Booth vs. Division of Taxation – Important Decision Effect New Jersey Planning


Booth vs. Division of Taxation

 

            BACKGROUND

Booth vs. Director, Division of Taxation, 27 N.J. Tax 600, decided February 11, 2014 is a far reaching and significant opinion that will change the way tax planners view the “New” New Jersey Estate Tax.  The New Jersey Estate Tax, enacted in June 2002 for individuals passing away after January 1, 2002, seeks to impose a “state death tax credit” which had been formerly allowed by federal law (pursuant to IRC §2011) by treating all New Jersey resident decedents as if they died December 31, 2001.  N.J.S.A 54:38-1 (a)(2).  For the past dozen years, estate planners (this author included) have assumed the statute was to be taken literally as if the client died in 2001.  The Booth decision provides a unique set of circumstances which has significantly shifted the focus.

When enacted, the new tax was dubbed the “New” New Jersey Estate Tax because the legislation “decoupled” the state estate tax rules from the federal rules.  Initially, many states (about 20 states) “decoupled,” however, now there are about eight states (and the District of Columbia) which impose a tax similar to New Jersey by reliance on the former federal credit amount.  The State of New Jersey has received negative publicity for imposing the tax threshold at the lowest level in the nation, $675,000 in value.  However, the tax that is imposed, once the value of the estate exceeds the state’s applicable exemption threshold, will be the same tax to a New Jersey resident or to a resident of the other states that have “decoupled”.  In New Jersey, the estate tax is imposed on the value of assets in excess of $675,000 and a resident estate is obligated to file and pay a tax at that dollar threshold because that was the estate tax threshold in place in 2001.  Other jurisdictions have set the filing and exemption threshold at higher figures, $1,000,000 (Maryland, Massachusetts, District of Columbia), $2,000,000 (Maine).  Eight other states have created similar “stand alone” estate taxes.  Recent New York legislation has sought to “repeal” the tax on smaller estates by an increase to the federal threshold in stages over the remaining decade.  [1]

The basis of the New Jersey Estate Tax is to share (or “soak up”) revenue that was generated by the federal estate tax as imposed by the federal government in years before 2001.  When the 2001 federal tax cut (the initial “Bush tax cut”) was established, the federal rules both increased the federal exemption threshold and reduced the rate, and it phased out a benefit provided to the states in a sharing arrangement of this tax credit.  The phase out ran from between the years 2002 and 2004 and from there, any tax paid became deductible.  This New Jersey tax was established in order to eliminate an immediate loss of revenue that would have occurred because the federal government had repealed this “soak up” provision that was previously contained in §2011 of the Internal Revenue Code as was in effect at that time.  This New Jersey rule now imposes the Estate tax irrespective of the federal exemption amount.

Because the estate tax was a “soak up” tax, it had been widely assumed that a federal determination of the amount of the tax credit would be binding upon the State of New Jersey for computation “new” New Jersey Estate Tax.  In other words, in a circumstance where a federal determination of the amount of the pre-existing credit occurred by virtue of a federal assessment of tax, the federal assessment would set the values for calculation of this tax.  Booth is an important case as it demonstrates that one should never ASSUME!

N.J.S.A. 54:38-1 (a)(2) provides:

 

“Upon the transfer of the estate of every resident decedent dying after December 31, 2001 which would have been subject to an estate tax payable to the United States under the provisions of the federal Internal Revenue Code of 1986 (26 U.S.C. s.1 et seq.), in effect on December 31, 2001, the amount of which tax shall be, at the election of the person or corporation liable for the payment of the tax under this chapter, either (i)   the maximum credit that would have been allowable under the provisions of that federal Internal Revenue Code in effect on that date against the federal estate tax that would have been payable under the provisions of that federal Internal Revenue Code in effect on that date on account of taxes paid to any state or territory of the United States or the District of Columbia . . .” (emphasis added).

 

The statute, as passed by the legislature, seems to imply that the purpose of the tax was to incorporate, by reference, all of the provisions of the federal Internal Revenue Code so that it could have the effect of continuing the credit which had been provided under pre-2002 rules.  However, upon closer inquiry, we will consider whether the words “would have been allowable” should be considered as the primary inquiry or whether the words “would have been payable” should receive the primary focus.

Booth presents the interesting circumstances surrounding the death of Lillian Garis Booth, an exceedingly wealthy resident of Bergen County, New Jersey.  This decision is the most recent in a conflict which had spawned earlier litigation a settlement and then continued disagreement among the respective heirs.  Unlike the earlier decision, Booth vs. Director, Division of Taxation, 27 N.J. Tax 600 (2014) has been approved for publication.  However, this decision may not be the final issue on the topic as the matter was remanded for further factual findings at which point the taxpayer will need to eventually decide on whether or not to appeal the ruling.

 

FACTS

Lillian Booth (“Lillian”) died testate in 2007.  She was a resident of Bergen County and had resided with Michael/Misha Dabich (“Michael”) for over 51 years.  Lillian had a 1958 Will and a 1991 Codicil and an estate valued at near $200,000,000 which made no provision for Michael.  The initial round of litigation involved Michael’s complaint against the estate alleging that because of his relationship and 36 years of cohabitation in New Jersey that he should be treated as a “spouse.”  Michael’s argument was that, upon traveling to Lebanon, Pennsylvania to visit his hometown, he and Lillian had held themselves out together as “spouses” and, accordingly, they met the test for a Pennsylvania common law marriage.  Pennsylvania subsequently outlawed common law marriage in 2005, but the common law marriage, if valid at that time, would have made him a “spouse” in New Jersey in the same way that they would have been “spouses” in had they been married in a formal Pennsylvania ceremony.

As a result of Michael’s complaint against the estate, the parties entered into an amended settlement agreement which provided that he would receive a trust with approximately $5,000,000 in value together with the home and other payments for a total settlement of about $9,900,000.  Apparently, the parties entered into a September 23, 2008 settlement agreement recognizing the claims as a surviving spouse pursuant to the “elective share” or “omitted spouse” provisions of N.J.S.A. 3B:8-1 or 3B:5-15.  Michael had sought to set aside the 2008 settlement agreement which resulted in an amended settlement agreement in 2009.

In the federal estate tax proceeding with the Internal Revenue Service, the federal estate tax audit granted the estate a “marital deduction” pursuant of IRC §2056 in the amount of $9,900,000.  The initial state tax computation for the estate was based upon the premise that the federal allowance of the federal marital deduction would result in a comparable reduction in the state death tax credit based upon a federal marital deduction.  The Division of Taxation filed a Notice of Assessment and found that “there was no evidence of a common law marriage other than circumstantial evidence” and the IRS determination that [Michael] was a common law spouse was similarly not adequately supported.  27 NJ Tax at 613.  The Division of Taxation found that it was not bound by the IRS’s recognition of the Q-TIP (permitted by IRC §2056 (b)(7))status as to the trust Id..  The estate moved for summary judgment on the basis that the “New Jersey Estate Tax is dependent upon the federally calculated and allowed state death tax credit.  Therefore, defendant (“Taxation”) is bound by the federal estate tax determination…”  27 NJ Tax at 603.

The secondary issue in the case relates to disallowance of certain expenses including taxes, accounting fees, executor’s commissions, and administrative expenses as well as administration expenses to maintain the property.  27 NJ Tax at 612.  The latter issue was reconsidered but will not be addressed herein.  Upon redetermination, the Court held that the Division could not use an Inheritance tax regulation around executor commissions to disallow an Estate tax deduction.  This analysis will focus on the primary issue of whether the New Jersey Estate Tax constitutes a predetermined “credit” as fixed by the Internal Revenue Service or whether the New Jersey Estate Tax is intended to be considered a “stand alone” tax which is based upon federal principles, but primarily based upon the New Jersey aspects of the determination.

 

PREEXISTING AUTHORITY

Why had tax lawyers “assumed” that the New Jersey Estate Tax was a federally fixed figure?  Let’s look at the tax background.  First, the statute provides that the tax due would be the amount payable as if a decedent died on December 31, 2001.  At that time, the amount that would have been payable would have been fixed by the federal determination of the tax liability being due.  This premise was set forth in the case involving publishing magnate, Malcolm Forbes.  Estate of Forbes v Director, Division of Taxation 14 NJ Tax 257 (1994). When Malcolm Forbes died on February 24, 1990, a resident of Bedminister, Somerset County, New Jersey, his estate opted for a federal installment payment of the estate tax under a provision of the Internal Revenue Code, IRC §6166, which permitted a deferral arrangement where a business constituted a large portion of the estate.  While the law has been changed since then, the provisions of §6166 permitted the estate to pay the tax over a 15 year term together with interest.  Moreover, and the interesting part of this of the case, was that the interest paid on the estate tax was deductible in arriving at the amount of tax eventually due.  This interest figure was not projected at the outset because the estate could always prepay the tax, but rather the tax computation was adjusted each year as payments were made.  In other words, the tax was computed at the date of death and the election was made. Then, when the estate paid the tax in installments, for example, in year two or three, when the interest was actually paid on the deferred payment of estate tax, the executor was permitted to claim a refund for tax after incorporating in the additional interest deduction which reduced the tax.

One nuance of the IRC §6166 computation of the state death tax credit, when considered in light of the deferred payment of estate tax, was that the §2011 state credit was based upon the value of the estate after applicable deductions.  However, this was not to be paid in installments, in fact, was to be due at a single point in time nine months after the decedent’s passing.  Accordingly, due to the amended federal returns being filed each successive year, the amount of the state death tax credit and the amount due to New Jersey would be reduced.  This situation created a considerable dilemma for the estate, because, pursuant to New Jersey law, the statute of limitations on filing claims for refund would expire at the end of four years.

In this circumstance, the New Jersey Tax Court was presented with a choice, it could either stick to the strict statute of limitations thereby denying the refund or opt for a reduction in the tax due.  In arriving at the decision to allow for a reduced tax, Judge Lasser found that the tax due could only be the amount of the credit.  In other words, if there was no credit amount determined by the IRS, then no liability would exist for New Jersey Estate Tax purposes.  Judge Lasser held:

“The amount of the New Jersey estate tax is the maximum credit allowable against any federal estate tax.  The legislative intent, as indicated in N.J.S.A. 54:38-13, is to liberally construe the statute to obtain for the State the benefit of the “credit allowed” under the IRC.  The statute does not indicate any intent to impose an estate tax in excess of the federal credit.  Therefore, implicit in the New Jersey estate tax is the incorporation of the provisions of the federal estate tax including exemptions and deductions and in particular §6166. ”  Emphasis added.  14 NJ Tax at 264.”

 

Thus, before 2002 and the enactment of the “New” New Jersey Estate Tax, it was very clear that the federally determined amount was fixed by the federal government and not a separate determination to be made based upon New Jersey rules.

The new provisions were subsequently considered in the case of Stevenson vs. Director, Division of Taxation, 23 N.J. Tax 583 (2008).  In this case, the Tax Court of the State of New Jersey again looked at the mechanism for determining the amount of the federal credit.  In this situation, a decedent had named a “P/O/D” (pay on death) amount directly to her children in excess of the $675,000 exemption threshold.  Accordingly, a New Jersey Estate Tax would be imposed to her estate even though she was survived by a spouse and could have opted for a marital deduction to limit the tax liability.  In Stevenson, the decedent had a Will which directed that the payment of all of her estate taxes (including the estate taxes on the P/O/D account) to be paid out of the residue of the estate, and the residue amount was scheduled to pass to her husband.  Because of the tax (approximately $40,000) due, the Court denied the estate a marital deduction over that portion of the property.  A marital deduction could not be granted over property (the tax being paid) that the husband could not receive.

Since the Will provided that the remaining assets would pass to a spouse, the Division argued that the marital deduction should be denied for amounts which the husband would not receive.  The Court agreed with the Division.  What is interesting about Stevenson for purposes of this analysis is that, not only was the marital deduction denied for the actual tax that was due and paid out of the residue passing to the husband, but also the marital deduction was denied for an amount of federal tax that would have been due had the decedent actually passed away in 2001.  In other words, the P/O/D bequest would have generated a federal estate tax and a New Jersey estate tax had death occurred in 2001. The Court found that the marital deduction was denied for each by taking an extremely narrow view of reality.  The Tax Court denied marital deduction not only on the tax paid, but on “phantom” tax which could have been paid.  Once again, this myopic view of the world placed the estate exactly in 2001 “as if” the law had not been changed and as if the actually decedent died December 31, 2001 following the statute literally.

When considering this situation, planners have questioned how to interpret the strict reading of these rules in light of subsequent legislative changes.  Should federal cases decided after 2001 be considered in determining the New Jersey Estate Tax?   Should federal or statutory or regulatory changes be considered?

It appeared that the State of New Jersey would seek to take positions only in their best interest.  For example, federal law during the decade was wrestling with difficult decisions about “minority” or “marketability” or “fractional interest” discounts.  Typically, discounts involved business interests that represented less than an entirety of a business unit.  If a parent gave a thirty percent (30%) in their family held corporation or limited liability company to a child, that value for transfer tax purposes is to be considered “fair market value” for purposes of the tax.  Fair market value could be defined to include these aforementioned “discounts” because it is clear that a unrelated third party would not pay thirty percent (30%) of the whole, for such an interest.  Moreover, since 1993 (Revenue Ruling 93-12), the IRS had admitted that the use of fractional interest discounts in inter-family planning was appropriate, notwithstanding the possibility that the family continued to maintain control over the entity.

When New Jersey adopted regulations under the New Jersey Estate Tax, it took the position that discounts would be limited to ten percent (10%).  See N.J.A.C. 18:26-3A.2(b).  As luck would have it, the regulation contains a very limited approach merely to “partnerships” and not to Limited Liability Companies (taxed as partnerships) or corporations, two common situations in practice.  Accordingly, the opportunity to challenge the regulation did not frequently present itself for taxpayers willing to embark on a challenge.   However, the State evidenced a willingness to ignore the uncertainty of the federal law as it existed in 2001 in order to take a position that would benefit the Division.

 

THE DECISION

After finding that the factual circumstances set forth a circumstance where summary judgment could be maintained, the Court began its analysis.  In sum, the opinion works its way through argument after argument made by the taxpayer consistently finding in favor of the Division.  The Court acknowledged that a legally recognized marital relationship would permit a marital deduction for federal purposes.  In other words, federal Revenue Rulings 58-66 and 76-155 allowed that marital status of individuals it to be determined under state law.  Moreover, in the uniform application of the tax laws, comity is granted to state marriages to allow uniform nationwide rule. The Court even cited to the recent ruling in 2013 that the IRS will allow a same sex marriage to be recognized nationally based on the “place of the ceremony” and not the “place of residence”. See Revenue Ruling 2013-17.   Thus, the fact that the marriage was “entered” in Pennsylvania would not prohibit treatment as a spouse and a marital deduction.

However, the Court goes on to reject the argument that the State of New Jersey should be bound by the IRS determination of a marital relationship.  The Court “finds that in absence of a Courts finding or recognition of a common law marriage, Taxation is not foreclosed from recomputing the state death tax credit because it disagrees with the federally allowed marital deduction which was provided on the basis of an alleged common law marriage of a New Jersey resident decedent.”  27 N.J. Tax at 626.  Nevertheless, the Court rules that the marital deduction is to be denied thereby increasing the estate tax due to the estate. The Court finds that the fact that the legislative history calls the new legislation “decoupling” means that the tax is “no longer a pick-up tax and was imposed independently of the federal estate tax and of the federal credit for state death taxes.” 27 N. J. Tax at 619.

In the opinion, the Court provides an extensive discussion of the New Jersey state laws concerning “common law marriage”. It finds that the marital deduction can be denied by the Director because a “common law marriage” need not be recognized in New Jersey.  Next, the Court turns to the Forbes decision discussed above. While the Court finds that “premise does not apply after the 2002 Amendments” because the new law is “decoupled” hence not controlling, the opinion explains that the facts were sufficiently different.  The Court seems to opine that because the Forbes case was about an interest deduction and this case centered on marital deduction, it would not control.

The next section rejects the possibility that the “consistency” provisions (first espoused in a 2004 letter of the Division and later codified in NJAC 18:26-3A.8(d)) should mandate consistent application of the marital deduction. As indicated, the Division has forced taxpayers to take positions “consistent” with the positions taken on their federal returns.  The Court found that Taxation could not be “consistent” because a common law marriage is void in New Jersey, 27 N.J. Tax at 626 and “treated” in the Regulations does not mean “treated by the IRS.” 27 N.J. Tax at 624.

Finally, the last section of the opinion reconsiders the “common law marriage” and concludes that because the IRS determination did not “contain any analysis of Pennsylvania laws” on common law marriage and thus, “IRS’ determination is not binding on Taxation.” 27 N.J. Tax 629.

 

 

ANALYSIS AND OPINION OF THIS AUTHOR[2]

In the opinion of the author, the primary inquiry to application of the statute should be the statute.  N.J.S.A. 54:38-1 breaks down the application to people that pass away before 2002 and people that pass away after 2002.  In each case, the tax is the amount of the federal credit. Moreover, even if a resident taxpayer passes after 2001, the tax is as if he/she died IN 2001. Thus, the tax should be the same – exactly the same- because the statute says that people who die after 2001 are told to look to the 2001 tax computation. This is a relation back which, as the legislative history made painfully clear, was to prevent the loss of revenue. The term “decoupling” means that it is “decoupled” from the federal rule which would have caused state revenue to do down. It does NOT mean or imply that the legislature intended to raise MORE revenue or that it intended by using the terms to create a new law.

The Booth opinion finds that because the state has “decoupled” from the federal credit and, that the legislation is to be read “liberally,” that these circumstances provide for a different result.  I fail to understand how the result in Booth can produce a different tax than if an individual actually passed away in 2001.  Both the Forbes and Stevenson decisions ratify this result.

The effect of Booth is to apply the “new” New Jersey estate tax law as if the “plumbing” of the federal statute in effect on December 31, 2001, is to be incorporated going forward on some other basis.  However, because the statutory language refers back to December 31, 2001, there appears to be a missing element.  How can the Court disregard that aspect to the statutory scheme?  Moreover, the Court agrees that Stevenson stands for the proposition that the tax is to be imposed exactly as it was in 2001.  However, the Court finds that the statute “liberal” interpretation and the “decoupling” (albeit the term ‘decoupling’ from the federal regime) is a matter of legislative history and does not address the clear statutory terms.

Even if one ignores the statute, and Forbes and Stevenson, much of the opinion is based on New Jersey common law marriage rules. The granting of comity to non state marriages is a matter of common practice. Shouldn’t the focus be ‘is the Pennsylvania marriage valid’ not ‘does New Jersey accept common law marriage’?  If a taxpayer married in another state, does that by implication mean that they are not “married” for purposes of New Jersey law?  No, however, the Court seems to find that the prohibition on New Jersey common law marriages would have an impact on the applicability of the marital deduction.

For those married in Maryland or Nevada, should they remarry in New Jersey to make sure the marital deduction is allowed? Many states have different requirements for becoming married but once “married,” citizens are married everywhere. More troubling, suppose a person was in a same sex marriage, would the marital deduction be permitted.  In the opinion of the author, the entire common law marriage analysis in the opinion is misplaced.  The final section of the opinion gratuitously finds that the lack of “analysis” by the IRS on Pennsylvania common law marriage means that the Division is not bound. The relevance on this aspect of the opinion is unclear?  Had the IRS provided a legal opinion on Pennsylvania law (which it would never do), would that matter? Since the IRS does not often provide analysis for the result, can the Division disregard other findings?

In the Forbes and Stevenson analysis,the Court strains to reach its considerations. First, as to Forbes, there is no question that it was “good law” on December 31, 2001. If someone died December 31, 2001, their estate would be bound to its holding. The Court never addresses this disconnect. Moreover, adding that it is factually different further adds to confusion. In each case, the central question is the amount of the “credit”.  Whether the issues is the amount of the interest deduction to arrive at the tax base or the marital deduction makes no difference whatsoever. As to Stevenson, the opinion, at best, cites to the dicta about “decoupling” and “liberal construction” and completely misses the holding. The holding was that the tax was to be computed as if the decedent died December 31, 2001. If Ms. Booth had died December 31, 2001, a federal marital deduction would have been permitted, as the federal computation would be binding. The Booth analysis does not address this holding.

In the Booth opinion, the Court quotes Stevenson to the effect that the New Jersey tax is different than the federal tax, unconnected to the federal law and “[c]ontrary to plaintiff’s contentions, then, the New Jersey Legislature clearly indicated that the New Jersey Estate tax was no longer a pick up tax and was imposed independently of the federal estate tax and of the federal credit for state death taxes.” 23 N.J. Tax at 591. No one doubts that the two taxes are not interdependent because it is the federal law that has changed.

Tax lawyers have generally understood the New Jersey “consistency” rule to be that where a federal tax return is filed, the Division wanted a “consistent” election for State tax purposes.  The Court “does not read ‘treated’ in the regulation as ‘treated by the IRS.’” 27 N.J. Tax at 624. If a position is not consistent with the IRS, who is it supposed to be consistent with? The Court says that the regulation “cannot exceed state law” so does that mean that the oft- considered “consistency” rule does not apply any more? Is the Court saying that the consistency rule applies to taxpayers but not to the Division? The weak analysis provided by the opinion leaves more questions than answers.

The Division had also relied on a case, Schaevitz Trust v Director, Division of Taxation, 15 N. J. Tax 296 (1995) for the proposition that federal determinations are not binding on the Division. In Schaevitz Trust, the taxpayer had made clear errors in the computation of “tax basis” in a corporate merger and sale and the IRS missed the mistake. In that case, Court ruled that the Division was not bound to the erroneous “basis” because the income tax laws at issue are to be administered as “correctly applied” (citing to N.J.S.A. 54A:5-1(c ) ). If there was an erroneous position it should not be upheld. That is a different setting than here, were the IRS in Booth correctly accepted the settlement of bona fide claims against the estate.

 

CONCLUSION

In sum, the Booth decision stands for a position that the New Jersey Estate Tax is not a tax based upon federal law, but, in fact some alternate structure that incorporates the “plumbing” from prior law.  At the outset, we focus on the words “would have been allowable” or “would have been payable” under the Internal Revenue Code.  It appears that the Booth decision has opted to consider an amount allowable (e.g., not allowed or required, but allowable under the federal Internal Revenue Code) to arrive at a figure for the tax which is different from the amount that would have been dictated by the confines of the Internal Revenue Code in effect on December 31, 2001. While the tax was intended to be revenue “neutral” from prior 2001 law, the State and this opinion, now seem to have a tax that was, in fact, a tax increase.

 

[1] Effective April 1, 2014, New York enacted several changes to its estate and gift tax regime. For starters, the exemption is being increased from $1,000,000 to the amount of the federal exemption in years 2014 to 2019.  Like the current law, once the “exemption” threshold is surpassed the entire amount of the “State death tax credit” amount of the 2001 IRC Section 2011 credit is due in tax. Only estates with a value under the “exemption” are free from the tax. The 2014 NY law also made several other changes to the estate, gift and generation skipping tax rules.

 

[2] It should be noted that these are opinions in which others may feel differently.  Even in extensive discussions with other respected tax attorneys, opinions vary wildly.