The Maryland Court of Appeals has ruled that the failure of Maryland law to allow a credit against county income tax for Maryland residents for their pass-through income from an S corporation's out-of-state activities that was taxed by another state was unconstitutional.1 The Comptroller had denied application of the credit with respect to the taxpayers' county-level tax liability, which according to the Court, tended to discourage taxpayer shareholders of S corporations from conducting business outside Maryland and discriminated against interstate commerce in violation of the dormant Commerce Clause.2
Background
The taxpayers, a married couple residing in Howard County, Maryland, held an ownership interest in a federal S corporation providing health care services on a nationwide basis. On both their 2006 federal and Maryland income tax returns, the taxpayers reported a portion of the income of the S corporation as "pass-through" income. On the Maryland return, the taxpayers claimed a credit against their individual income tax for taxes paid to other jurisdictions. The S corporation had filed state income tax in 39 different states and allocated to each shareholder a pro rata share of taxes paid.3 The Maryland Comptroller only allowed the taxpayers to apply the credit against their state taxes owed, disallowing the credit against local taxes owed and resulting in the issuance of an assessment against the taxpayers.4 The Hearings and Appeals Section of the Comptroller's Office subsequently affirmed the assessment and the taxpayers appealed to the Maryland Tax Court. Before the Tax Court, the taxpayers, for the first time, argued that the Comptroller's limitation of the credit (for tax payments made to other states) to the Maryland state-level tax, discriminated against interstate commerce in violation of the Commerce Clause of the U.S. Constitution. The Tax Court rejected the taxpayers' argument, ruling in favor of the Comptroller. The taxpayers subsequently sought judicial review in the Circuit Court for Howard County. After the circuit court reversed the Tax Court's decision, the Court of Appeals ultimately granted certiorari.
At issue before the Court of Appeals was whether the denial of the taxpayers' credit for out-of-state income taxes paid against their Maryland local tax (county tax) liability violated the Commerce Clause.
Dormant Commerce Clause Violated
Implication of Dormant Commerce Clause
The Court of Appeals determined that the denial of the credit for out-of-state income taxes paid, with respect to the taxpayers' county-level income tax liability, "implicated" the dormant Commerce Clause, which prohibits a state from unjustifiably discriminating against or unreasonably burdening interstate commerce. In particular, the limitation of the credit raised concerns over the variance in treatment of a Maryland resident taxpayer who earns substantial income from out-of-state activities versus a Maryland resident taxpayer who earns income entirely from in-state activities. Moreover, the Court stated that the dormant Commerce Clause restrains states not only at the state level, but also "through its subdivisions," i.e. counties.5 Further, the Court asserted that the dormant Commerce Clause analysis has broad application, and is not necessarily limited to the transfer of goods, or even interstate activity.6 Therefore, the county income tax at issue fell within the analysis. In coming to this conclusion, the Court rejected an argument by the Comptroller that the taxpayers were subject to the Maryland state and county taxes as residents and not due to their activities in intrastate or interstate commerce.
Violation of Dormant Commerce Clause
Having determined that the matter "implicated" the dormant Commerce Clause, the Court turned to the Complete Auto four-prong test to determine that the state did, in fact, violate the dormant Commerce Clause.7 Under this test, a state tax survives the dormant Commerce Clause challenge if it meets the following requirements: (1) applies to an activity with a substantial nexus with the taxing state; (2) is fairly apportioned; (3) is not discriminatory towards interstate or foreign commerce; and (4) is fairly related to the services provided by the state. As the taxpayers conceded that the substantial nexus and "fairly related" requirements were met, the Court was solely tasked with deciding whether the fair apportionment and non-discrimination requirements were also met.
With respect to the fairly apportioned requirement, each state may tax "only its fair share of an interstate transaction." The purpose of this requirement is to prevent multiple taxation of interstate commerce. While a particular income allocation formula for apportionment is not mandated, courts give weight to whether tax is "internally" and "externally" consistent,8 and an internally and externally consistent tax is more likely to withstand a dormant Commerce Clause challenge.
Since the imposition of a county tax, without a credit, by each and every state would result in a disadvantage to interstate commerce compared to intrastate commerce, the Court found that the Maryland county tax, as applied, failed the internal consistency test. To illustrate, the Court discussed an example of a Maryland resident with only in-state income versus a Maryland resident with multi-state income. Assuming that the state and countylevel taxes and credit mechanism in Maryland was applied to all states, the latter resident with multistate income owed a higher combined total amount of tax for state income tax purposes.
According to the Court, the failure of the internal consistency test does not always result in a finding that a tax is unconstitutional. One of the principal cases that found no Commerce Clause violation despite an internal inconsistency related to a state's action with respect to in-state activity.9 However, the issue at hand pertained to activity or business performed outside the state. In addition, though the Comptroller contended that under the dormant Commerce Clause analysis, the county tax should be regarded as separate and distinct from the state level tax, there was no case law before the Court that supported this contention.
The Court also concluded that the county tax without a credit was externally inconsistent. The relevant inquiry was whether a state, such as Maryland, taxed the value that was fairly attributable to economic activity within its borders. Due to the lack of a credit against the county tax for income that was earned outside the state, Maryland did not properly apportion the income that was subject to tax, and the potential for multiple taxation of the same income (by Maryland and the non-resident state) existed. This improper apportionment effectuated external inconsistency and the findings of both internal and external inconsistencies were indicative of a dormant Commerce Clause violation. The Court could have stopped its analysis at this point and concluded that the credit mechanism as applied to the county-level tax was unconstitutional. However, the Court also evaluated whether the county tax impermissibly discriminated against interstate commerce. According to the Court, the application of the county tax in question was analogous to an unconstitutional North Carolina tax that was imposed on the value of corporate stock owned by in-state residents where a higher rate applied to holdings in companies that conducted business outside North Carolina.10 Like the North Carolina tax, the Maryland county tax, as applied, resulted in a higher rate on value attributable to outof- state business. The S corporation's income earned through activities outside Maryland was taxed at a higher rate. Although the North Carolina discrimination was due to the state's own variance in rates and the discrimination in this case was due to the imposition of another jurisdiction's tax coupled with the refusal to provide a credit, both scenarios created discrimination.
The denial of the credit against the county tax also resulted in discrimination similar to the discrimination found when a Louisiana statute imposed a greater tax on goods manufactured outside Louisiana than on goods manufactured within the state.11 As was the case with the Louisiana statute, the denial of the credit created an incentive for taxpayers to perform their business activities within Maryland, discriminating against interstate commerce.
Thus, the application of the county tax, without a credit against the tax for pass-through income that arose from activities in another state, failed to satisfy the fair apportionment and non-discrimination requirements under the relevant Complete Auto test and as such, violated the dormant Commerce Clause.
The Court noted that the county tax itself or the credit itself was not unconstitutional, and should not be entirely rejected, as proposed by the taxpayers. Rather, it was the application of the tax without allowing the credit to the county tax that resulted in a constitutional violation. Therefore, the Court remanded the matter to the Tax Court for recalculation of the taxpayers' liability, taking into account the credit against the county tax owed.
Dissent
Two justices dissented from the Court's decision, arguing that Maryland's decision to apply a credit for taxes paid in other states to the taxpayers' state tax, but not their county tax, did not violate the dormant Commerce Clause. According to the dissent, nothing on the face of the Maryland statute imposing a county tax or the statute limiting credits for taxes paid in other states to state taxes discriminated against interstate commerce. The dissent concluded that the only distinction drawn between income earned in intrastate commerce and income earned in interstate commerce under these laws was that a benefit is provided to interstate commerce through the credit that is applied to state taxes.
Commentary
Although both the circuit court and the Court of Appeals found a constitutional violation in the application of the county tax, Maryland may very well appeal the decision to the U.S. Supreme Court. As it stands, Maryland resident taxpayers are permitted to claim the full credit for taxes paid to other states12 on their current Maryland income tax returns. Even though the case specifically concerned the pass-through income of an S corporation, the ruling in this case, if upheld, may also apply to Maryland owners of other types of pass through entities such as partnerships. Taxpayers who have not yet filed amended returns in response to the circuit court decision should do so now as the statute of limitations for refund claims runs three years from the date the original return was filed or two years from the date the tax was paid, whichever is later.13 We have been advised that the Comptroller is seeking a rehearing of this decision.
Footnotes
1 Maryland Comptroller v. Wynne, Maryland Court of Appeals, No. 107, Jan. 28, 2013.
2 Note that the Court did not hold that any particular statute was unconstitutional. As explained by the Court, "[w]hat is unconstitutional is the application or lack thereof of the credit to the county income tax." Notably, a credit had been available with respect to the county tax prior to 1975. Former MD. CODE ANN., TAX-GEN § § 10-703(a), repealed by Ch. 3, Laws of Maryland (1975).
3 The state returns did not indicate the payments of income taxes to particular local jurisdictions.
4 The Maryland income tax on individuals is composed of three parts: (i) a state income tax; (ii) a county income tax imposed on residents at a rate set by the county within the range allowed by the state; and (iii) a tax on those subject to state income tax but not the county tax (known as the special non-resident tax or SNRT) at a rate equal to the lowest county tax. MD. CODE ANN., TAXGEN § § 10-103, 10-105, 10-106, 10-106.1. Under the statutory authority, a county must impose an income tax that ranges from 1 percent to 3.2 percent of an individual's Maryland taxable income. MD. CODE ANN., TAX-GEN § 10-106. The highest county tax rates are imposed by Montgomery County and Prince Georges County, which are populous areas adjacent to Washington, D.C. In addition, the City of Baltimore imposes the 3.2 percent rate.
5 The Court cited Associated Industries v. Lohman, 511 U.S. 641, 650-51 (1994).
6 The analysis has been relevant to the movement of people across borders as well as intrastate activity that substantially affected intrastate commerce.
7 Complete Auto Transit v. Brady, 430 U.S. 274 (1977).
8 The Court cited Oklahoma Tax Comm'n v. Jefferson Lines, 514 U.S. 175, 185 (1995).
9 American Trucking Ass'ns, Inc. v. Michigan Pub. Serv. Comm'n, 545 U.S. 429 (2005).
10 The Court discussed Fulton Corp. v. Faulkner, 516 U.S. 325 (1996).
11 Halliburton Oil Well Co. v. Reily, 373 U.S. 64 (1963).
12 However, it is important to note that no credit is allowed for tax paid on wages earned in Pennsylvania, Virginia, West Virginia and Washington, D.C. due to Maryland's reciprocal tax agreements with these jurisdictions.
13 Administrative Release No. 20, Maryland Comptroller of the Treasury, Sept. 1, 2009.
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