TRENTON, NJ. In 2004, CFO Magazine1 ranked New Jersey as having “the most unfair and unpredictable tax environment.” It was also ranked among the five most aggressive or least fair states in seven of eight categories.
Consider General Engines Company, Inc. General Engines sells trailers and trailer parts and is headquartered in Florida. It has only a small parts office in New Jersey. It earns less than $200,000 of profits a year in New Jersey. Nonetheless, New Jersey has assessed income tax of $100,000—effectively over 50%—on those profits. That’s just tax—not penalties or interest.
General Engines is suing the Director of the Division of Taxation in New Jersey to challenge this tax on constitutional and other grounds. General Engines is represented by one of largest law firms in the country to fight this tax, Reed Smith LLP. General Engines joins other taxpayers, such as Pfizer and Nordstrom, in this challenge. Although those taxpayers are affected by the challenged tax, they are not suffering quite like General Engines. Pfizer, for example, has nowhere near a 50% effective tax rate on its New Jersey profits.
What is the challenged tax? It’s called “throwout.” Throwout was enacted in 2002 as a “loophole” closer, but since then New Jersey’s taxing authority, the Division of Taxation, has aggressively interpreted the statute. General Engines is an extreme example of this. General Engines doesn’t engage in tax planning and conducts only a small amount of business in New Jersey. But as a result of throwout, General Engines’ effective tax rate in New Jersey is 55%. Before throwout, General Engines effective tax rate in New Jersey was only 9%, which is the rate provided by law.
Historically, New Jersey had a reputation for fair tax administration and for actively courting business. This changed in 2002 with the passage of the Business Tax Reform Act, which implemented a number of new business tax increases, including the throwout rule. Since 2002, New Jersey has been at the bottom of state business tax surveys, such as the CFO survey mentioned above. Also, the Tax Foundation, a nonpartisan educational organization, has ranked New Jersey’s state business tax climate as one of the worst in the country in its annual index (available at http://www.taxfoundation.org/files/bp52.pdf).
The throwout rule, which General Engines is challenging through its appeal, is one of the reasons that New Jersey fares so poorly in business tax rankings. (New Jersey is the only state besides West Virginia with a throwout rule.) Throwout involves how a corporate taxpayer’s income is assigned to New Jersey for purposes of computing the New Jersey tax due on that income. A corporate taxpayer’s income is assigned to New Jersey, in large part, based on the ratio of the taxpayer’s sales in New Jersey to total sales everywhere. The higher this ratio, the more New Jersey tax due. Under throwout, if a taxpayer makes sales into a state where it has no operations, those sales are ignored (or “thrown out”) when computing this ratio—thereby increasing the New Jersey tax. Throwout was designed by the legislature to ensure than a taxpayer’s income was taxable in the states where it actually has operations. The Division’s interpretation of the statute, however, goes much further than this objective.
The vast majority of General Engines’ activities are conducted outside New Jersey. Only 8% of its sales are to New Jersey customers and its only New Jersey location is a small warehouse with 6 employees and less than $150,000 in inventory. But under the Division’s interpretation of throwout, General Engines’ is taxed as if it made 100% of its sales to New Jersey simply because the other states where General Engines conducts operations have chosen not to impose an income tax or because federal law prohibits those states from doing so. In its appeal, General Engines asserts that the Division’s application of throwout violates protections afforded by the U.S. Constitution.
General Engines’ appeal may have far reaching effects for other New Jersey taxpayers. Any company that pays more New Jersey tax because of throwout could benefit from this litigation. Companies that are hit particularly hard by throwout are those that sell goods through sales representatives, license trademarks or patents, or conduct lending or credit card activities. General Engines is being represented in this appeal by Kyle Sollie and David Gutowski of Reed Smitht LLP.
About General Engines.
Since 1946, General Engines has been manufacturing the highest quality construction equipment trailers, which are sold under the name Eager Beaver Trailers®. The company’s approach to transportation safety has made Eager Beaver Trailers® a leader in product development and dealer support nationwide. Eager Beaver Trailers® is headquartered in Lake Wales, Florida and has a network of over 300 dealerships throughout the United States, Canada, Mexico, and Latin America. More information is available at www.eagerbeavertrailers.com.