ONE WAY RETIREES ARE SCREWED ON THE NJ-1040

Here is an interesting, and unintended, way the State of New Jersey screws retired residents.

This is different from the way the NJ Division of Taxation screws taxpayers by remaining unethically silent upon receiving overpayments.

If your NJ Gross Income is not more than $100,000, and you are age 62 or older, you can exclude up to $15,000 ($20,000 for married filing joint and $10,000 for married filing separately) of the pension, annuity, and IRA income reported on Line 19a of the NJ-1040.

If you do not use the full $10,000, $15,000, or $20,000 toward pension, annuity, or income income – i.e. Line 19 is only $7,500 – you can claim the difference as an “Other Retirement Income Exclusion”.

You cannot claim any “Other Retirement Income Exclusion” is you have what the state considers “too much” earned income from wages or self-employment (sole-proprietor, partner, sub-S corporation shareholder) income.  In this case “too much” is $3,001.

The instructions tells us that one of the requirements for being able to claim this additional exclusion is –

“Income from wages, net profits from business, distributive share of partnership income, and net pro rata share of S corporation income totaled $3,000 or less.”

Where a retiree gets screwed is when it comes to “distributive share of partnership income”. 

It is clear that the intention of the law was to use the $3,000 threshold for the distributive share of partnership self-employment income – the type of income equivalent to that reported on a federal Schedule C.  However the screwing occurs because of how “distributive share of partnership income” is reported on the NJ-1040.

On the federal return the different types of partnership income are passed through via the Form K-1 to Form 1040 based on the type or source of the income.  Interest and dividends are reported on Schedule B, capital gain income is reported on Schedule D, and self-employment business income is reported separately.

However on the NJ-1040 partnership income is reported as one category of income rather than in respective categories.  Interest, dividends, rents, gains, or losses earned by a partnership are now combined with Federal ordinary income (loss) to arrive at New Jersey partnership income (loss).

So the amount reported as “distributive share of partnership income” includes interest, dividends, royalties, capital gains, etc. as well as “business income”.  A special worksheet included in the NJ publication on partnership income is used to consolidate the federal K-1 entries into the one NJ-1040 entry if a NJ-K-1 is not issued.

Unfortunately, when investing money for retirees many brokers purchase, as an alternative to stock or mutual fund shares, units in limited partnership investments.  The result is truly a PITA for tax preparers.

Another result is that the income from the limited partnership investment, for the most part interest, dividends, and capital gains which are reported separately on the federal return, is combined to determine net “distributive share of partnership income” reported on the Form NJ-1040.

The instructions for the NJ-1040 do not indicate that excess business income from a partnership can eliminate any “Other Retirement Income Exclusion”.  It simply says “distributive share of partnership income”.

Here is an example of the screwing.

A 90+ year old taxpayer, retired with no “earned” income, does not have any taxable pension, annuity, or IRA income.  His total NJ taxable income comes from his investments – interest, dividends, capital gains, and investment income from limited partnership investments.  His NJ Gross Income is less than $100,000.  So you would think he could claim a $15,000 “Other Retirement Income Exclusion”.

But what if the total pass-through investment income generated by the investments in limited partnerships exceeds $3,000?  Under current NJGIT law this causes him to lose the $15,000 exclusion.  And $1.00 in partnership income can cause him to lose the $15,000 exclusion!  So he is royally screwed!

Actually the “net pro-rata share of S corporation income” can be true dividend-equivalent income – if the shareholder is a passive investor in the corporation.  Another case of retiree screwing.

Obviously the best way to avoid this screwing is to not invest in limited partnerships (something that would certainly make tax preparers very happy).  I firmly believe that a broker could find a stock or mutual fund investment that would provide the same potential for income and gain as any limited partnership.  But, (this is my personal opinion – and not necessary gospel) perhaps because the broker receives a better commission from selling limited partnership units, brokers do not look for an alternative and insist on buying LP units for clients.

It seems very clear to me that allowing investment income from a partnership to “exclude the exclusion” was not the intention of the idiots in Trenton when creating the “Other Retirement Income Exclusion”.  But because of the way partnership income is reported on the NJ-1040 it is what can happen.

I expect it would take legislation to fix this FU.

Tax pros – your thoughts?

TTFN