Credit Where Credit Is Due
In Doherty v. Director, Div. of Taxation, the New Jersey Tax Court explained how to compute the resident tax credit. The taxpayers, New Jersey residents, were shareholders in an S corporation doing business in New Jersey and Pennsylvania. The shareholders were subject to tax in both states on the S corporation’s income. Pennsylvania taxed the shareholders, as nonresidents, only on the income earned in Pennsylvania. New Jersey taxed the shareholders, as residents, on all income of the S corporation. The shareholders claimed a credit against their New Jersey tax for all the tax paid to Pennsylvania on their S corporation income. The Division of Taxation, on audit, found the shareholders claimed too large a credit.
Under the Gross Income Tax (GIT) Act, a resident of New Jersey is taxed on all her income. The resident must pay New Jersey tax on income even if it is earned outside the state. For example, a New Jersey resident owns an interest in a partnership. The partnership does business in New Jersey and Pennsylvania. A portion of the partnership’s income is earned in each state. The partnership’s income flows through to its partners and is taxed to them individually. Pennsylvania will tax the New Jersey resident on the portion of the partnership’s income earned in Pennsylvania and attributable to her. New Jersey will tax its resident on her share of all the partnership’s income, including the portion earned in Pennsylvania. This results in the Pennsylvania income being taxed by both states.
Calculating the resident tax credit for tax paid has been a point of tension between taxpayers and the Division of Taxation. The tension results for various reasons including (i) states computing income differently, (ii) states using different rules for dividing income earned by a multistate business and (iii) states taxing income at different rates of tax.
In Doherty, Pennsylvania and New Jersey used different rules for allocating S corporation income. The apportionment formula used by Pennsylvania to divide taxable income between the states in which the S corporation did business attributed 81.7087% of the income to Pennsylvania and 18.2913% to New Jersey. Pennsylvania imposed its 3.07% flat tax rate on its determined share of income. The taxpayer paid tax to Pennsylvania and claimed credit for the entire tax paid to the Commonwealth.
The formula used by New Jersey determined that 69.5464% of the income was attributable to Pennsylvania and 30.4596% was attributable to New Jersey. New Jersey imposed tax on all the S corporation’s income. The taxpayers claimed a full credit for the tax paid to Pennsylvania. However, the Division of Taxation limited the credit for Pennsylvania tax to the income attributed to Pennsylvania using New Jersey’s formula, 69.5464%, rather than a full credit for the entire Pennsylvania tax actually paid by the taxpayer on the 81.7087% of S corporation income taxed by Pennsylvania.
Because Pennsylvania’s tax rate was about one-third the taxpayers’ effective New Jersey rate, Pennsylvania’s tax on the larger share of income claimed under its apportionment formula was less than the New Jersey tax on the smaller share of Pennsylvania income claimed under New Jersey’s apportionment formula.
Nonetheless, the Court held that the taxpayers could only claim a credit for Pennsylvania tax paid on the portion of income attributable to Pennsylvania using New Jersey’s rules for dividing multistate income, 69.5464%. Credit could not be claimed for Pennsylvania tax paid on the 12.1623% of the S corporation’s income claimed by both states under their differing apportionment provisions. The New Jersey Tax Court observed that the taxpayers’ real quarrel is not with New Jersey for not allowing the credit, but rather with Pennsylvania for allocating too much of the income to Pennsylvania.