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Wirth v. Commonwealth

Supreme Court of Pennsylvania

June 17, 2014

ERNEST & BEVERLY WIRTH, Appellants
v.
COMMONWEALTH OF PENNSYLVANIA, Appellee; JOHN K. HOUSSELS, JR., Appellant
v.
COMMONWEALTH OF PENNSYLVANIA, Appellee; THOMAS SHAKER, Appellant
v.
COMMONWEALTH OF PENNSYLVANIA, Appellee; ROBERT J. MARSHALL, JR., Appellant
v.
COMMONWEALTH OF PENNSYLVANIA, Appellee

 Submitted August 19, 2013

Petition for certiorari filed at, 11/26/2014

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Appeal from the order of Commonwealth Court at No. 424 FR 2008 dated August 16, 2012 Overruling the exceptions to the January 3, 2012 order and Affirming in Part the PA Board of Finance and Revenue order dated April 25, 2008 at No. 0619432 and Vacating and Remanding the amount of tax to the Board for recalculation. Appeal from the order of Commonwealth Court at No. 757 FR 2008 dated August 16, 2012 Overruling the exceptions to the January 3, 2012 order and Affirming in Part the PA Board of Finance and Revenue order dated September 19, 2008 at No. 0712902 and Vacating and Remanding the amount of tax to the Board for recalculation. Appeal from the order of Commonwealth Court at No. 932 FR 2008 dated August 16, 2012 Overruling the exceptions to the January 3, 2012 order and Affirming in Part the PA Board of Finance and Revenue order dated December 19, 2008 at No. 0813407 and Vacating and Remanding the amount of tax to the Board for recalculation. Appeal from the order of Commonwealth Court at No. 933 FR 2008 dated August 16, 2012 Overruling the exceptions to the January 3, 2012 order and Affirming in Part the PA Board of Finance and Revenue order dated December 19, 2008 at No. 0811195 and Vacating and Remanding the amount of tax to the Board for recalculation. Intermediate Court Judges: Dan Pellegrini, President Judge; Bonnie Brigance Leadbetter, Judge; Robert E. Simpson, Judge; Mary Hannah, Judge; Kevin P. Brobson, Judge; Patricia A. McCullough, Judge; Anne E. Covey, Judge; Johnny J. Butler, Judge.

For Ernest & Beverly Wirth, APPELLANT: Christopher Andrew Jones, Esq., Wendi Lynn Kotzen, Esq., Ballard Spahr Andrews & Ingersoll, LLP.

For Commonwealth of Pennsylvania, APPELLEE: Kevin A. Moury, Esq., Claudia M. Tesoro, Esq., Carol L. Weitzel, Esq., PA Office of Attorney General.

For John K. Houssels, Jr., APPELLANT: Joseph C. Bright, Esq., Cheryl Ann Upham, Esq., Cozen O'Connor.

For Commonwealth of Pennsylvania, APPELLEE: Kevin A. Moury, Esq., Claudia M. Tesoro, Esq., Carol L. Weitzel, Esq., PA Office of Attorney General.

For Thomas Shaker, APPELLANT: Joseph C. Bright, Esq., Cheryl Ann Upham, Esq., Cozen O'Connor.

For Commonwealth of Pennsylvania, APPELLEE: Kevin A. Moury, Esq., Claudia M. Tesoro, Esq., Carol L. Weitzel, Esq., PA Office of Attorney General.

For Robert J. Marshall, Jr., APPELLANT: Joseph C. Bright, Esq., Cheryl Ann Upham, Esq., Cozen O'Connor.

For Commonwealth of Pennsylvania, APPELLEE: Kevin A. Moury, Esq., Claudia M. Tesoro, Esq., Carol L. Weitzel, Esq., PA Office of Attorney General.

BEFORE: MR. JUSTICE BAER. CASTILLE, C.J., SAYLOR, EAKIN, BAER, TODD, McCAFFERY, STEVENS, JJ. Mr. Justice Eakin, Madame Justice Todd and Mr. Justice McCaffery join the opinion. Mr. Chief Justice Castille files a concurring opinion in which Mr. Justice Stevens joins. Mr. Justice Saylor files a dissenting opinion.

OPINION

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MR. BAER, JUSTICE

In this direct appeal, we examine a decision by the Commonwealth Court, sitting en banc, which considered the application of Pennsylvania personal income tax (PIT) to various nonresidents, who invested as limited partners in a Connecticut limited partnership, which existed for the sole purpose of owning and operating a skyscraper in the City of Pittsburgh, which ultimately went into foreclosure in 2005. The Commonwealth Court held that the partnership was subject to PIT commensurate with the total debt discharged as a result of the foreclosure, and therefore the nonresident limited partners were liable for PIT in an amount proportionate with their shares in the partnership. In this case that presents several issues of first impression, for the reasons that follow, we affirm.

I. BACKGROUND

In late 1984-early 1985, the five Appellants in this case, a married couple (Ernest and Beverly Wirth) and three individuals (John Houssels, Jr., Thomas Shaker, and Robert Marshall, Jr.), all purchased various interests in a limited partnership known as 600 Grant Street Associates Limited Partnership (Partnership). Appellants' interests in the Partnership ranged from one-quarter of a unit to one unit.[1] All Appellants were non-Pennsylvania residents. The sole purpose of the Partnership, which was organized pursuant to Connecticut law, was the purchase and management of the property located at 600 Grant Street in the downtown section of the City of Pittsburgh, commonly known as the U.S. Steel Building (the Property). In all, 735 limited partners, only 25 of whom were Pennsylvania residents, comprised the Partnership. All of the limited partners were passive investors; none took an active role in managing the Property.

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Investment in the Partnership began when the general partner made a comprehensive " Offering Memorandum" available to potential investors. The memorandum stated that while the Partnership would likely incur economic and tax losses for the first several years of its existence, due to expected growth in the Pittsburgh commercial real estate market, eventually the limited partners would be allocated a substantial gain upon the anticipated sale of the Property. The memorandum further specified that each investor could be subject to negative tax consequences, both under federal and Pennsylvania tax laws. The memorandum also indicated that these tax consequences would be determined primarily based on the financial liquidity of the Property when the mortgage on the Property matured.

With the Partnership in place, it proceeded to purchase the Property in 1985 for $360 million. Of that, $52 million was paid in cash, and the Partnership pledged the Property as collateral to secure a nonrecourse Purchase Money Mortgage Note (PMM Note), with an initial principal balance of the remaining $308 million.[2] Interest on the PMM Note was payable on a monthly basis, at a rate of 14.55% per annum. The PMM Note contained an important caveat, however: should the monthly interest amount exceed the Partnership's net operating income from the Property, the excess did not have to be paid, and instead would defer and compound on an annual basis, subject to the same 14.55% rate. The PMM Note originally delineated the maturity date as November 1, 2001; the parties subsequently extended that date to January 2, 2005.

As the years progressed, the Partnership's net income from operations did not meet the projections of the general partner. Indeed, it incurred net operating losses for accounting, federal tax, and PIT purposes in every year of its existence. Relevant to this case, for PIT purposes, the Partnership allocated those losses to Appellants (and all of the other limited partners) and, because Appellants had no Pennsylvania-based income for 1985-2004, they did not file Pennsylvania PIT returns for those years. Moreover, because the net operating income was less than the monthly interest on the PMM Note, the Partnership did not pay the interest and therefore deferred it as noted above. By June 30, 2005, the compounded, accrued interest totaled $2.32 billion, thus making the total liability on the PMM Note more than $2.6 billion.[3]

When the PMM Note matured on January 2, 2005, given the insurmountable debt that had accrued, the Partnership was unable to sell the Property. Accordingly, on June 30, 2005, the lender foreclosed, and, because the Partnership no longer owned the Property (which was the sole reason for the Partnership's existence), the Partnership soon after liquidated. None of the limited partners, including Appellants, received any proceeds from the Property's foreclosure or the Partnership's liquidation, and therefore lost their entire investments in the Partnership.

Following the Property's foreclosure, but prior to the Partnership's liquidation, the Partnership reported a gain as a result of the foreclosure on its federal

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and state tax filings that consisted of the unpaid balance of the PMM Note's principal and the accrued, compounded interest, totaling $2,628,491,551. Accord Commissioner v. Tufts, 461 U.S. 300, 103 S.Ct. 1826, 75 L.Ed.2d 863 (1983) (holding, as will be explained in greater detail, infra Part III(A), that foreclosures on nonrecourse mortgage notes constitute the disposition of property and therefore result in the realization of income or gain for federal tax purposes equal to the amount of the discharged debt). Concomitantly, the Partnership reported each individual limited partner's respective share of that gain. Therefore, and despite their individual investment losses, the Pennsylvania Department of Revenue (the Department) assessed PIT against Appellants, plus interest and penalties, related to the foreclosure on the Property for tax year 2005. The PIT equaled each limited partner's distributive share of the gain associated with the foreclosure, multiplied by the Pennsylvania PIT rate of 3.07%. See 72 P.S. § 7306.[4] Appellants unsuccessfully challenged the assessments in the Department's Board of Appeals and, subsequently, in the Board of Finance and Revenue. Timely appeals to the Commonwealth Court followed.[5]

On January 3, 2013, in four separate decisions, an en banc panel of the Commonwealth Court affirmed the Board in part, vacated in part, and remanded.[6] The court began its analysis by examining as a threshold matter whether taxing Appellants in the first instance violated the Commerce and Due Process Clauses of the United States Constitution,[7] under the theory that none of them as nonresidents could be subject to the Pennsylvania Tax Reform Code (the Code). While recognizing that in taxation cases, Commerce and Due Process Clause arguments are interrelated, the court opined that " the two should not be intermingled" because, according

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to the United States Supreme Court, they " are analytically distinct." Commonwealth v. Marshall, 41 A.3d 67, 73 (Pa. Cmwlth. 2013) ( en banc ) (quoting Quill Corp. v. N. Dakota, 504 U.S. 298, 305-06, 112 S.Ct. 1904, 119 L.Ed.2d 91 (1992)). The court concluded that Appellants only disputed whether minimum contacts existed to permit Pennsylvania to tax them, and a minimum contacts analysis only implicates due process. Accordingly, the court concluded that Appellants waived the Commerce Clause claim.[8]

Turning to the due process claim, the court determined that a reasonable, definitive connection between Appellants and Pennsylvania existed because the primary purpose of the Partnership was the ownership and management of real estate within the Commonwealth's borders. While it ultimately failed, the Partnership's sole objective was to return a profit on the building, and therefore the Partnership and its limited partners purposely established contacts with Pennsylvania for that purpose. Thus, the court found that subjecting Appellants to PIT did not violate due process. Id. at 74 (citing, e.g., Kulko v. Superior Court of California, 436 U.S. 84, 92, 98 S.Ct. 1690, 56 L.Ed.2d 132 (1978) (whether minimum contacts exists for purposes of due process is fact specific and " must be weighed to determine whether the requisite 'affiliating circumstances' are present" )).

The court next turned its attention to whether the foreclosure upon the Property, and therefore the discharge of the nonrecourse debt associated with it, constituted a taxable event for purposes of PIT. In Pennsylvania, the imposition of PIT is governed by Section 302 of the Code, which provides as follows:

(a) Every resident individual, estate or trust shall be subject to, and shall pay for the privilege of receiving each of the classes of income hereinafter enumerated in section 303, a tax upon each dollar of income received by that resident during that resident's taxable year at the rate of three and seven hundredths per cent.
(b) Every nonresident individual, estate or trust shall be subject to, and shall pay for the privilege of receiving each of the classes of income hereinafter enumerated in section 303 from sources within this Commonwealth, a tax upon each dollar of income received by that nonresident during that nonresident's taxable year at the rate of three and seven hundredths per cent.

72 P.S. § 7302. Section 303 of the Code then enumerates eight classes of income, which are subject to PIT. Relevant to this appeal, the court noted that subsections (a)(2) and (a)(3) permit the collection of PIT upon " the net income from the operation of a business, profession, or other activity . . ." ; and, the " net gains or net income, less net losses, derived from the sale, exchange or other disposition of property, including real property [and] intangible personal property . . . ." Id.

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§ 7303(a)(2) & (3).[9] In furtherance of subsection (a)(3), Department Regulation 103.13 provides, " A gain on the disposition of property is recognized in the taxable year in which the amount realized from the conversion of the property into cash or other property exceeds the adjusted basis of the property." 61 Pa. Code § 103.13(a).[10]

Rather than a matter of statutory interpretation, the court viewed the question of whether PIT applies to the consequence arising from a foreclosure upon a nonrecourse debt as one of regulatory interpretation, and thus gave deference to the Department's interpretation of Regulation 103.13. To that end, the court noted that the Department, " in this matter . . . has interpreted [Regulation] 103.13 as applying to real property foreclosures, even when the mortgagor does not receive any cash or other property . . . upon foreclosure." Marshall, 41 A.3d at 77. The court then looked to the United States Supreme Court's decision in Tufts, in which the Court, as a matter of federal tax law, held that " where a lender forecloses on property securing a nonrecourse loan of a partnership, for tax purposes the amount realized by the partnership from the disposition of the property is the full amount of the nonrecourse obligation." Id. (citing Tufts, 461 U.S. 300, 103 S.Ct. 1826, 75 L.Ed.2d 863); see also Crane v. Commissioner, 331 U.S. 1, 14, 67 S.Ct. 1047, 91 L.Ed. 1301, 1947-1 C.B. 97 (1947) (holding that when a seller of real property " transfers subject to the mortgage, the benefit to him is as real and substantial as if the mortgage were discharged, or as if a personal debt in an equal amount had been assumed by another." ). Since Tufts, the Internal Revenue Service (IRS) has continued to find tax liability under what has become known as the " Tufts rule," as further discussed herein

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in Part III(A), upon the disposition of nonrecourse debts due to foreclosures.

For guidance, the Commonwealth Court looked to Section 1001 of the Internal Revenue Code (IRC), which states that if the amount realized from " the sale or other disposition of property" exceeds the adjusted basis, then the gain is taxable as income. 26 U.S.C. § 1001(a). Importantly to the Commonwealth Court, the federal definition of " amount realized," in accord with Department Regulation 103.13, is limited to " money received plus the fair market value of the property (other than money) received." Id. § 1001(b). Given the similarities in phraseology between the federal and Pennsylvania sections, the court concluded,

because [the Department's] interpretation of its regulation is consistent with well-settled interpretations of similar federal tax provisions, [the Department's] interpretation of Section 103.13 as applying to real property foreclosures, even when the mortgagor does not receive any cash or other property (i.e., proceeds) upon foreclosure, is reasonable and will not be disturbed by this Court.

Id. at 78.

The court further determined that the investment loss suffered by Appellants did not save them from tax liability. The court noted that the gain associated with the Property was attributable to the Partnership as the entity which owned the Property. However, the limited partners, including Appellants, were liable for the gain as individuals based upon the individual shares in the partnership. 72 P.S. § 7306. Accordingly, in as much as the Commonwealth Court initially had to determine whether the Department correctly imposed PIT liability upon Appellants, it concluded that Appellants' actual investment loss associated with the Partnership's failure and liquidation was of no moment, reasoning: " [t]he issue here is whether the Partnership encountered a gain on disposition of the Property, not whether [Appellants] recovered the purchase price of [their] Partnership interests or, stated otherwise, suffered a loss on [their] investment[s]." Marshall, 41 A.3d at 80.

The court next analyzed whether the Department correctly calculated the amount of PIT due from Appellants. It first noted that, as is black letter tax law, a gain upon the disposition of property occurs when " the amount realized from the disposition of the property exceeds the adjusted basis of the property at the time of disposition." Id. at 81. With that, the court initially determined that a remand to Board of Finance and Revenue would be required no matter what it decided, because the Board had failed to calculate the adjusted basis in the Property, given that it had not taken evidence regarding depreciation, amortization, or any other factor which could affect this figure.

This somewhat minor point aside, the court next moved to examine what, if any, amount of gain the Partnership realized from the foreclosure upon the Property. In citing extensively to Tufts, the court determined that the Partnership, at a minimum, realized income " in the form of the extinguishment of its obligation to repay the principal amount of the PMM note . . . - $308 million." Id. at 84. The majority recognized, however, that Tufts did not analyze the question of including accrued but unpaid interest, which in the instant case totaled $2.32 billion. The court thus turned to Allan v. Commissioner, 856 F.2d 1169, 1173 (8th Cir. 1988), which held that, under Tufts, " the amount realized is the full amount of the nonrecourse liabilities which are discharged as a result of the transfer of the property." Given the reasoning

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of Allan, the court again found the decision by the Department, under its promulgated regulations, to impose PIT on the full amount of principal and interest was reasonable and within the Code's provisions and Department's regulations.

The court next analyzed whether Appellants' tax liabilities could be reduced or offset in any manner, by examining whether the taxable amount of the accrued, but unpaid, interest owed by the Partnership ($2.32 billion) should be reduced to only that portion of the unpaid interest utilized by the Partnership over the course of its existence to negate operational income that otherwise would have been subject to PIT in previous years (a total of $121 million, see supra note 3). Specifically, the panel examined whether the net operational losses incurred by the Partnership could reduce the amount of assessed PIT. The majority noted, however, that unlike the federal IRC, which defines income in an all-encompassing manner,[11] the Code enumerates eight specific categories of income, see supra note 9, of which net profit from business operations (72 P.S. § 7303(a)(2)), and net profit from the disposition of property (id. § 7303(a)(3)), are two distinct classifications. The court further stated that Department Regulation 121.13(a) prohibits the " offset [of] a gain in one class of income with a loss in another class of income." 61 Pa. Code § 121.13(a).[12] Given this regulation, the court refused to permit Appellants to reduce the taxable amount arising from the disposition of the Property by losses suffered during the operation of the business.[13]

Finally, the court considered whether Appellants were disparately treated by the Department because they were ultimately liable for a greater PIT than the limited partners who were Pennsylvania residents. Specifically, Appellants argued that while the Department permitted the Pennsylvania-resident limited partners to offset their PIT liability arising from the foreclosure with the income loss associated with the

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failed investment in the Partnership, Appellants and the remaining non-resident limited partners were not given the same ability to offset.[14] Appellants contended that such treatment violated the Privileges and Immunities, Commerce, and Equal Protection Clauses of the United States Constitution,[15] as well as the Uniformity Clause of the Pennsylvania Constitution.[16] The court denied relief on the constitutional claims, noting that intangible personal property, like an ownership interest in a limited partnership, is localized in, and sourced to, the domicile of the taxpayer. For taxation purposes, the foreclosure on the Property was a realization of income from within Pennsylvania, while the investment loss suffered by Appellants, as nonresidents, was sourced outside of the Commonwealth, i.e., in each Appellants' home state. Thus, despite the fact that the disposition of real property and the disposition of intangible personal property both fall with the Section 7303(a)(3) class of income, given that federal constitutional law prohibits the Department from assessing PIT upon income nonresidents gain from outside of Pennsylvania, see, e.g., Shaffer v. Carter, 252 U.S. 37, 56, 40 S.Ct. 221, 64 L.Ed. 445 (1920), the court concluded that it follows that a deduction of Pennsylvania-sourced income cannot come from losses sourced to a foreign jurisdiction. Therefore, no disparate treatment occurred between resident limited partners and Appellants.

Judge Patricia McCullough, joined by Judge Robin Simpson, dissented, articulating three main points. First, the dissent averred that the applicable Pennsylvania Tax Code provisions and Department regulations did not support the finding that PIT could be assessed on the foreclosure, regardless of the Tufts decision. Unlike the IRC, which defines income broadly, the Code is explicit in what is and is not income. The dissent therefore contended that, to the extent the Code is ambiguous regarding whether the foreclosure upon a nonrecourse mortgage is taxable, the Code must be construed strictly in favor of the taxpayers, and therefore absent direction from the General Assembly that situations such as that presented instantly fall within the Code, courts should construe applicable Pennsylvania law against imposing such a tax.

Second, assuming arguendo that PIT could be assessed, the dissent argued that the tax benefit rule should have been applied to recognize the " economic reality" of the situation. The only benefit that Appellants ever realized from their venture into the Partnership was the sheltering of the $121 million in operational income, and therefore, in the dissent's view, if Appellants owed any PIT at all, it would be upon their respective shares of the $121 million.

Finally, the dissent asserted that under the Pennsylvania Constitution's Uniformity Clause, Appellants as non-residents should have been given the ability to offset their assessed PIT in the same manner as Pennsylvania-domiciled limited partners. The dissent disagreed with the majority's reasoning that, because income cannot be taxed across state borders, losses likewise should not be able to be deducted. Moreover,

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and specific to the Uniformity Clause argument, in the Dissent's view, both resident and non-resident limited partners in the Partnership were all on equal footing in the Partnership, i.e., members of the same class as all were passive investors, each of whom sustained the same loss of their respective investments. Thus, the dissent concluded that the Uniformity Clause is violated " where taxpayers enjoying the same privilege of receiving, earning[,] or otherwise acquiring the same amount of income as others [are] required to pay a larger dollar amount of taxes." Marshall, 41 A.3d at 104 (McCullough, J., dissenting) (citing Amidon v. Kane, 444 Pa. 38, 279 A.2d 53 (Pa. 1971)).

Following the decision, Appellants individually filed exceptions, which the Commonwealth Court denied with the same 5-2 majority, with Appellant-Marshall's case again serving as the lead, see Marshall v. Commonwealth, 50 A.3d 287 (Pa. Cmwlth. 2013) ( en banc ), and then decided the remaining Appellants' exceptions in unpublished memoranda. Following the court's denial of exceptions, Appellants sought direct review in this Court, and upon dispositional review, we consolidated the four matters and ordered that the case be submitted on briefs for a full opinion. Appellants asserted nine allegations of error by the Commonwealth Court, which will be addressed in five parts.[17] The

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questions surrounding application of the various constitutional provisions, such as the Due Process and Commerce Clauses of the United States Constitution, and Uniformity Clause of the Pennsylvania Constitution, comprise pure questions of law, for which our standard of review is de novo and our scope of review is plenary. See Commonwealth v. Janssen Pharmaceutica, Inc., 607 Pa. 406, 8 A.3d 267, 271 (Pa. 2010). Similarly, whether the assessment of PIT based upon the foreclosure of the Property, and the subsidiary questions stemming there from, are also pure questions of law, to which the same standard and scope of review apply. Id.

II. THE COMMERCE AND DUE PROCESS CLAUSES

As the Commonwealth Court did before us, we initially address questions concerning whether the Commerce and Due Process Clauses of the federal constitution prohibit the Department from assessing PIT against Appellants at all. We would not typically turn first to constitutional issues. However, if either of these provisions bar the imposition of PIT, it will be unnecessary for us to examine the statutory questions raised by Appellants. Accordingly, we examine them as threshold matters.

(A) Commerce Clause

We concentrate first on the Commonwealth Court's holding that Appellants waived any contentions that they could not be assessed PIT for the foreclosure of the Property based upon the Commerce Clause. The court below deemed any Commerce Clause arguments to be waived as not sufficiently developed. The court, citing to language from the United States Supreme Court, faulted Appellants for not sufficiently distinguishing between the Commerce Clause and the Due Process Clause arguments. See Marshall, 41 A.3d at 73 (quoting Quill, 504 U.S. at 305-06 (recognizing that, in taxation cases, Commerce and Due Process Clause arguments are interrelated but " the two should not be intermingled" because the two constitutional provisions " are analytically distinct" ; Commerce Clause analyses ...


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