In a highly anticipated decision, the U.S. Supreme Court has ruled that certain residents of Maryland are double-taxed on income earned in other states because the state doesn’t provide a full credit for the taxes paid on that income. Accordingly, the state’s tax structure violates interstate commerce law and was found to be unconstitutional.
The high court ruling could cost Maryland counties up to $200 million in tax refunds — and could dilute the coffers of other state and local jurisdictions around the country. Although the decision deals only with Maryland, it is creating questions about whether the way other states and localities tax their residents is legal.
The Supreme Court — which is often sharply divided — sided in favor of the plaintiffs by the narrowest of margins, 5 to 4. The majority opinion, written by Justice Samuel Anthony Alito, was accompanied by four dissenting opinions on various grounds.
As with most other states, Maryland raises much-needed revenue by imposing a personal income tax on its residents. In Maryland, the state income tax has two components:
A state income tax that is based on graduated tax rates (like the federal income tax rate structure); and
A county income tax, which varies from county to county, but is capped at 3.2 percent.
Despite the names that Maryland has assigned to these taxes, both the “state” income tax and the “county” income tax are treated as state income taxes. In addition, the state’s Comptroller of the Treasury collects both components of the state income tax.
Of course, it’s not unusual for residents of one state to earn income in other states, which have their own state income taxes. In this case, when Maryland residents pay income tax to another state for income earned while there, Maryland allows them a credit against the “state” tax, but not the “county” tax. As a result, part of the income earned by a Maryland resident outside of the state borders may effectively be taxed twice.
Maryland also taxes the income of nonresidents under a two-part system:
- Nonresidents must pay the “state” income tax on all the income that they earn from sources within Maryland.
- Nonresidents who aren’t subject to the county tax must pay a “special nonresident tax” in lieu of the “county” tax. The special nonresident tax is levied on income earned from sources within Maryland and the rate is equal to the lowest county income tax rate set by any Maryland county.
Facts of the New Decision
A married couple, who are Maryland residents, argued that the state law violated the Commerce Clause of the U.S. Constitution. In 2006, the husband owned stock in a health care services firm, operated as an S corporation, where the taxable income was passed through to the couple. The corporation earned income in states other than Maryland in 2006, so the couple had to pay state income tax on 39 returns in that year.
Maryland allowed the couple to claim a tax credit against their state income tax, but denied their claim for the offset against the county income tax that was reported on the same return. (The county tax was levied by Howard County.) This situation is common in Maryland for individuals holding stock in an S corporation or an interest in a partnership operating businesses in several states.
The Hearings and Appeals Section of the Maryland Comptroller’s Office slightly modified the assessment, but otherwise affirmed the initial ruling. The Maryland Tax Court also affirmed, but the Circuit Court for Howard County reversed on the ground that Maryland’s tax system violated the Commerce Clause. Then the Court of Appeals of Maryland affirmed. Eventually, the U.S. Supreme Court agreed to review the case.
Supreme Court Outcome
On May 18, 2015, the Supreme Court handed down its ruling in favor of the couple (affirming the Maryland Court of Appeals). In doing so, it determined that Maryland’s failure to allow a credit for taxes paid to other states against the county tax component, in addition to the credit against the state tax component, discriminates against interstate commerce in violation of the “dormant” Commerce Clause.
Under the Commerce Clause, Congress has the power to “regulate Commerce . . . among the several States.” Although the Clause is characterized as a positive power that’s been granted to Congress, the Supreme Court has consistently held that the language contains an additional negative feature called the dormant Commerce Clause. This provision, which prohibits certain types of state taxation even if Congress hasn’t legislated on the issue, is the one the Supreme Court said Maryland violated.
Justice Alito also applied an “internal consistency test” to determine that Maryland’s tax rate structure discriminates against interstate commerce by taxing its residents on all of their income without allowing a credit for taxes paid to other states while nonresidents are taxed on income earned in Maryland. Notably, the Court didn’t offer any specific options to Maryland for curing the constitutional defect in this type of tax scheme. (Comptroller of the State of Maryland v. Wynne, S. Ct. No. 13-485)
In their dissenting opinions, Justices Antonin Scalia and Clarence Thomas reiterated their previous contentions on record that the so-called dormant Commerce Clause is nonexistent. In addition, they dismissed use of the internal consistency test, which the two justices believe was eliminated by a prior decision.
What Happens Next?
This controversial Supreme Court decision is likely to start a scramble by Maryland taxpayers seeking refunds based on taxes paid to other states. To claim a refund, however, the statute of limitations for the tax year in question must still be open. In addition, residents of certain other jurisdictions could be affected (see right-hand box). Seek professional tax guidance when appropriate.
Where Else Is Double Tax a Problem?
The impact of the new Supreme Court case will clearly be felt in Maryland. But what about other locations throughout the country where residents are being double-taxed? The issue may be more prevalent than you think.
Tax professionals are examining laws in various jurisdictions to see how the Supreme Court decision may affect them. It’s too early to say exactly which areas will be affected by the decision, but tax codes may be amended and refunds may be issued. Other states are also now unlikely to try to tax income as Maryland did.
In a brief filed with the Supreme Court, the International Municipal Lawyers Association cited these states that allow only a partial credit for taxes paid to outside jurisdictions: North Carolina, Tennessee and Wisconsin. The association also cited the following cities that may be affected: Cleveland, Detroit, Kansas City, St. Louis and Wilmington, Delaware, as well as counties in Indiana.
Legal groups say other jurisdictions that may feel the impact are Ohio, Pennsylvania and the city of New York.
Court: Individuals Should Be Treated the Same as Corporations
In its decision, the Supreme Court noted that it has long held that “states cannot subject corporate income to tax schemes similar to Maryland’s.” It added that “we see no reason why income earned by individuals should be treated less favorably.”
Maryland argued that individuals reap the benefits of local roads, police and fire protection, public schools and health benefits more than corporations do.
The argument fails, the Court responded, because corporations also benefit from state and local services.
For example, corporation trucks hauling supplies and goods use local roads. Corporations call on local police and fire departments to protect their facilities and rely on schools to educate prospective employees. Government services and the availability of good schools may aid businesses in attracting and retaining employees.
Therefore, the Court stated, “disparate treatment of corporate and personal income cannot be justified based on the state services enjoyed by these two groups of taxpayers.”
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