U.S. Supreme Court Holds Lack Of County Personal Income Tax Credit For Taxes Paid To Other States Violates Commerce Clause

On May 18, the U.S. Supreme Court held in Comptroller of the Treasury v. Wynne that the failure of Maryland law to allow a credit against county personal income tax for Maryland residents for their pass-through income from an S corporation's out-of-state activities that was taxed by other states was unconstitutional.1 In affirming the judgment of the Maryland Court of Appeals by a 5-4 decision, the U.S. Supreme Court held that the Maryland tax system impermissibly exposed taxpayers to the possibility of double taxation. Also, the Maryland tax system was held to violate the fair apportionment requirement of the dormant Commerce Clause because it failed the internal consistency test. This test supported the conclusion that Maryland's tax method was inherently discriminatory and operated as a tariff.

Background

The Wynne case developed from the issues that often arise when taxpayers earn income from multistate businesses and attempt to rely upon the credit for taxes paid to other states in order to prevent duplicative levels of state and local taxation.

The taxpayers, a married couple residing in Howard County, Maryland, held an ownership interest in a federal S corporation providing nationwide health care services. On both their 2006 federal and Maryland income tax returns, the taxpayers reported a portion of the S corporation's income as "pass-through income." On their Maryland return, the taxpayers claimed a credit against their personal income tax for taxes paid to other states. The S corporation filed state income tax returns in 39 different states and allocated to each shareholder a pro rata share of taxes paid.

Maryland's credit for taxes paid to other states is distinctive given that the structure of the income tax is directed to two separate levels of government. Maryland imposes a personal income tax on its residents that is comprised of a "state" income tax that is set at a graduated rate2 and a "county" income tax that is set a rate that varies by county.3 While the two taxes are designated as state and county taxes, both of these taxes are actually collected by the state, with the county tax then being disbursed to the counties. If Maryland residents earn income in another state and pay income tax to the other state, Maryland law allows them a credit against the "state" income tax, but not the "county" income tax.4 Maryland also imposes a two-part personal income tax on nonresidents. First, nonresidents must pay the "state" income tax on all of the income that they earn from sources within Maryland.5 Second, nonresidents that by definition cannot be a resident of a Maryland county and would not be subject to the county tax must pay a "special nonresident tax" instead of the county tax.6

The Maryland Comptroller only allowed the taxpayers to apply the credit against their state income tax, disallowing the credit against the county income tax and resulting in the issuance of an assessment. The Hearings and Appeals Section of the Comptroller's Office and the Maryland Tax Court subsequently affirmed the assessment. However, the Circuit Court for Howard County reversed the assessment and held that Maryland's tax system violated the dormant Commerce Clause.

Maryland Court of Appeals Decision

The Maryland Court of Appeals, the state's highest court, affirmed the Howard County Circuit Court and concluded that the Maryland tax system was unconstitutional to the extent that it denied the taxpayers a credit against the county tax for income taxes they paid to other states.7 In reaching its decision, the Maryland Court of Appeals applied the four-part test specified by the U.S. Supreme Court in Complete Auto Transit v. Brady8 that a statute must satisfy to survive a Commerce Clause challenge. The following four-prong test must be considered in determining the constitutionality of a state tax statute: (i) the tax must be applied to an activity with a substantial nexus with the taxing state; (ii) the tax must be fairly apportioned; (iii) the tax must not discriminate against interstate commerce; and (iv) the tax must be fairly related to the services provided by the state. The Court of Appeals held that the tax failed both the fair apportionment and nondiscrimination parts of this test. The tax did not satisfy the fair apportionment requirement because it failed both the internal and external consistency tests. The internal consistency test was violated because if every state adopted Maryland's tax system, interstate commerce would be taxed at a higher rate than intrastate commerce. The external consistency test was violated because it created a risk of multiple taxation. Also, the tax discriminated against interstate commerce because the interstate income earned by residents was taxed at a higher rate than income earned intrastate. The Comptroller appealed this decision and following intervention by the U.S. Solicitor General's office urging a hearing at the U.S. Supreme Court, certiorari was granted.

Dormant Commerce Clause Violated

The U.S. Supreme Court affirmed the Maryland Court of Appeals and held that the lack of a credit against the county income tax violated the dormant Commerce Clause. In reaching its decision in Wynne, the Court noted that the Commerce Clause grants Congress the power to "regulate Commerce . . . among the several States."9 This is phrased as a positive grant of power to Congress, but the Court has "consistently held this language to contain a further, negative command, known as the dormant Commerce Clause, prohibiting certain state taxation even when Congress has failed to legislate on the subject."10 The Court acknowledged that "this interpretation of the Commerce Clause has been disputed," but that "it also has deep roots." According to the Court, "[b]y prohibiting States from discriminating against or imposing excessive burdens on interstate commerce without congressional approval, it strikes at one of the chief evils that led to the adoption of the Constitution, namely, state tariffs and other laws that burdened interstate commerce."11 Under the dormant Commerce Clause, a state may not "impose a tax which discriminates against interstate commerce either by providing a direct commercial advantage to local business, or by subjecting interstate commerce to the burden of 'multiple taxation.'"12

Three Key Double Taxation Decisions

The Court explained that "[o]ur existing dormant Commerce Clause cases all but dictate the result reached in this case by Maryland's highest court." To support its decision, the Court discussed three cases that concerned taxing the income of domestic corporations.13 In J.D. Adams Manufacturing Co. v. Storen,14 Indiana taxed the income of a local corporation on sales made outside the state. The Court held that this tax system violated the dormant Commerce Clause because it taxed receipts from interstate commerce without apportionment and with the risk of double taxation. In Gwin, White & Prince, Inc. v. Henneford,15 Washington taxed a local corporation's income that was earned from shipping fruit to other states and foreign countries. The Court held that this method of taxation discriminated against interstate commerce because there was a risk of multiple taxation that did not exist for the intrastate sales. Finally, New York attempted to tax the portion of a local bus company's gross receipts from services provided in neighboring states in Central Greyhound Lines, Inc. v. Mealey.16 The Court held that this tax placed an unfair burden on interstate commerce because other states might attempt to tax these same gross receipts. In Wynne, the Court explained that each of these prior cases "struck down a state tax scheme that might have resulted in the double taxation of income earned out of the State and that discriminated in favor of intrastate over interstate economic activity." According to the Court, Maryland's tax system...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT