In an important ruling for taxpayers with out-of-state income, the Maryland high court held Monday that Maryland’s refusal to fully credit income taxes paid to other states violates the U.S. Constitution’s dormant Commerce Clause. Hogan Lovells partner Christopher Handman represented the successful taxpayers in Maryland State Comptroller of the Treasury v. Wynne, with assistance from associates Dominic Perella and Sean Marotta.   

Background

Anytime a taxpayer earns income in multiple states, he runs the risk of being taxed twice on the same income. The state where the taxpayer earns the income typically asserts a right to tax the income earned within the state. The state where the taxpayer lives, meanwhile, typically asserts a right to tax all of the taxpayer’s income, no matter where it is earned. That can lead to double taxation of the income earned out of state. 

Most states solve the double-taxation problem by giving resident taxpayers a credit for taxes they pay in other states on income earned there. Maryland, however, does not offer a full credit. It divides its income tax into two parts – denominated the “state” portion of the tax and the “county” portion – and it gives taxpayers with out-of-state income credits only against the “state” portion. The “county” portion stands as a separate income tax against which taxpayers with out-of-state income receive no credits. If they earn money across state lines, they are taxed twice on it.

The decision

The U.S. Supreme Court has held in other contexts that double taxation can violate the dormant Commerce Clause, which limits how states may burden interstate economic activity. The Maryland Court of Appeals’ decision in Wynne applies that principle to the state’s refusal to grant a full credit for out-of-state income.

Plaintiff Brian Wynne owns shares in a Subchapter-S corporation, a “pass-through” entity that passes corporate income through to its shareholders so that they are treated as if they earned the income themselves wherever the corporation does business. Due to his stake in the corporation, Wynne earned income in a number of states. Maryland refused to grant him a full credit for that out-of-state income, and Wynne and his wife brought suit. They argued that they faced a higher income tax bill than similarly-situated residents who earned all of their income in Maryland, that that higher tax bill discourages interstate economic activity, and that Maryland’s failure to offer a full credit violated the dormant Commerce Clause. The trial court agreed. The Maryland Court of Appeals has now affirmed in a 5-2 decision. 

The Court first rejected the State’s argument that its tax did not implicate the Commerce Clause because it was not a tax directly on interstate commerce. Because the tax scheme forces taxpayers with interstate income to pay higher taxes, the Court explained, it “may affect the interstate market for capital and business investment and, accordingly, implicate the dormant Commerce Clause.” The Court then applied the U.S. Supreme Court’s dormant Commerce Clause precedents and found that Maryland’s failure to provide a full credit was unconstitutional in three respects. First, Maryland’s system acts as an “extra tax on interstate income-earning activities” because if every state used the system, taxpayers with out-of-state pass-through income would be taxed at a higher rate than those with only in-state pass-through income. Second, the Court looked at the Maryland system as it actually interacted with other states’ tax codes and found that the Wynnes were, in fact, being taxed twice on the same income. Finally, the Court held, Maryland’s system discriminates against pass-through entities that engaged in economic activity across state lines. That created an incentive to invest in companies that conduct business inside Maryland rather than outside of it — exactly the type of incentive the dormant Commerce Clause forbids.

In the end, the Court concluded that “the failure of the Maryland income tax law to allow a credit . . . with respect to pass-through income of an S corporation that arises from activities in another state and that is taxed in that state violates the dormant Commerce Clause.” It ordered the State to credit the Wynnes for the taxes they paid on pass-through income earned and taxed in other states.

Impact

Although the Court’s opinion came in the context of pass-through income from Subchapter-S corporations, its reasoning should apply to all forms of out-of-state pass-through income earned by Maryland residents. Thus, Maryland residents with out-of-state pass-through income from limited liability companies and partnerships may see their overall tax bill decline as a result of the decision. It remains to be seen whether the Court’s opinion will influence areas other than the taxation of pass-through income.