As we approach the final income tax filing deadline of 2016, this is a reminder that income can often be earned in one jurisdiction but subject to tax in another. States often adopt credit regimes so that residents can get a credit for income tax paid to another state, but sometimes they don’t. The Supreme Court this past May held that state tax systems that lead to double taxation of interstate commerce are unconstitutional, which is good news for individuals paying tax in multiple states.
Following a Supreme Court decision in May, states will be reviewing their taxing provisions to ensure they don’t unconstitutionally impede interstate commerce. The good news for taxpayers is that the Supreme Court reemphasized that state taxes cannot operate in a manner that leads to intentional double taxation of the same income.
At issue in Comptroller of the Treasury of Maryland v. Wynne was Maryland’s tax framework that allowed state residents to credit taxes paid to other jurisdictions against state tax, but not against an additional mandatory county tax also imposed and collected by the state. The Wynnes, who were Maryland residents, received income from passthrough entities that paid taxes in a large number of states. Although they were allowed to claim a credit for their portion of the out-of-state taxes paid against their Maryland state tax, the state did not allow the same credits against their out-of-state county tax liability. The Wynnes sued, and although a lower court dismissed their claim, Maryland’s highest state court agreed that the state tax structure violated the U.S. Constitution. The state appealed and the U.S. Supreme Court granted review of the case.
On May 18, 2015, a divided Supreme Court held that Maryland’s tax scheme regarding applicability of credits against out-of-state taxes paid violated the dormant Commerce Clause. A majority of the Court’s justices found that prior caselaw established that a state is not justified in utilizing a tax system that treats in-state income more favorably than income arising from outside the state. The resulting tax burden violates the constitutional prohibition against states discriminating against interstate commerce, the Court held.
It is quite common for taxpayers these days to receive income from passthrough entities (such as partnerships or S corporations) that do business nationally or in large geographic markets that encompass many states. Consequently, it is likely that taxpayers may be paying taxes in states other than where they reside. Under the Court’s analysis of the federal constitution, a state cannot refuse to credit taxes paid out-of-state on income that the state is also taxing based on the taxpayer’s residency. Although the Supreme Court affirmed that a state has broad jurisdiction to tax the income of its residents, that taxing power cannot lead to certain income being unfairly taxed multiple times simply because of where the taxpayer lives.
Going forward, taxpayers should work closely with their tax advisers to ensure that all state tax reporting adequately makes use of all available credits from taxes paid in other states. To the extent that a state tax structure is viewed as unfairly punitive, close scrutiny should be applied to determine if the system violates the principles enunciated in Wynne.