Tuesday, November 11, 2014
Supremes to Consider State Tax Credits for Out-of-State Income
The Supreme Court will hear oral arguments tomorrow in Comptroller v. Wynne, the case testing the scope of a state's authority to tax the out-of-state income of its residents. In particular, the case asks whether a state can provide a credit for income tax paid to other states against a resident's state income tax without also providing a credit against that resident's county income tax. Here's an exerpt from my preview of the case for the ABA's Preview of United States Supreme Court Cases:
Maryland imposes a “state income tax” and a “county income tax” on all of the income earned by a Maryland resident, even income earned out of state. (For those subject to the state income tax but not the county income tax, because they live out of state but earn income in Maryland, the state imposes a “Special Non-Resident Tax,” or “SNRT.”) That means that a Maryland resident who earns income out of state pays the Maryland “state income tax,” the Maryland “county income tax,” and the state income tax of the other state on that income. Maryland allows an off-setting credit for income tax on out-of-state income tax paid in another state, but only as to the Maryland state income tax, not as to the Maryland county income tax. (Maryland used to allow the off-setting credit as to the state income tax and the county income tax. But in 1975, the legislature amended the state tax code to eliminate the credit as to the county income tax.)
An example may help. (This comes from the Maryland Court of Appeals ruling in this case.) Suppose that Maryland imposes a state income tax of 4.75 percent on all income earned by its residents, a county income tax of 3.2 percent on all income earned by its residents, and an SNRT of 1.25 percent on the income earned by non-residents in Maryland. Suppose that Pennsylvania imposes the exact same taxes at the exact same rates.
Suppose that John lives in Maryland and earns $100,000 per year. Suppose he earns half of his income from activities in Maryland and half of his income from activities in Pennsylvania. If so, John owes $4,750 (or .0475 x $100,000) in Maryland state income tax and $3,200 (or .032 x $100,000) in Maryland county income tax, for a total of $7,950 for all Maryland taxes.
At the same time, John also owes $2,375 (or .0475 x $50,000) in Pennsylvania state income tax and $625 (or .0125 x $50,000) in Pennsylvania SNRT tax for a total of $3,000 for all Pennsylvania taxes.
Based on John’s tax owed to Pennsylvania, John qualifies for a Maryland state tax credit in the amount of $2,375 (the maximum allowable credit under the Maryland tax code, given the assumptions in this example). That means that John owes a total Maryland tax of $5,575, and John’s total state income tax burden is $8,575 (or $5,575 for all Maryland state taxes plus $3,000 for all Pennsylvania state taxes).
(Note that John’s total state tax burden is $625 more than the total state income tax burden for an individual, let’s call her Mary, who earned the same amount of income, but only in Maryland. Mary would only owe $7,950 in Maryland state taxes—the same as John’s Maryland state tax burden without the credit for taxes paid to Pennsylvania.)
In the 2006 tax year, Brian and Karen Wynne found themselves in a position like John’s—that is, paying state income taxes in other states, but not receiving a credit toward their Maryland county tax. Brian and Karen Wynne are a married couple living in Howard County, Maryland. Brian Wynne was one of seven owners of Maxim Healthcare Services, Inc., a company that does a national business providing healthcare services. Maxim is an S-corporation under the Internal Revenue Code, which means that Maxim’s income is imputed (or “passed through”) to its owners for federal income tax purposes. Maryland also accords pass-through treatment to the income of an S-corporation. In 2006, Maxim earned income in 39 states and, as an S-corporation, allocated to each owner a pro rata share of the taxes paid in each state.
The Wynnes reported Brian Wynne’s income from Maxim on their 2006 Maryland state tax return. The Wynnes claimed a credit based on Brian’s pro rata share of state and local income taxes paid to other states.
The Maryland Comptroller made a change in the computation of the local tax owed by the Wynnes and revised the credit for taxes paid to other states. This resulted in a deficiency in the Maryland taxes paid by the Wynnes, and they appealed. After exhausting their administrative appeals, the Wynnes appealed to the Maryland Tax Court, where they argued that the limitation on the credit to the Maryland state tax (which did not extend to the Maryland county tax) for tax payments made to other states discriminated against interstate commerce in violation of the Dormant Commerce Clause of the United States Constitution. The Tax Court rejected the argument, and the Wynnes appealed, until the Maryland Court of Appeals, the state high court, agreed. This appeal followed.
While the Commerce Clause gives Congress authority to regulate interstate commerce, the so-called Dormant Commerce Clause restricts the states from discriminating against interstate commerce. (The Dormant Commerce Clause is not in the Constitution as such. Instead, the Court infers it from the Commerce Clause and federalism principles.) One way that a state might discriminate against interstate commerce is through its tax scheme. When this happens, the Court uses a four-part test first articulated in Complete Auto Transit, Inc. v. Brady. 430 U.S. 274 (1977). Under that test, a state tax does not violate the Commerce Clause if
- [the tax] is applied to an activity with a substantial nexus to the taxing state;
- it is fairly apportioned so as to tax only the activities connected to the taxing state;
- it does not discriminate against out-of-staters; and
- it is fairly related to services provided by the state.
The Maryland Court of Appeals held that the Maryland tax scheme violates the second and third prongs of this test. The court ruled that the tax scheme was not fairly apportioned, because it amounted to double-taxation of income. The court ruled that the scheme discriminated against out-of-staters, because it favors individuals who do business only in Maryland over individuals who do business across state lines.
The parties disagree over whether and how the Complete Auto test applies to the Maryland tax scheme for individual income taxes passed through an S-corporation. (That last part is important, because, as described below, different rules may apply to a state tax scheme for corporate income taxes owed by a C-corporation.) They also disagree over the application of the time-honored principle that states can tax all the income of their residents, even income earned in other states.
Maryland argues first that states have authority to tax all income of their residents, including income earned outside the state’s borders. The state says that this authority is based on the taxpayer’s domicile, not the source of his or her income, and it claims that the state’s authority to tax its residents is justified based on the substantial benefits that residents receive from the state. The state contends that it has designed its income tax system to ensure that all Maryland residents contribute to the benefits that the state offers those residents. In particular, the state says that the tax credit for out-of-state income tax is designed to reduce Maryland tax payments for residents earning income outside the state while at the same time requiring those residents to pay some income tax to support state and local government programs.
The state argues that the Maryland Court of Appeals ruling—compelling Maryland to give a credit for tax payments to other states against both the state income tax and the county income tax—would mean that certain Maryland taxpayers could take advantage of state and local benefits “without contributing any income taxes in return.” The state claims that this is particularly unjustified, because Maryland taxpayers can exercise their political power within Maryland to change the state tax system. (In contrast, the state argues, other tax schemes invalidated by the Supreme Court involved disproportionate income taxes on nonresidents, who did not have political power within the taxing state.) The state says that “Maryland’s system simply asks something more of the State’s own citizens,” and that those citizens can work through the political process to change it, if they like.
The state argues next that the Maryland Court of Appeals ruling would undermine the principle that a state can tax all the income of its residents, wherever earned. It says that the ruling effectively means that a state is barred from taxing its residents’ out-of-state income to the extent that another state has already taxed that income. This, in turn, means that a state’s authority to tax its residents’ income is subordinate to another state’s authority to tax that income. The state contends that this does not square with the general rule that a state can tax all its residents’ income. It also says that this is not supported by the Constitution, which treats all states equally for this purpose and does not provide a priority of states’ authority to tax.
The state claims further that no principle of double taxation bars Maryland from denying a credit toward the Maryland county tax. It says that there is no problem with double taxation so long as both sovereigns have valid authority to impose the taxes that result in double taxation. It claims that this rule is consistent with the principle that a state can impose taxes to pay for a fair share of services, and the reality that “states do significantly more for their residents than they do for taxpayers who simply earn income within their territory.”
Finally, the state argues that the Maryland Court of Appeals wrongly applied the standard under Complete Auto Transit, Inc. v. Brady. It says that the court wrongly looked at the taxes that the Wynnes paid to all states, and not the taxes they paid only to Maryland. The state contends that the Maryland scheme, taken on its own, is completely neutral with respect to interstate commerce, and that a higher overall tax burden (as illustrated in the example above) is only due to the accident of two taxing sovereigns simultaneously exercising their valid taxing authorities. Moreover, the state claims that the Maryland Court of Appeals was wrong to conclude that the Maryland tax is not fairly apportioned. It says that the Maryland tax is based on Maryland residency, and that there is no need for it to be apportioned—indeed, that residency cannot be apportioned.
The federal government, weighing in as amicus curiae in support of Maryland, adds that Wynne is wrong to focus on whether the Commerce Clause requires states to offer credits for out-of-state income taxes paid by corporations. (Wynne’s argument on this point is summarized below.) The government says that C-corporations have a different relationship to, and receive different benefits from, the state than individuals (taxed as an S-corporation)—and that corporate income tax is different than personal income tax. The government contends that this means that the Commerce Clause analysis for these different types of taxes might be different. Moreover, the government says that it is an open question whether states must apportion income of resident corporations by providing credits for out-of-state income tax.
Wynne argues first that the Maryland tax scheme violates the Commerce Clause. He says that the scheme results in double taxation of out-of-state income as a result of engaging in interstate commerce. He says that the Court has long invalidated that kind of tax.
Wynne argues next that the state applies the wrong test. Wynne says that the state never applies the Complete Auto test and instead “tries to float above the Commerce Clause jurisprudence” to find an exception to the rule that a state may not double tax interstate commerce. He claims that the state’s reliance on its sovereign authority to tax its residents is misplaced, because the Court has struck state taxes—even taxes on residents—that violate the Commerce Clause. He contends moreover that this reliance is misplaced, because the Court’s jurisprudence has never turned on labels (like “residency”); instead it turns on whether a tax substantially affects interstate commerce. And Wynne says that Maryland’s scheme has a substantial effect on interstate commerce, because, as here, “it discourages interstate activity by a corporation that operates in dozens of States.”
Wynne argues that the state is wrong to say that it can double-tax income in order to ensure that residents pay for state services. He claims that he would still pay substantial state income taxes even with a credit against his county tax, and that he pays all manner of other state taxes that go to support state services. And Wynne contends that Maryland and other states provide extensive services to resident corporations, but that, under Supreme Court precedent, they cannot double-tax them. He says that this shows that Maryland’s argument about paying for services “proves too much.”
Finally, Wynne argues that the state’s position would have a “bizarre result.” He says that the state’s position means that states could not double-tax resident C-corporations, but could double-tax resident S-corporations. He claims that this makes no sense, given that each kind of corporation engages in interstate commerce.
This case could have immediate and important fiscal significance for Maryland and states and municipalities around the country. For Maryland, a ruling affirming the Maryland Court of Appeals could cost the state between $45 and $50 million per year in tax revenue, and as much as $120 million in retroactive tax-refund claims. Around the country, such a ruling could affect more than 2,000 municipal income taxes nationwide that might not provide credits for out-of-state income taxes. States could seek to make up losses by increasing income tax rates (or imposing or increasing other taxes), but that option could be politically difficult.
More generally, the case potentially tests the long-standing principle that a state may tax all the income of its residents, even if earned out of state. But this principle is well established and universally relied upon. The Court is unlikely to rule in a way that threatens it.
Finally, the ruling of the Maryland Court of Appeals is in tension with other state-court rulings on similar (but not exactly the same) issues. This case will settle the matter, and tell us whether a state must provide a credit against all aspects of the state income tax.