The White House and Republican congressional leadership released an outline this week to guide forthcoming legislation on federal tax reform. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This memorandum outlines some of the key areas—individual taxation, general business taxation and international taxation— with which the states will be concerned as details continue to unfold.
The Supreme Court granted the petition for certiorari filed by the Maryland Comptroller of Treasury in Comptroller v. Wynne, Dkt. No. 13-485 (U.S. Sup. Ct., cert. granted May 27, 2014). The central issue in Wynne is whether a state must allow its residents a credit for income taxes paid to other states, in a manner sufficient to prevent double taxation of income from interstate commerce, to avoid violating the fair apportionment and discrimination prongs of the dormant Commerce Clause.
Like most states, Maryland taxes its residents on their entire income, wherever earned, and permits a credit for income tax paid to other states, limited to the amount of Maryland tax on the income taxed by other states. But Maryland’s income tax includes both a state and a county tax component, and Maryland permitted a credit for taxes paid to other states only with respect to its state income tax. The state rate was 4.75 percent and the county tax rate applicable to the Wynnes was 3.2 percent (which could vary by county). The county tax was imposed and administered by the state on the same tax base as the state income tax, and residents file a single return that reflects both state and county income taxes. Thus, Maryland provided a credit only against the Maryland state income tax, but not the substantial county income tax, on the income taxed by other states, resulting in a form of double taxation of that income (i.e., by the other state and by the Maryland county).
The Wynnes reported substantial income on their 2006 individual return from business activities in interstate commerce. They owned 2.4 percent of an S corporation doing business in 39 states, and paid income tax to most of those states on the income that flowed through to their individual return. The Wynnes reported $2.7 million of income and $126,636 of Maryland state income tax (not including the county income tax portion) prior to credits, and claimed a credit of $84,550 for taxes paid to other states. The Maryland Comptroller permitted the Wynnes to claim a credit against the state income tax, but not the county portion of the income tax, for taxes paid to other states. Maryland’s highest court, the Court of Appeals, agreed with the Wynnes that they suffered double taxation of the income in violation of the dormant Commerce Clause doctrine that taxation of multistate business requires fair apportionment and no discrimination against interstate commerce, citing Complete Auto Transit v. Brady, 430 U.S. 274 (1977) and other Supreme Court cases.
In its petition for certiorari, the Maryland Comptroller relied upon settled Due Process doctrine that states have plenary power to tax all of the income of their residents. The Comptroller’s petition essentially ignored the Commerce Clause issues raised by the Maryland Court of Appeals.
The U.S. solicitor general filed an amicus curiae brief supporting the Maryland Comptroller’s position, recognizing the different standards imposed by the Due Process Clause and the Commerce Clause but nonetheless contending that the longstanding Due Process Clause precedents permit states to tax all of the income of their residents without regard to the Commerce Clause. The solicitor general’s support likely was a significant factor in the Supreme Court’s decision to grant the Maryland Comptroller’s petition.
Comptroller v. Wynne is an important case because growing numbers of large multistate businesses are conducted in pass-through entity form as S corporations, partnerships or limited liability companies, and the income from these enterprises often is reported on individual tax returns. Despite the substantial precedent supporting a state’s right to tax all of the income of resident individuals without a credit for taxes paid to other states, this Due Process doctrine collides with Commerce Clause principles that prevent undue burdens on interstate commerce when applied to income that resident individuals receive as pass-through income from entities clearly engaged in interstate commerce. A decision in favor of the Maryland Comptroller has the potential to validate double taxation by states of their residents on income earned in interstate commerce, while a ruling for the taxpayers has the potential to cost state and local governments tens of millions of dollars per year.
The Wynne case may raise other significant Due Process and Commerce Clause issues, including whether any distinction should be drawn between double taxation attributable to county rather than state level income taxes and whether a substantial but imperfect credit for taxes paid to other states can satisfy the Commerce Clause doctrines. The final decision may have far reaching implications for taxation of individuals, trusts and other taxpayers that traditionally have been protected by Due Process limits on state taxation, but whose protection by the Commerce Clause has been uncertain.