Howard County Circuit Court Rules that Out-of-State Tax Credit Mechanism Violates the Constitution

A recent ruling by the Howard County Circuit Court, on an appeal from the Maryland Tax Court, offers the possibility of potential refund claims for Maryland residents.

An Overview of the Tax Credit Mechanism

Maryland residents are entitled to take a credit for taxes paid to other jurisdictions as a result of their business activities. Typical activities that would give rise to such a credit for a Maryland resident would include extensive travelling as an employee to jurisdictions that do not have a reciprocal withholding agreement with Maryland, as well as the ownership of an interest in a pass-through entity, such as an S corporation, a limited partnership, or an LLC that does business in multiple jurisdictions.

The Maryland personal income tax is graduated, with 2011 marginal rates starting at 2 percent at the lowest income levels and increasing to a rate of 6.25 percent for incomes exceeding $1 million. Maryland’s 23 counties and Baltimore City impose an additional income tax at a flat rate varying by county but which ranges from 1.25 percent to 3.2 percent.

Maryland residents who pay income taxes to other jurisdictions are entitled to a credit for tax paid to other jurisdictions. This credit is subject to some limitations and may not exceed the amount of the state tax paid in a given year. So, for example, if a Montgomery County resident calculates an initial tax liability of $10,000 in state taxes and $5,000 in county taxes, while incurring $25,000 in taxes paid to other jurisdictions, the taxpayer, according to the Comptroller, was entitled to a credit for $10,000, but would still owe the $5,000 in county taxes. The Comptroller’s theory was that the statutory language of the credit only applied to the state portion and not the county portion.

The taxpayers in Wynne v. Comptroller, (Howard County Circuit Court, Case Number 13-C-10-80987) (June 29, 2011) took issue with this approach, contending that they should be allowed a credit for taxes paid to other jurisdictions that extends to the county portion of their income tax. The Howard County Circuit Court agreed, and concluded that the Comptroller’s refusal to extend this credit violated the dormant Commerce Clause of the United States Constitution.


The Circuit Court undertook an exhaustive 80-page analysis in reaching its conclusion. While a thorough review of this decision is beyond the scope of this article, it should be noted, however, that the Circuit Court did make some interesting comments on the Tax Court’s decision, which have been highlighted herein

In its decision, the Tax Court indicated that it had heard several cases, including Comptroller v. Blanton,1 that analyzed the Constitutional ramifications of the tax credit mechanism and had determined that the mechanism itself was not unconstitutional. The Circuit Court disagreed and said that the Tax Court decided Blanton based upon statutory interpretation (principally that the county-level tax was not a "state income tax" and therefore not subject to the credit pursuant to the plain language of the statute) and did not pass judgment on the constitutionality of the tax credit mechanism. Interestingly, the Circuit Court did note that in a 2009 decision, Frey v. Comptroller,2 the Court of Special Appeals reached the conclusion that the county tax was the equivalent of a state tax because it was imposed by the state.

The Circuit Court also summarily dismissed the Comptroller’s claim that the credit mechanism in the instant case did not implicate interstate commerce, under the theory that the dividend income received from the S corporation did not involve interstate commerce. The Circuit Court relied on the Frey decision to dismiss this claim, noting that the S corporation owned by the shareholders did an interstate business. It also dismissed the notion that income received from the pass-through S corporation was passive, noting that both for federal and state income tax purposes, income received by a pass-through corporation retains the same characteristics in the hands of the shareholders as it does when received by the S corporation. The Circuit Court further noted that, even if the income were considered passive, it would not be dispositive as to whether the income was received as a result of interstate commerce.

The Circuit Court also undertook a thorough analysis of the scheme under the four-prong test for Commerce Clause constitutionality under the Supreme Court’s decision in Complete Auto Transit v. Brady.3 These prongs generally require that a tax, to be sustained under the Commerce Clause, must be imposed only on a taxpayer with substantial nexus to the taxing jurisdiction, that the tax not discriminate unfairly against interstate commerce, the tax be applied consistently, and that the tax imposed bear a fair relationship to the services provided by the state.

Of these four prongs, it is clear that the taxpayers, residents of Howard County, have tax nexus with both Maryland and the county. The most interesting analysis is under the fair apportionment prong. Jurisprudence4 has developed a two-fold analysis under this prong – the tax imposed must be both internally and externally consistent. Under the internal consistency test, a hypothetical is posed whereby every state imposes a tax system similar to Maryland’s. Under this hypothetical, the analysis seeks to determine whether a resident taxpayer doing business solely in Maryland would pay substantially less tax than a similarly situated resident taxpayer whose entire business was outside of Maryland.

This analysis clearly indicates that the latter taxpayer, the one whose business operates solely outside of Maryland, would pay more tax than the taxpayer with a wholly intrastate business. Under this approach, each taxpayer’s Maryland base liability would be the same. However, since the taxpayer whose business is entirely outside of Maryland would likewise be subject to similar taxes in the state(s) where it does business outside of Maryland (including some degree of county-level tax), he or she ends up paying more tax than the intrastate taxpayer, since his or her liability would exceed the state portion but would not be creditable against the county portion of his tax bill. As a result, the tax credit mechanism fails the internal consistency test.

The Circuit Court likewise concluded that the tax violated the principle of external consistency because it fails to provide a credit for fairly apportioned taxes paid to other states at the county level. Likewise, the Circuit Court determined that the tax credit as applied by the Comptroller unfairly discriminated against interstate commerce by providing a significant preference for intrastate commerce as opposed to interstate commerce. It finally noted that, as a matter of policy, the failure to provide such a county-level credit would provide a significant economic incentive to leave the state.

Pepper Perspective

The Circuit Court’s opinion provides an analysis of the internal consistency of the tax credit mechanism that is directly on-point and consistent with recent cases in other states that have determined that their statutes violate the internal consistency requirement, including the cases involving LLC fees in California and the franchise tax (since repealed and replaced by the margins tax) in Texas. It is likely that this case will be appealed by the Comptroller; while it is always difficult to project what will happen in an appeal, it seems that the reasoning of the Howard County Circuit Court is solid and likely to withstand appellate scrutiny. Those taxpayers who are partners in partnerships as well as shareholders in S corporations who are taxable in other jurisdictions, especially in high-tax jurisdictions like New York, New Jersey, Massachusetts and California, would be well advised to review their tax returns for those years that remain open under the statute of limitations and consider filing protective refund claims with the Comptroller in order to preserve their rights to refunds.