Sometimes, the most difficult part of drafting a blog post is conjuring up a title.  This post deals with a case involving state income tax credits that was argued before the United States Supreme Court on November 12, 2014 and that will be decided by the end of the Court’s term in June 2015.  If I’d titled this post “Supreme Court to Decide Unique and Important Dormant Commerce Clause Issue,” you never would have read this post.  Enticing you to read this post took something big, like a play on the “Winning!” quote made famous by Charlie Sheen during his 2011 unraveling (you’ll see the connection momentarily).  Now that you’ve made it this far, why not stay for a discussion of a case that is of interest to any city, county, or other state political subdivision that both levies an income tax and issues bonds?

Comptroller of the Treasury of Maryland v. Wynne (connection revealed!) involves a unique issue – does the Commerce Clause of the United States Constitution mandate that a state or its political subdivisions grant an income tax credit to residents for taxes paid to other states (or political subdivisions of those states) on income that was earned in those other states?  Put another way, does the Commerce Clause limit the ability of a state or its political subdivisions to tax all the income, wherever earned, of the state’s or political subdivision’s residents?

The Wynne Case

Wynne deals with income earned in 2006 by a married couple that resided in Howard County, Maryland.  The Wynnes owned stock in a corporation that was treated as an S corporation for federal income tax purposes.  An S corporation is generally not subject to federal income tax; instead, the shareholders are subject to federal income tax on their respective distributive shares of the S corporation’s income.  Maryland follows the federal income tax treatment of S corporations both for purposes of the Maryland state income tax and the income tax imposed by Maryland counties.  Thus, the Wynnes were subject to Maryland state and county income tax on their roughly $2,667,000 share of the net income earned by the S corporation in 2006.

Much of the S corporation’s net income, however, was earned in states other than Maryland.  The S corporation filed income tax returns on behalf of its shareholders in 39 states for 2006 and allocated to each of its shareholders not only a pro rata portion of the S corporation’s net income, but also each shareholder’s applicable portion of the state income taxes that the S corporation had paid.  In preparing their Maryland state and county income tax returns for 2006, the Wynnes claimed an income tax credit of $84,550 for the income taxes paid to other states in respect of the S corporation’s net income.  Maryland denied the credit claimed for the Maryland county income tax.  Although Maryland grants an income tax credit for state income tax purposes for income taxes paid by residents to other states on income that was earned in those other states, Maryland does not grant such a credit for purposes of the Maryland county income tax.

The Maryland Court of Appeals, the highest court in Maryland, sustained the Wynnes’ position (pdf) that although the Due Process Clause of the United States Constitution allows a state to tax a resident’s entire income, regardless of where earned, the Commerce Clause requires a state (or political subdivision of the state) to grant an income tax credit for taxes paid to other states.  The Court of Appeals reasoned that if the state (or political subdivision) of residence does not grant such an income tax credit, the multistate tax liability borne on the income earned in other states will exceed the income tax liability on income earned by the resident in the state of residence.  The greater tax liability on interstate income is a disincentive to earning such income and, in the view of the Maryland Court of Appeals, results in discrimination against interstate commerce in violation of the Commerce Clause.

This holding is a novel application of the dormant Commerce Clause.  The United States Supreme Court stated in Granholm v. Heald, 544 U.S. 460, 472 (2005), that “time and again this Court has held that, in all but the narrowest circumstances, state laws violate the Commerce Clause if they mandate ‘different treatment of in-state and out-of-state economic interests that benefits the former and burdens the latter.’”  The Supreme Court has adhered to this principal in holding that state tax structures discriminate against interstate commerce in violation of the dormant Commerce Clause where the state levies a tax on interstate transactions that does not apply to in-state transactions (or uses a greater tax base for interstate transactions than for in-state transactions), imposes a higher tax rate on interstate activities than on in-state activities, or denies of a tax benefit to interstate activities that is available to in-state activities.  None of this is present in Wynne.  Maryland is taxing the in-state and interstate income of its county residents at the same rate; it is simply not granting an income tax credit to its residents for county income tax purposes.  Thus, the purported discrimination against interstate commerce here results from the combination of Maryland county income tax and the income taxes of other states being imposed on the same income.  Wynne therefore raises a fundamental question of state sovereignty – does the dormant Commerce Clause require the state (or political subdivision) of residence to yield to the taxation of other states when levying an income tax on its residents?

The Stakes Involved                 

As detailed in a 2011 report by the Tax Foundation, nearly 5,000 state political subdivisions, such as cities, counties, and school districts, in 17 states levy an income tax, with these local income taxes extending to over 23,000,000 people.  Although each state that imposes an income tax assesses it on all the income, wherever earned, of its residents, each such state allows its residents to claim an income tax credit for income taxes paid to other states on income earned in those other states.  Income taxes imposed by political subdivisions of states often do not, however, have this feature.  In addition to the absence of this credit for purposes of the Maryland county income tax, New York City does not grant such a credit for purposes of its income tax, and virtually none of the more than 700 municipalities and school districts in Ohio that charge an income tax allow a credit for taxes paid to other states (although virtually all Ohio municipalities that impose an income tax grant a full or partial credit for income taxes paid to other municipal corporations, regardless of whether the other municipal corporation is in Ohio).

Consequently, if the United States Supreme Court sustains the Maryland Court of Appeals, these political subdivisions will be required to provide a full income tax credit to their residents for income taxes paid to other states (or the political subdivisions of other states).  Such a decision would reduce the income tax receipts of these various state political subdivisions and could make it more difficult for these subdivisions to service their outstanding and future debt obligations.

A Prediction of the Outcome

It’s always dangerous business to predict the outcome of a Supreme Court case, but, like Austin Powers, I like to live dangerously, particularly when there is no real cost to doing so.  The oral arguments in Wynne (pdf) do not give many clues as to how the case will be decided, but there is enough in the oral arguments, along with past opinions by two justices, to make a prediction.

The oral arguments revealed clear hostility by Chief Justice Roberts and Justice Alito towards Maryland’s position (Alito went so far as to embrace the position of an amicus brief filed by various economists in asking why the Maryland county income tax structure should not meet the same fate as a tariff).  The oral arguments also revealed concern, especially on the part of Justices Ginsburg, Kagan, and Sotomayor, with the “free rider” problem created by upholding the Maryland Court of Appeals.  If the Supreme Court sustains the Maryland Court of Appeals, Maryland county residents like the Wynnes, who earn almost all of the their income outside Maryland, will be able to enjoy the benefits of governmental services provided by Maryland counties without having to pay for them.

The two Justices to watch in this case are Justices Scalia and Thomas.  Both Justice Scalia (pdf) and Justice Thomas (pdf) find the dormant Commerce Clause to be of dubious merit but, in adherence to stare decisis, at least Justice Scalia has followed the application of dormant Commerce Clause decisions that were squarely on point with the case at issue.  As discussed above, however, the Wynne case raises a unique question under the Commerce Clause, and the Supreme Court’s past Commerce Clause decisions are not on point with the facts of, and the question raised by, the Wynne case.  It was clear from the oral arguments that Justice Scalia took issue with the Wynnes’ position that the dormant Commerce Clause requires the grant of a credit for purposes of the Maryland county income tax (Justice Thomas observed his usual silence during oral arguments).  Assuming the free rider problem that concerned Justices Ginsburg, Kagan, and Sotomayor causes them to vote against the Maryland Court of Appeals, Justices Scalia and Thomas will have the opportunity to prevent the extension of the dormant Commerce Clause whose very existence they question.  Accordingly, my prediction is that the Supreme Court will reverse the Maryland of Court of Appeals.  If I’m wrong, it’s not a total loss – we then should at least have the opportunity to read one of the sharply worded dissenting opinions for which Justice Scalia is renowned.