The Supreme Court struck down the state of Maryland’s practice of taxing a resident’s income that was earned and already taxed in another state without providing a full tax credit, ruling Monday that the practice violates the Constitution.
Maryland imposes a tax consisting of both a state portion and a county portion on the worldwide income of its residents. If the Maryland resident owes tax to other jurisdictions on the income, the Maryland tax code allows a credit for income tax paid with respect to the state income tax, but not the county tax.
Nonresidents who earn income from sources within Maryland must pay the state income tax, and nonresidents not subject to the county tax must pay a special nonresident tax in lieu of the county tax.
The case involved Maryland residents who earned pass-through income from an S corporation that earned income in several states. They claimed an income tax credit on their 2006 Maryland income tax return for taxes paid to other states. The Maryland Comptroller allowed a credit against their state income tax but not against their county income tax and assessed a tax deficiency.
After some preliminary skirmishing, the Court of Appeals of Maryland ruled that the failure to allow a credit with respect to the county income tax for taxes paid to other states on pass-through income earned in those states discriminates against interstate commerce and violates the Commerce Clause of the constitution. Maryland appealed the case to the U.S. Supreme Court.
The decision, announced Monday in the case Comptroller of the Treasury of Maryland v. Wynne, struck down the practice of Maryland in taxing a resident’s income that was earned and already taxed in another state without providing a full tax credit, holding that the practice violates the Constitution’s Commerce Clause. Justices Clarence Thomas, Antonin Scalia, Ruth Bader Ginsburg and Elena Kagan dissented.
Although the Commerce Clause is framed as a positive grant of power to congress, the Court noted, “We have 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.”
“A state cannot tax its individual residents without dormant Commerce Clause restraints,” said Katina Peterson, a partner at the international law firm Dorsey & Whitney in the Tax, Trusts and Estates department and co-chair of the Tax Controversy and Litigation practice group. “By denying a full credit for personal income taxes paid to other states, Maryland’s personal income tax regime subjects its residents to double taxation. It is taxing income that has already been fully taxed by another state. For Maryland and other states with similar regimes, this decision will cause impacted taxpayers to file claims for refund for prior tax periods that remain open under the statute of limitations. At least in Maryland, the refund claims are projected to be close to $200 million. The impact on revenues going forward will likewise be financially significant.”
"Today’s decision is important because it affirms that individuals and small businesses are entitled to the same constitutional protection against double taxation as corporations,” said Steven Roll, managing editor at Bloomberg BNA.
“For purposes of individual income taxes, states allow a credit for income earned and taxed in other states,” explained Roll. “At issue in Maryland is how this credit must be applied to its income tax, which is comprised of a portion representing state tax and a portion representing county tax. Maryland limits the application of the credit to the state tax portion of its individual income tax. As a result, the credit may not be claimed against the county tax portion its income tax.”
“From a state tax standpoint, the case highlights an important difference between the corporate income tax and individual income tax systems,” Roll said. “To avoid double taxation in corporate income tax systems, business entities allocate income to the state in which they are based and apportion income to the other jurisdictions in which they operate according to their level of business activity within the state. But there is no similar mechanism in place for pass-through entities such as S corporations, whose shareholders are subject to the individual income tax. Instead, owners of these types of businesses avoid double taxation by claiming each jurisdiction’s credit for taxes paid to other states,” he said. “The Court ruled that Maryland’s limited credit violated the Dormant Commerce Clause, which prohibits states from burdening interstate commerce by subjecting it to multiple taxation."
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