Nexus expansion continues to be a hot topic in state and location taxation. States have become increasingly aggressive in subjecting entities without a physical presence to taxation, often by asserting that the out-of-state company has “economic nexus” with the state. In a recent decision, the New Jersey Tax Court has reinvigorated a nexus ghost from tax years past, seemingly looking to the unitary business principle (or at least the hallmarks of a unitary business) to conclude that a corporate limited partner was subject to tax in New Jersey by virtue of its interest in a partnership that was doing business in the state. Preserve II, Inc. v. Director, Div. of Taxation, Docket No. 010920-2013 (N.J. Tax Ct. Oct. 4, 2017).
The petitioner in this case, Preserve II, Inc. (“Preserve”) was a Michigan corporation and a 99% limited partner in two Michigan partnerships, Pulte Homes of NJ, L.P. (“Pulte NJ”) and Pulte Communities of NJ, L.P. (“Pulte Communities NJ,” collectively with Pulte NJ, the “Pulte Partnerships”). The Pulte Partnerships were in the business of developing, building, and selling residential homes in New Jersey. Preserve and the general partners in the Pulte Partnerships, Preserve I, Inc. and Pulte Home Corporation of the Delaware Valley, shared a common owner, Pulte Home Corporation, and all of the entities—Preserve, the Pulte Partnerships, and the general partners—were indirectly owned by the same corporate parent, Pulte Group, Inc.
Initially and on its original filed returns for 2005 through 2007, Preserve did not dispute that it had nexus in New Jersey and filed Corporation Business Tax (“CBT”) returns as an investment company, which allowed it to pay CBT on a reduced portion (40%) of its income. After the original returns were filed, however, the New Jersey Tax Court held in BIS LP, Inc. v. Director, Div. of Taxation, 25 N.J. Tax 88 (N.J. Tax Ct. Jul. 30, 1999), aff’d, 26 N.J. Tax 489 (Super. Ct. App. Div. 2011), that an out-of-state limited partner did not have nexus in New Jersey for CBT purposes when its only contact with the state was its interest in a New Jersey partnership. While the appeal in BIS was pending, Preserve argued during an audit that it, like the limited partner in BIS, lacked nexus with New Jersey and requested a refund. Although BIS was ultimately affirmed by the Superior Court, Appellate Division, the Division determined that Preserve had nexus in New Jersey and also that it was not entitled to file as an investment company, issuing a CBT assessment. Notably, in making its nexus determination the Division relied on the fact that Preserve had a “unitary relationship with the two partnerships due to commonality of officers and shared banking facilities.”
Before the Tax Court, Preserve argued that, because it was a limited partner in the Pulte Partnerships, and was not otherwise doing business in New Jersey, it could not be subject to the CBT, consistent with the holding in BIS. The Tax Court disagreed, beginning its analysis by noting that the “doing business” definition within the CBT statutes did not “distinguish or immunize New Jersey sourced partnership income from the CBT on grounds the recipient was a foreign corporate limited partner.” Rather, the relationship between a corporate limited partner and the partnership doing business in the state will determine if the partner has nexus with New Jersey under the due process and commerce clauses of the U.S. Constitution. The Tax Court, following the analysis used in an earlier case, Village Super Market of PA, Inc. v. Director, Div. of Taxation, 27 N.J. Tax 394 (N.J. Tax Ct. 2013), agreed that a “passive investor in an unrelated business enterprise” would not have nexus with New Jersey. However, where the corporate limited partner actually manages and operates the partnership, the partner will be subject to the CBT.
Using this framework to make its nexus determination, the Tax Court rejected Preserve’s argument that the partnership agreements at issue “render[ed] it a mere limited partner with no role in the business conduct or operation of either partnership[.]” The court found that looking to the language of the partnership agreements, rather than the actual extent to which the partner participated in the management of the partnership’s business, would be to “elevate form over substance.” In examining all of the facts and circumstances of Preserve’s involvement in the Pulte Partnerships and the interdependence of the Pulte group as a whole (a key characteristic of a unitary business), the Tax Court found that the entire group functioned to serve one common purpose—i.e., the Pulte group’s “core business” of developing land, building and selling homes—and therefore it could not be said that Preserve was a mere passive investor in the partnerships that were doing business in New Jersey. The court also found that, unlike the taxpayer in BIS, Preserve had no separate business apart from the group’s core business. Finally, the Tax Court rejected Preserve’s alternative claim that it was entitled to be taxed as an investment partnership, noting that it “had no authority to make, sell, or diversify any investments.”
While the Tax Court did not directly conclude that the unitary business principle was a corollary for nexus, the Division did, and the Tax Court in upholding the Division’s assessment used many of the characteristics of a unitary business to conclude that Preserve had New Jersey nexus. “Unitary nexus” grabbed headlines several years ago when a Maryland appellate court directly employed the unitary business principle to establish nexus over an out-of-state company. Comptroller of Treasury v. Gore Enter. Holdings, Inc., 60 A3d 107 (Md. Ct. Special App. 2013). The Maryland Court of Appeals (the state’s highest court) later rightfully rejected the unitary nexus concept, stating that the unitary business principle “does not confer nexus to allow a state to directly tax a subsidiary based on the fact that the parent company is taxable and that the parent and subsidiary are unitary.” Comptroller of Treasury v. Gore Enter. Holdings, Inc., 87 A3d 1263, 1272 (Md. 2014). While it is clear that the unitary business principle is not itself jurisdictional, as the Tax Court seems to have noticed, some of the factors that determine whether two entities are engaged in a unitary business might also be relevant in determining whether the operations of one entity create nexus for the other. The Maryland Court of Appeals in Gore recognized this point as well, noting that “[a]lthough the unitary business principle and economic substance inquiry . . . are distinct inquiries with distinct purposes, there is no reason—based either in case law or logic—for holding that the factors that indicate a unitary business cannot also be relevant in determining whether subsidiaries have no real economic substance as separate business entities.” Gore, 87 A3d at 1277–1278. Here, the Tax Court focused heavily on the integration of the entities at issue and on the fact that they were all engaged in a common enterprise to conclude that Preserve had nexus in New Jersey. In light of these “unitary factors,” the Tax Court was ultimately unconvinced that Preserve was a mere passive investor that lacked a sufficient connection to New Jersey.
Unfortunately for taxpayers with partnership interests in New Jersey, BIS does not stand for the proposition that corporate limited partners are shielded from CBT liability merely by virtue of their status as limited partners. Rather, a fulsome analysis of the facts and circumstances surrounding the partner and the partnership (many of which are similar to those factors that would be reviewed as part of a unitary business analysis) may be necessary before reaching a nexus determination. After Preserve II, taxpayers should expect that if they do not engage in the necessary analysis beforehand, the Division is likely to do so on audit.
Nevertheless, mere passive investors in out-of-state partnerships engaged in business activities that are unrelated to the partner’s business should still feel secure—and should argue vehemently if challenged on audit—that they do not have nexus solely by virtue of their partnership investments. However, when the lines between the partner and the partnership begin to blur, the partner risks having its income subject to tax in the state where the partnership is conducting business, even if the partner is not conducting any business in the state itself.