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N.J. Treatment of Closed Year Carryforwards ‘Up in the Air’ After R.O.P. Aviation

July 6, 2021, 8:00 AM

It has been a slow first half of the year for tax decisions from the New Jersey courts, but in May the Tax Court of New Jersey handed an aircraft leasing business a significant victory when it held that the New Jersey Division of Taxation is not permitted to make adjustments to NOL carryforwards from a closed tax year.

R.O.P. Aviation Inc. v. New Jersey Div. of Taxation, No. 001323-2018 (May 27, 2021) is an important case because it rejects federal rules that allow audit adjustments to NOLs from closed years. As a result, taxpayers currently under audit in New Jersey should consider whether they can make a statute of limitations argument to oppose audit adjustments relating to carryforward items on procedural grounds.

The facts described in R.O.P. Aviation are fairly commonplace in corporate tax audits, both at the federal and state level. The taxpayer was in the business of aircraft leasing to an affiliate. The taxpayer reported over $18 million in NOLs on its corporation business tax (CBT) returns for the years 2007 through 2011 (closed years). The taxpayer used the NOLs to offset its income on its 2014 CBT return.

The division failed to audit the closed years within the four-year statute of limitations that applies to CBT audits. On the audit of the taxpayer’s subsequent tax years 2012 through 2015, the division reduced the NOLs carried over from the closed years to zero on the basis that the closed years’ returns did not reflect arm’s-length transactions between the taxpayer and its affiliate lessee.

Under New Jersey Statutes Section 54:49-6(b), New Jersey’s statute of limitations for CBT assessments provides the general rule that “No assessment of additional tax shall be made after the expiration of more than four years from the date of the filing of a return.” Although conceding it could not issue an assessment with respect to the closed years, the division contended that a separate statutory provision, N.J. Stat. Section 54:10A-10, gave the division the authority “to make any other adjustments in any tax report or tax returns as may be necessary to make a fair and reasonable determination of the amount of tax payable.”

The Tax Court rejected the division’s reliance on its discretionary authority under N.J. Stat. Section 54:10A-10 in favor of a strict construction of the statute of limitations. The Tax Court found that adjusting the NOL carryforward from the closed years in the later open years was “an indirect additional assessment of tax” for the closed years. According to the Tax Court, the division could not do “indirectly, what the statute does not permit directly: bypassing the four-year statute of limitations.”

For tax practitioners familiar with federal procedural rules, the decision in R.O.P. Aviation comes as a surprise. With respect to IRS audit adjustments, federal courts have long held that a tax item from a closed tax year can be adjusted in an open tax year. See Barenholtz v. United States (“It is well settled that the IRS and the courts may recompute taxable income in a closed year in order to determine tax liability in an open year.”). However, the New Jersey Tax Court rejected the federal interpretation, noting that it was not bound by the IRS’s construction of a federal income tax statute for purposes of the CBT. The Court instead focused on reconciling two paragraphs in New Jersey’s statute:

The court finds that N.J.S.A. 54:49-6(a) and (b) must be read together. Subsection (a) requires Taxation to examine a filed return and provides it the ability to “audit or investigate” the filed return. If the audit is conducted, and a deficiency is determined, Taxation must assess the additional tax. However, although Subsection (b) separately requires that assessment of any additional tax shall be made within four years of the return’s filed date, it does not mean that the return’s audit/investigation can be made at any time, and outside the four-year period. The tax assessment flows from the audit made under Subsection (a), therefore, the audit and resultant tax assessment should be subject to the same four-year period.” (emphasis added).

While R.O.P. Aviation is good news for taxpayers in a similar position who will benefit from not being subject to audit on carryforward items from closed years, the decision leaves open the question of whether the same reasoning applies if the taxpayer seeks to increase a claimed carryforward. For example, if R.O.P. Aviation had made a counterclaim that it actually underreported its losses in the closed years, would the Tax Court’s reasoning apply to disallow a taxpayer favorable adjustment in the open years?

Instead of examining the statute of limitations on assessments, the statute of limitations on refunds might come into play. Under the logic of R.O.P. Aviation, it might be necessary to examine whether increasing a reported NOL from a closed year in order to generate a refund (or offset an assessment) in an open year results in “doing indirectly what the statute does not permit directly” by bypassing the four-year statute of limitations on CBT refunds.

Assuming the holding in R.O.P. Aviation survives any appeal, it could impact tax items other than the NOL carryforward because of broad language in the opinion referring to “other permitted carryforwards.” In rejecting the division’s arguments, the Tax Court explained that, if accepted, the division’s position “would render the existence of this statute of limitations illusory as to any item of carryforward (NOL or other permitted carryforwards) under the CBT Act.” (emphasis added).

Beyond carryforwards, the implications of the Tax Court’s reasoning could be as far-reaching as barring adjustments to historic positions reported on a return from a closed year. For example, will the division and taxpayers be prohibited from adjusting a misreported original cost basis of capital assets merely because it has been four years since the filing of the return on which the basis was first reported?

While R.O.P. Aviation should apply to other carryforward items under the CBT, it is unclear whether it would have an impact on the gross income tax (GIT) carryforward items of individuals, such as the alternative business calculation deduction. New Jersey statutes contain a separate, shorter statute of limitations for GIT assessments. N.J. Stat. Section 54A:9-4 provides “any tax under this act shall be assessed within 3 years after the return was filed (whether or not such return was filed on or after the date prescribed).”

Previously, the Tax Court has observed that the GIT statute of limitations and the federal statute of limitations on IRS assessments in federal tax code Section 6501 are “virtually identical” and for purposes of the GIT, the Tax Court has adopted federal interpretations of the statute of limitations after being “persuaded by the sound reasoning and interpretations provided under federal case law.” DiStefano v. New Jersey Div. of Taxation (holding that the limitations period for GIT deficiency notices begins to run from the date of the original tax return and not from the date of the amended return).

The relevance and persuasive value of federal interpretations has always been up for debate in New Jersey tax law. For every tax decision that follows federal law it is possible to find one that rejects federal interpretations, as in the case of R.O.P. Aviation and DiStefano. But ultimately these two cases may be viewed as not in conflict because they involved two different tax regimes and interpretations of distinct statutes that are worded and structured differently. In addition, both decisions were grounded in the principle that the statute of limitations on tax assessments must be strictly construed, which resulted in the disallowance of adjustments that were deemed to occur after the close of the statute of limitations.

While New Jersey has a reputation for aggressive audit positions, R.O.P. Aviation is a good reminder that in New Jersey the statute of limitations on assessments is inflexible, and the courts will uphold its purpose to provide finality in the assessment process. On the flipside, that principle can also work to the taxpayer’s disadvantage when applied to the statute of limitations on refunds.

Thus, for some taxpayers R.O.P. Aviation will be a welcome decision, because it creates a procedural argument that will block an unfavorable audit adjustment to a carryforward item. But for those taxpayers who have a potential favorable adjustment to a loss carryforward from an old year, it will be important to examine whether any additional steps need to be taken to preserve the refund in light of R.O.P. Aviation’s rejection of the federal treatment of carryforwards from closed years.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Chris Doyle is leader of Hodgson Russ LLP’s State & Local Tax Practice. His practice spans most tax matters, but focuses primarily on New York State and New York City taxes.
Open Weaver Banks is located in Hodgson Russ LLP’s Hackensack, N.J., office and focuses on New Jersey, New York State, and New York City taxes.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.