U.S. Supreme Court Holds Maryland Personal Income Tax Unconstitutional Under Commerce Clause

In Comptroller of the Treasury of Maryland v. Wynne, Dkt. No. 13-485 (U.S. May 18, 2015), the U.S. Supreme Court found that Maryland’s system of personal income taxation violated the nondiscrimination prong of the dormant Commerce Clause. The Court concluded that the system did not grant a resident credit for Maryland county income tax paid on income earned and taxed in another state.

The state’s personal income tax scheme is composed of several elements: (1) a state tax imposed on all income of Maryland residents and the income of nonresidents from sources within Maryland, (2) a county tax (collected by the state) imposed on all income of state residents, and (3) a special nonresident state tax imposed on the income of nonresidents from sources within Maryland, which tax is said to be in lieu of the county tax and is imposed at a rate equal to the highest county tax within the state. Maryland provides a credit to its residents against their state tax liability for taxes paid to other states on the same income. Maryland does not provide a credit to residents against their county tax for taxes paid to other states on the same income. The Wynnes were state residents and subject to tax in 39 other states because they owned an S corporation that did business in the other states. While the Wynnes were able to take a credit against their Maryland state tax for the taxes paid to other states on the S corporation income, they were not permitted a credit against the Maryland county tax for taxes paid to other states on the S corporation income.

The Court confirmed that the dormant Commerce Clause applies to net income taxes the same as to gross receipts taxes and to individuals the same as to corporations. The Court then held that Maryland’s personal income tax system was not internally consistent under the Commerce Clause and therefore unconstitutionally discriminatory. According to the Court, if every state imposed their personal income tax in the same way as Maryland, an individual who lived in one state and worked in another would always be subject to a higher tax burden than an individual who lived and worked in the same state. The taxing scheme gave preferential treatment to purely intrastate activities versus interstate activities. For example, assume Mary lives in State A and works in State B, while John lives and works in State A. State A and State B impose the same personal income tax, as follows, and do not provide a credit for taxes paid to other states: 1.25 percent on the income of residents from all sources and a 1.25 percent tax on income of nonresidents earned in the state. Mary would have to pay tax at the rate of 2.5 percent of her income – 1.25 percent to State A and 1.25 percent to State B. Meanwhile, John would only have to pay tax at the rate of 1.25 percent, all to State A. Therefore, Mary would be subject to a higher tax burden solely as a result of her interstate activity, thus providing preferential treatment to wholly intrastate activity.

The Court did not hold that a state must always allow their residents a credit against taxes paid to other states. The majority implies (and the dissent outright states) that Maryland could remedy the discrimination in one of two ways: (1) allow a credit against the county tax for taxes paid by residents to other states or (2) eliminate Maryland’s special nonresident state tax imposed in lieu of the county tax. In either instance, the lack of internal consistency should be eliminated, as an individual living in one state and working in another should no longer be subject to a higher tax burden than an individual living and working in the same state. Looking to the example above, if a credit is allowed for taxes paid to other states, both Mary and John will pay tax at the rate of 1.25 percent. Mary would pay 1.25 percent to State B and owe nothing to State A after getting a credit in State A for the taxes paid to State B. John would pay 1.25 percent to State A. Conversely, if all of the states eliminate their tax on nonresidents, both Mary and John will pay tax at the rate of 1.25 percent – all to State A. Either way, the tax in both states are now internally consistent.

The majority appears to have relied on Moorman Manufacturing Company v. Bair, 437 U.S. 267 (1978), in implying that revising Maryland’s tax by simply eliminating the special nonresident state tax, while still allowing for the possibility of double taxation of the same income of an individual, would not result in unconstitutional discrimination under the external consistency test of the Commerce Clause, because a tax is not externally inconsistent where the possibility of multiple taxation is caused by the interplay of two states’ disparate, but constitutional, taxing systems. Again looking to the above example, assume State A eliminates its tax on nonresidents, while State B continues to tax nonresidents, but provides for a credit to residents for taxes paid to other states. State A’s tax is internally consistent, since if all states imposed their tax in the same manner as State A, Mary and John would both pay tax at the rate of 1.25 percent of their income. State B’s tax is also internally consistent, since if all states imposed their tax in the same manner as State B, Mary and John would both pay tax at the rate of 1.25 percent of their income. However, in actuality, State A and State B do not impose tax in the same manner, and thus, Mary will be subject to tax at the rate of 2.5 percent of her income, while John will pay tax at the rate of only 1.25 percent of his income. While Mary is in fact subject to double taxation, neither State A nor State B’s tax scheme should be found to be unconstitutional, because (1) both State A and State B’s taxes are internally consistent and (2) neither State A nor State B is taxing any more than what it is entitled to given Mary and John’s connection to the state (i.e., they are both externally consistent). The double taxation of Mary’s income is not caused by State A’s tax alone nor State B’s tax alone, it is caused by the interplay of the two disparate, but still constitutional, taxes.

Locally, the taxes affected by the Wynne decision include: (1) the Pennsylvania Personal Income Tax, which effective for tax years 2014 and forward, was amended to remove the resident credit for taxes paid to foreign countries on income also subject to Pennsylvania PIT; and (2) the Philadelphia Wage Tax and Net Profits Tax, both of which are imposed on residents and non-residents and which do not provide a resident credit for taxes paid to states other than Pennsylvania on income that is also subject to tax in Philadelphia.