05.20.2015 Maryland’s Denial of Credit for Tax Paid in Other States Declared Unconstitutional
In a 5-4 decision, the U.S. Supreme Court, in the case of Comptroller of the Treasury of Maryland v. Wynne, 575 U.S. ____ (2015), has struck down, under the “dormant” Commerce Clause, an aspect of Maryland’s income tax laws that allowed for double taxation of the income of Maryland residents earned outside of the state.
Over the years, the Court has recognized that the U.S. Constitution’s grant of authority to Congress to regulate interstate commerce carries with it an implied negative command that the states not interfere with or discriminate against interstate commerce. The Court in Wynne holds that Maryland’s tax scheme violates this “negative” or “dormant” aspect of the Commerce Clause by favoring income earned by its residents within the state over that earned by its residents in other states.
Maryland’s income tax scheme is composed of three parts:
- a state tax on residents’ income wherever earned and non-residents’ income from sources within Maryland (the “State Income Tax”);
- a county tax on all income wherever earned by residents of each county at rates set by the county within a state-prescribed range (the “County Income Tax”); and
- a tax on income earned by non-residents from sources within Maryland at a rate equal to the lowest county rate (the “Non-Resident Tax”).
Like most States, Maryland allows a credit to residents against the State Income Tax for taxes paid to other states for income earned in the other states. However, Maryland does not allow such a credit against the County Income Tax.
The named Taxpayers in this case are Maryland residents who owned stock in an S Corporation, Maxim Healthcare Services, Inc., which filed state income tax returns in 39 states. The Wynnes reported the pass-through income from Maxim on their Maryland tax returns and claimed a credit for taxes paid to other states for income earned in those states. Maryland granted the credit against the State Income Tax but denied the credit against the County Income Tax.
The majority opinion by Justice Alito applied “the internal consistency test” employed in previous Supreme Court decisions to Maryland’s income tax scheme. This test examines whether, assuming that every state has the same tax scheme as the state at issue, interstate activities are taxed at a higher rate than in-state activities. Applying the test to Maryland’s laws, if all states used the same tax scheme and tax rates, Maryland residents would have to pay the State Income Tax and County Income Tax on income from in-state activities but, because there is no credit allowed against the County Income Tax, they would have to pay an equivalent tax to other states on income from out-of-state activities and also would have to pay the County Income Tax to Maryland. This would result in the Maryland taxpayer being double-taxed on out-of-state income. The Court holds that this scheme amounts, in essence, to an unconstitutional tariff in violation of the “dormant” Commerce Clause.
The principal dissent, authored by Justice Ginsburg, argues that the internal consistency test is itself an inconsistent tool to determine whether a state’s income tax scheme discriminates against interstate commerce, and that the potential for double taxation should not be sufficient to overcome the entrenched principle that a state may tax all of the income of its residents, no matter where it is earned. The principal dissent, in closing, argues that balancing the competing interests of avoiding double taxation with ensuring that all who live or work within a state shoulder their fair share of the costs of government is a matter of policy best left to the state legislatures and Congress.
Justice Scalia, while agreeing with Justice Ginsberg, also dissented separately, arguing that the “dormant” Commerce Clause is a judicial fraud and should be extended no further. Justice Thomas did not join with Justice Ginsburg and issued a separate dissent stating that the “dormant” Commerce Clause jurisprudence should be abandoned altogether.
So what does this mean? Maryland residents reporting out-of-state income can file protective refund claims for any years open under Maryland’s statute of limitations for the amount of County Income Tax paid in excess of what would have been payable had the full credit been allowed against the County Income Tax. Maryland will also have to amend its tax code going forward to remedy this problem, and, while the Court refrained from telling Maryland exactly what to do, Maryland will almost certainly remedy the problem by allowing the credit for taxes paid to other states to extend to the County Income Tax as well as the State Income Tax.
It should be noted that Maryland, anticipating the possibility of losing this case, reduced the amount of interest on refunds retroactively to reduce the impact on state and county coffers.
Finally, other states and municipalities, most notably New York City, that tax non-residents on income earned there without allowing a credit to its own residents for income taxes paid to other jurisdictions will also have to amend their tax codes and may have to issue refunds.