In June 17, 2014, in Wirth v. Commonwealth, 82-85 MAP 2012, the Pennsylvania Supreme Court (the “Court”) affirmed the Commonwealth Court’s holding that nonresident limited partners were liable for Pennsylvania Personal Income Tax (“PIT”) on the amount of their pro rata share of total nonrecourse debt discharged as a result of a foreclosure.

FACTS

In 1985, a Connecticut partnership was formed for the sole purpose of purchasing and managing an office tower at 600 Grant Street in Pittsburgh, commonly known as the U.S. Steel Building (the “Property”).  Of the 735 limited partners, only 25 were Pennsylvania residents.  The limited partners were passive and did not take part in the management of the Property.

The Property was purchased for $360 million, consisting of $52 million in cash with the remaining $308 million covered by a nonrecourse purchase money note.  The note provided for monthly payments at 14.55% interest; however, the note provided that if the monthly interest amount exceeded the partnership’s net operating income from the Property, the excess need not be paid and would defer and compound on an annual basis.  In fact, the Property incurred net operating losses for every year of its existence.  Accordingly, the partnership allocated those losses to the limited partners, including the appellants in this case.  Because the appellants were nonresidents and had no other Pennsylvania source income, no PIT returns were filed.

On June 30, 2005, in light of maturity of the note, the debt that had accrued, and the partnership’s inability to sell the Property, the lender foreclosed.  At the time of foreclosure, interest had deferred and compounded to a total of $2.32 billion, making the total amount outstanding on the note more than $2.6 billion.  As a result of the foreclosure, the partnership liquidated.  The partnership reported a gain of over $2.6 billion, the amount outstanding on the note.  None of the limited partners received any proceeds from the Property’s foreclosure and all lost their entire investment in the partnership.  Recall that the original investment was only $52 million in cash and a $308 million note.

Revenue Department Issues Assessments

As a result of the partnership reporting a $2.6 billion gain, the Department of Revenue (the “Department”) assessed PIT against each of the limited partners in the amount of their distributive share of the “gain” associated with the foreclosure.  The appellants, all nonresidents, appealed their assessments.  The Board of Appeals, the Board of Finance and Revenue, and the Commonwealth Court all sustained the assessments.  This appeal to the Supreme Court followed.

Pennsylvania Supreme Court Analysis

Due Process and Commerce Clause Challenges
The appellants argued that the assessments violated the Due Process and Commerce Clauses of the United States Constitution.  The Court quickly rejected those arguments.  First, with respect to the Commerce Clause challenge, the Court agreed with the Commonwealth Court’s conclusion that the appellants had waived that claim because the appellant’s briefing at the Commonwealth Court did not contain a discussion of the Commerce Clause argument and was not developed in a meaningful fashion.

With respect to the Due Process Clause issue, the Court held that the appellants had the necessary “minimum contacts” with Pennsylvania in order to satisfy the Due Process analysis.  The Court noted that the partnership was to own, operate and gain income from an office tower located within Pennsylvania.  Thus, the “minimum contacts” threshold was met.

Nonrecourse Debt Foreclosure
The appellants argued that the assessment was improper because pursuant to 61 Pa. Code § 103.13, the foreclosure on the Property never resulted in the Property being converted “into cash or other property.”  The Court rejected that argument by relying on the United States Supreme Court case of Commissioner of Internal Revenue v. Tufts, 461 U.S. 300 (1983), which held that the gain for tax purposes in the event of a foreclosure of property secured by a nonrecourse loan is the full amount of the nonrecourse obligation.  The Court relied on Tufts despite the language in § 103.13 which contemplated the disposition of property being converted “into cash or other property.”  Instead, the Court focused on the language in the statute, which provides that tax will be applied to income “derived from the sale, exchange or other disposition of property…”  72 P.S. § 7303(a)(3).  The Court agreed with the Department that the regulation simply includes conversion “into cash or other property” in the amount to be treated as income.  The Court concluded by holding that the foreclosure of the Property “cannot be described as anything other than the ‘disposition of real property’ ...” subject to PIT.

The appellants also argued that the assessment was improper because they lost their entire investment in the Property, and therefore were being assessed PIT on income they never received.  The Court rejected this argument by holding that the reasoning in Tufts controlled the situation and that the “gain” was from the discharge of indebtedness.

Calculation of Income Realized
In its analysis of the amount of income that should be taxed, the Court discussed the Tax Benefit Rule, a creature of federal common law that is now codified.  Generally, the Tax Benefit Rule deals with a situation where a taxpayer takes a deduction of some sort for a loss in one year, only to have the amount previously deducted recovered in a following tax year.  Normally, a taxpayer would include the amount of recovery in taxable income in the year it occurred.  The Tax Benefit Rule, however, provides that a taxpayer need not include the recovery if the previous deduction did not reduce the amount of tax in the year the deduction was taken.  With respect to the accrued interest, the appellants argued that the Department used the inclusionary part of the Tax Benefit Rule without also using the exclusionary part.  The Court rejected this argument by noting that the appellants never took an interest deduction because they never filed a return, therefore the Tax Benefit Rule did not apply.

Finally, while noting that the issue of whether to include accrued interest into the amount of gain was one of first impression, the Court concluded that the reasoning in Tufts also applied to accrued interest as it was nothing more than an increase in the amount of the nonrecourse note.

Availability of a Reduction of Income Realized
The Appellants argued that the Commonwealth Court erred when it denied them the ability to take a deduction based upon the net operating losses, holding that the income from gain constituted income from the disposition of real property, while the net operating losses of the Partnership represented a business expense.  Because the character of the disposition of real property is different from that of a business expense, under Pennsylvania law, one could not be used to offset the other.  The appellants argued that both the gain and the investment loss should be viewed as a single economic transaction and therefore, a deduction should be permitted against the gain.

The Court noted that the Department disagreed with the Commonwealth Court’s suggestion that the disposition of the Property and the investment loss are different categories of income.  Rather, the Department took the view that a partnership interest is an intangible asset that should be “localized at the owner’s domicile for purposes of taxation.”
The Court agreed and held that the appellants could not use their intangible losses to offset the Tufts nonrecourse debt forgiveness gain.

Disparate Treatment of Nonresidents
The appellants argued that by not allowing them to deduct their losses in the partnership from the Tufts gain, they were being treated differently than Pennsylvania residents.  The Court held that the limited partners were all treated the same, and that the inability of the appellants to deduct their investment losses from the disposition of the Property did not preclude them from using other deductions based on some other Pennsylvania-sourced loss that properly fell within that category of income.  Further, the Court noted that Pennsylvania could not have taxed any gain the appellants might have had on their investment; therefore, the appellants would not be permitted to use investment losses as an offset against the Tufts income.

The Court’s Conclusion
The Court noted that it was “not without empathy for Appellants who find themselves with significant financial burdens because of the loss of their investments, the liquidation of the Partnership, and the foreclosure of the Property.”  Still, the Court held that the Department’s actions were proper and remanded the case back to the Board of Finance and Revenue to calculate the basis in the property and the amount of tax to be assessed.