The New Jersey Division of Taxation was just dealt a severe judicial setback in its ability to impose tax on passive corporate limited partners whose only connection to the state was an investment in a limited partnership doing business in the state.

The case, BIS LP, Inc. v. Division of Taxation, N.J. Superior Court, Appellate Division, Docket No. A-1172-09T2 (Aug. 23, 2011) involved a taxpayer (the Limited Partner) holding company whose only investment was a 99 percent limited partnership interest in a limited partnership, BISYS Information Solutions, LP (the LP). Outside of its investment, the Limited Partner had no other connection to New Jersey.

The Limited Partner was a foreign corporation with no place of business, property, employees, agents, or representatives in New Jersey. Its only asset was its investment in the LP, which did business in New Jersey. Both the Limited Partner and the LP were a part of a larger group of commonly controlled entities owned by the BISYS Group, Inc. (Group). Group owned BISYS, Inc. (BISYS), which in turn owned the Limited Partner.

The LP was formed when BISYS transferred 99 percent of the assets and liabilities of its banking information solutions division to the LP and 1 percent to the Limited Partnership. The LP, in turn, contributed these assets and liabilities to the Limited Partnership in exchange for its 99 percent limited partnership interest. There is a formal limited partnership agreement between BISYS, the 1 percent general partner in the limited partnership, and the LP, the 99 percent limited partner. The limited partnership agreement generally conferred management rights of the partnership on the general partner, and limited the LP’s role in the operations of the Limited Partnership.

The Limited Partner elected to be taxed as an investment company pursuant to the statute, which limited its tax liability by 40 percent of entire net income and 40 percent of entire net worth. The Director of the Division of Taxation (the Director) disallowed the election. The Limited Partner also alleged that it did not have constitutional nexus with New Jersey. The Director rejected this position, claiming that it had a unitary relationship with the business conducted by the LP in New Jersey.

The Tax Court decided in favor of the Limited Partner in holding that it did not have nexus with New Jersey. The Court of Appeals took a de novo review of the Tax Court’s decision.

On appeal, the Director argued that the entire transaction that created the LP was "devised to export taxable income" from New Jersey. The Director noted that none of the contemporaneous business purpose documentation for the formation of the LP indicated that tax minimization or tax avoidance was a purpose of the transaction. In fact, in a counter-statement of material facts, the Director listed the business purposes behind the transaction and those business purposes did not include any mention of tax. The Court of Appeals, then, justifiably dismissed the Director’s claim that tax avoidance and a desire to export taxable income from New Jersey were the chief motivations behind the transaction.

The Director also argued that the Tax Court ignored the evidence that the Limited Partner, the LP, and BISYS were unitary, despite the fact that the decision explicitly determined that the businesses were not unitary. The Director claimed that the judge failed to consider the fact that the partnership agreement reserved certain decisions to the Limited Partner, and that both partners had to consent to admit additional partners, merge, or consolidate the partnership with another entity. Each partner also had a right of first refusal with respect to the sale of the other’s partnership interest. The Court of Appeals summarily dismissed these claims, noting that they were irrelevant as to whether the businesses were unitary.

The Director further claimed that the Limited Partnership and the LP had the same operating location in New Jersey, although this was unsupported by the record, and the Director admitted as much when it agreed with the LP’s statement of undisputed material facts that the LP did not have a place of business in New Jersey. The Court of Appeals dismissed the Director’s reliance on the existence of a "c/o" address for the LP in New Jersey.

The Director next tried to argue that overlapping corporate officers between the Limited Partner and BISYS meant that the businesses were unitary. The Court of Appeals was able to point to several cases that refuted this argument.

With regard to nexus, the Director relied on statutory language that equated nexus with the "privilege of deriving receipts from" New Jersey. The statute also contained language that stated that any activity that was sufficient to subject a corporation to tax under the Constitution would give rise to nexus. The Director claimed that the legislative intent behind these statutory changes, which took place in 2002, was to apply corporate income tax in all circumstances permitted by the Constitution.

The Court of Appeals reviewed the legislative history, to no avail. It reviewed the Tax Court’s decision and found that it addressed sufficiently whether the LP had nexus with New Jersey, and despite the legislative change, the Court of Appeals found that the constitutional limitations still apply. The Court of Appeals also considered and rejected a regulation-based argument that the LP and Limited Partner were unitary in light of this nexus argument. The Director also argued that the Supreme Court’s holding in MeadWestvaco v. Illinois Department of Revenue, 553 U.S. 16 (2008) permitted the taxation of the Limited Partner. The Court of Appeals dismissed this argument, noting that MeadWestvaco merely laid out the constitutional parameters involved in imposing a tax on a unitary business.

The Director also relied on Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992) for the idea that the unitary principle allows the taxation of the Limited Partner. Again, the Court of Appeals disagreed because the three Allied Signal hallmarks of a unitary business – functional integration, centralized management, and economies of scale – were not present. It noted that there was no functional integration because the Limited Partner was a holding company, which is an entirely different business than the technological business of the LP. The Director also argued that the flow of value from the LP to the Limited Partnership gave rise to New Jersey-sourced business receipts for the LP, and that the sole purpose of the LP was tax avoidance. The Court of Appeals dismissed this last-ditch argument, again noting that the contemporaneously documented business purpose made no note of any tax avoidance or minimization motive.

Pepper Perspective

The issue as to whether a limited partner has nexus by virtue of its investment in a limited partnership strikes right at a critical issue in partnership theory. Is a partnership an entity unto itself, or is it merely the aggregate of its partners? This decision clearly sides with the entity approach. States themselves have taken the entity approach when it is convenient for them – for example, in requiring partnerships (or single-member limited liability companies) to register for sales taxes. It will be interesting to see if the decision is appealed, and if it holds up under appeal. Should the decision be sustained, it will likely be another driver for states to move toward a forced consolidation or unitary approach in an effort to capture income of limited partners.