[author: James L. Fritz]
On August 16, the Commonwealth Court upheld its perplexing January 2012 decisions that nonresident limited partners who lost their entire investments in a partnership owning Pennsylvania real estate, and who apparently had no tax benefit from their shares of the partnership’s operating losses over a period of years, could somehow be subject to substantial amounts of Pennsylvania Personal Income Tax on their shares of the partnership’s “gain” on forgiveness of indebtedness resulting from foreclosure on a non-recourse mortgage. Robert J. Marshall, Jr., et al. v. Commonwealth, No. 933 F.R. 2008; Thomas Shaker v. Commonwealth, No. 932 F.R. 2008; John K. Houssels, Jr. v. Commonwealth, No. 757 F.R. 2008; Ernest & Beverly Wirth v. Commonwealth, No. 424 F.R. 2008. [One of the January 2012 decisions is reported at Robert J. Marshall, Jr. v. Commonwealth, 413 A.2d 67 (Pa. Cmwlth. 2012).]
The underlying real estate was purchased by the partnership for $360 million, of which $308 million was financed with the non-recourse mortgage. Under the terms of the loan, interest was imposed at 14.55% and, if not paid, was deferred and compounded. At the time of foreclosure, the total owed was $2.6 billion - $308 million of principal and $2.32 billion of accrued interest. According to the lone dissenting opinion in these cases:
There is nothing in the record to suggest that the property was worth anywhere near $2.6 billion, or for that matter, that even the original purchase price could have been recovered.
We would have to fill more than one entire newsletter to walk readers through the court’s full analysis. Instead, we will simply note that these cases probably will be appealed to the Pennsylvania Supreme Court and point out a few of the issues of general concern which presumably will be further addressed by the Supreme Court.
First, the Commonwealth Court’s decision leaves in place a substantial disparity in treatment of the partnership’s nonresident investors as compared to the investors who resided in Pennsylvania, and this disparity seems to result from an apparent inconsistency between the court’s analysis of the Commonwealth’s constitutional ability to tax the nonresident investors and its ability to tax the nonresident investors’ particular gains and losses.
Analytically, the partners here had two taxable events. One was their proportionate share of the deemed gain on forgiveness of indebtedness resulting from the foreclosure. A second was each partner’s loss on liquidation of the partnership, which here occurred in the same tax year as the foreclosure.
The Pennsylvania resident partners were permitted to offset the gain on foreclosure with the loss on liquidation. However, the nonresident partners were not permitted to recognize the loss on liquidation for Pennsylvania tax purposes. The court’s explanation for this was that intangible assets, such as a limited partnership interest, are deemed to reside where the holder is domiciled, with the result that any gain or loss respecting the disposition of a limited partnership interest owned by a nonresident is not sourced to Pennsylvania. The disparity, therefore, in the eyes of the court, resulted from constitutional limitations on Pennsylvania’s ability to impose extra-territorial taxation.
This, however, seems to clash directly with the court’s conclusion that the nonresident investors in these cases could constitutionally be subjected to tax on the partnership’s income precisely because they held the limited partnership interests. The court held that Due Process was not violated in treating the nonresident taxpayers as being taxable in Pennsylvania because they had intentionally invested in a partnership whose only investment was Pennsylvania real estate. While the court certainly cited to relevant precedent in reaching its disparate conclusions, one would think that our country’s founders might cringe if they knew their founding principles had been applied in such manner as to justify a state’s imposition of hundreds of thousands of dollars of income tax on nonresident investors while allowing other investors to escape such tax where the only factual distinction is that they were residents of the state. The result in this case seems to turn the principles underlying the United States Constitution on their head.
A second issue which hopefully will be addressed by the Pennsylvania Supreme Court is the fundamental question of what constitutes “income” for Pennsylvania Personal Income Tax purposes. In these cases, the taxpayers lost their investments.
Inasmuch as the indebtedness eliminated in foreclosure was nonrecourse, the investors really received no benefit from the forgiveness. They had no obligation to pay the debt to begin with and they received no distribution in cash or otherwise as a result of the foreclosure. Furthermore, the partnership itself never made a profit on operations and lost its only significant asset in foreclosure. The bank which made the loan to the partnership assumed virtually the entire risk that it would never collect what it was owed. The bank relied entirely on the value of the real estate and, although the record before the court does not seem to clearly address the issue, it would appear that the real estate was not worth anything near the value which the bank allowed to accrue before it foreclosed.
In common sense terms, how can an investor be subject to “income” tax when he or she lost their entire investment and received no other benefit as a result of their investment? Could the Legislature ever have intended to impose tax in this circumstance? As noted by the dissent in these cases, there is prior precedent suggesting an approach more focused on economic realities. It will be interesting to see whether the Pennsylvania Supreme Court, which in many past tax cases has rejected “technical” arguments by taxpayers, will follow the technical approach taken by the Commonwealth Court majority or will look for a “substance over form” approach which reaches for a more common sense result.
The third issue we wish to highlight is the “tax benefit rule.” The Commonwealth Court has ruled that the taxpayers in these cases are not entitled to relief under this rule. The writer of this article has found the guidance provided by the Department of Revenue respecting the scope and application of this rule in the Pennsylvania context to be confusing. The Commonwealth Court’s ruling in these cases does little to clarify the confusion - if anything, the court’s application of the rule adds to the complexity.
In very general terms, it seems to the writer of this article that the tax benefit rule is a rule which addresses inequities resulting from artificial constructs utilized in computing tax on the annual basis. For example, a taxpayer may take a depreciation deduction for an asset which has not depreciated at all in value. In other cases, there may be some diminution in value but the depreciation deduction may be more than that amount. When an asset is sold, it may generate a “profit” solely because its basis was reduced by depreciation for tax purposes - not because the asset has sold for more than the taxpayer paid for it. If the taxpayer realized some “benefit” from the depreciation deduction he or she took (e.g., offsetting other income), then it seems fair to tax the artificial gain on the sale of the asset which was depreciated for tax purposes. However, if the taxpayer received no benefit from the depreciation deductions and the asset is sold for less than was paid for it, common sense suggests there is no actual gain which should be taxed.
In these cases, if the taxpayers had benefitted from partnership losses recorded on an accrual basis, then they should, perhaps, have been taxed on the “gain” experienced when the partnership’s sole asset was foreclosed. However, the cases here suggest that the taxpayers realized no “benefit” from the interest and other deductions generated by the partnership. Furthermore, at the partnership level, only a small fraction of interest deductions actually offset operating receipts. Inasmuch as they lost their investments and otherwise actually realized no real gain on the foreclosure, why would the taxpayers be taxed on their partnership’s relief from paying the accrued interest? Shouldn’t the courts apply some sort of “tax benefit rule” here to reach a more logical result?
The Commonwealth Court actually rejected eleven distinct objections (“exceptions”) lodged by the taxpayers against the court’s original, January 2012 decision. Any reader desiring to review copies of the Commonwealth Court’s decisions in these cases may contact a member of the McNees SALT group. We look forward to reporting the Pennsylvania Supreme Court’s decision when it is rendered.