or other disposition of property" under N.J.S.A. 54A:5-1(c), and, as a result, they are allowed to report the loss on their New Jersey Gross Income Tax Return and offset capital gains. Because the New Jersey Gross Income Tax Act (the Act), N.J.S.A. 54A:1-1 to -10, does not permit such a deduction, the trial court’s decision was affirmed.

The trial court relied in part on Walsh v. Director, Division of Taxation, 15 N.J. Tax 180 (App. Div. 1995), and King v. Director, Division of Taxation, 22 N.J. Tax 627 (App. Div. 2005), which held that a loss from a nonbusiness bad debt could not be used to offset gains "derived from the sale, exchange, or other disposition of property" under N.J.S.A. 54A:5-1(c). The trial judge indicated that "net gains or income from disposition of property" is considered taxable income under N.J.S.A. 54A:5-1(c), which provides in part that New Jersey gross income consists of certain categories, including:

Net gains or net income, less net losses, derived from the sale, exchange or other disposition of property, including real or personal, whether tangible or intangible as determined in accordance with the method of accounting allowed for federal income tax purposes.

The judge reasoned that the Act "does not mirror federal taxing statutes" and observed that the Supreme Court explained in Smith v. Director, Division of Taxation, 108 N.J. 19, 32 (1987), that:

Even a cursory comparison of the New Jersey Gross Income Tax and the Internal Revenue Code indicate [sic] that they are fundamentally disparate statutes. The federal income tax model was rejected by the Legislature in favor of a gross income tax to avoid the loopholes available under the Code.

The court recognized that in Walsh the Legislature determined that the New Jersey Gross Income Tax should contain fewer deductions from income than the federal income tax. This was seen as a way of making the Gross Income Tax fairer. The Legislature did not explicitly provide for a deduction of a nonbusiness bad debt. Thus, in view of the legislative history, it would appear that the Legislature did not intend for N.J.S.A. 54A:5-1c to be read broadly to include a deduction for nonbusiness bad debts.

On appeal, plaintiffs contend that the decision of the judge conflicts with N.J.S.A. 54A:5-1(c) and the Supreme Court's clear direction to apply substantive federal tax rules to determine net gains and loses.

In Walsh, the taxpayers sought to deduct a nonbusiness bad debt following a personal loan to a corporation in which they were also shareholders. The corporation then transferred its assets to a second corporation, "but [the taxpayers] remained liable as . . . guarantor[s] on the bank loans." After the second corporation defaulted on the bank loans that the taxpayers guaranteed, the taxpayers paid off the debt and deducted the losses on their New Jersey Gross Income Tax return.

Quoting the Tax Court, the Appellate Court held that the worthless debt, although treated as a loss from the sale or exchange of a capital asset held for not more than one year . . . under the Internal Revenue Code, does not fit the statutory rubric of sale, exchange or other disposition of property" found in N.J.S.A. 54A:5-1(c).

Because Waksal's loss from their nonbusiness bad debt cannot be used to offset gains derived from the "sale, exchange or other disposition of property" under N.J.S.A. 54A:5-1(c), the judge concluded that plaintiffs could not report the loss to offset capital gains on their New Jersey income tax return.