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The Supreme Court Declares Maryland Resident Tax Credit Structure Unconstitutional Because It Leads to Double Tax

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Supreme Court buildingOn May 18, 2015, the U.S. Supreme Court declared Maryland's resident tax credit structure unconstitutional because it subjected income earned outside the state to potential double taxation. The Supreme Court concluded in a 5 to 4 decision in Comptroller of the Treasury of Maryland v. Wynne that this structure impermissibly favored income earned within Maryland over income earned outside the state. According to the court, this effectively created a tariff that violated the dormant Commerce Clause of the U.S. Constitution. 

Here's a quick review of the facts of the case. Brian and Karen Wynne are Maryland residents. Like most states, Maryland taxes residents on their worldwide income regardless of its source. In other words, Maryland residents can pay tax on income earned outside Maryland. In 2006, Brian Wynne owned stock in a Subchapter S corporation that operated and earned income in other states. In fact, the S corporation filed income tax returns in 39 states. The Wynnes reported the income that flowed through to them from the S corporation on their Maryland income tax returns but also claimed an income tax credit for taxes paid to other states. Almost every state tax code contains a similar credit. These credits are designed to avoid double taxation and to allow for the proper allocation of the tax burden to the jurisdiction where the income was earned.

The problem in the case arose because Maryland imposed two taxes, a state tax and a county tax. Despite imposing two taxes, the Maryland credit for taxes paid to other states only applied to the state tax, not the county tax. Thus, the Wynnes ended up being double taxed on the S corporation income. They paid tax to the states where the income was earned, and they paid the Maryland county tax on the same income. According to the Supreme Court, this scheme violated the dormant Commerce Clause of U.S. Constitution. 

This case is notable for several reasons:

  • The majority based its conclusion primarily on the "internal consistency" test, which has been applied in dormant commerce clause cases. The "internal consistency" test helps courts identify tax schemes that discriminate against interstate commerce by assuming that every State has the same tax structure. According to the court, Maryland's income tax scheme fails the internal consistency test because if every state adopted Maryland's tax structure, interstate commerce would be taxed at a higher rate than intrastate commerce. The court concludes that Maryland's tax scheme is inherently discriminatory and operates as a tariff.
  • The court explicitly concludes that Commerce Clause protections extend equally to taxes based on gross and net income (previous case law relied on by the majority had focused on gross receipts taxes) and to individuals as well as corporations (previous case law relied on by the majority dealt with corporations).      

As with any new Supreme Court case, we have to ask, will this case have a broad impact going forward? Well, as an attorney who frequently deals with the New York Tax Law, I can think of at least one New York rule that will likely be impacted. New York runs a similar resident credit scheme to the Maryland scheme that was deemed unconstitutional, except, instead of not allowing a credit for taxes paid to other jurisdictions against county tax, New York doesn't allow a credit against New York City tax. It's difficult to see how this structure can stand in the wake of the Wynne case. Of course, since very few states have tax rates higher than the New York State rate, this is a problem that probably doesn’t come up all that much.   

Double taxation also frequently occurs with respect to intangible income. Here's a typical scenario: A Connecticut resident commutes to work in New York City. The Connecticut resident also maintains a vacation home in the Hamptons. These facts allow the Connecticut resident to be taxed as a resident of New York as well because the taxpayer owns a home in New York and spends more than 183 days in the state for work (note the taxpayer does not have to spend 183 days at the Hamptons home to qualify as a NY resident). As both a Connecticut and New York resident, the taxpayer will pay tax on wages earned to New York. Connecticut will allow a credit for taxes paid on this wage income to New York, effectively subjecting this income to only one tax. However, as we've outlined in the past, both Connecticut and New York will seek to tax "intangible" income with neither state providing a credit for taxes paid to the other state. "Intangible" income typically includes investment income such as interest, dividends, capital gains on the sale of stock, etc.   

So the question is, will the Wynne case impact this double tax situation? Unfortunately the answer to this question is a bit tougher to determine because, unlike the New York City issue discussed above, this tax scheme is significantly different from the situation addressed in Wynne. Given the court's reliance on the "internal consistency" test, the burden on interstate commerce is a bit more attenuated in this scenario. Still, though, one of the reasons that courts have upheld this double-tax situation in New York is based on the idea that normal commerce clause jurisprudence doesn’t apply to income taxes because they don’t involve “commerce.” But the court rejected this idea, saying that "it is hard to see why the dormant commerce clause should treat individuals less favorably than corporations." 

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