Randy Gardner, J.D., LL.M., CFP®, CPA, is a professor of tax and estate planning at the University of Missouri and a practicing attorney with more than 30 years of experience. He is also co-author of 101 Tax Saving Ideas and co-founder of OnlineEstatePlanning.com.
Leslie Daff, J.D., is a state bar certified specialist in estate planning, trust, and probate law, and the founder of Estate Plan Inc.
In its Comptroller of the Treasury of Maryland v. Wynne decision in May, the U.S. Supreme Court held that the taxation of the same income by two or more political subdivisions violates the commerce clause of the U.S. Constitution. This offers a significant opportunity for affected taxpayers to claim tax refunds from their resident states, cities, or counties.
In the Wynne case, Brian and Karen Wynne were Maryland residents who were shareholders in an S Corporation that operated in 39 states and passed income through to the couple’s individual return. Their income was taxed in multiple states (including Maryland) and Howard County, the Maryland county where the Wynnes resided. The Wynnes claimed a resident state income tax credit in Maryland for the taxes paid to the multiple nonresident states, but at the county level, the claim for the resident credit was denied, resulting in double taxation of the earnings.
Although the Maryland state comptroller of the treasury tribunal and the Maryland tax court denied the Wynnes’ claim for a refund, the circuit court for Howard County and the Maryland Court of Appeals sided with the taxpayers. The U.S. Supreme Court affirmed the Maryland Court of Appeals’ decision, holding the Maryland income tax process violated the commerce clause for two reasons. First, the Maryland tax process failed the “internal consistency” test because if every state adopted Maryland’s tax scheme, interstate commerce would be taxed at a higher rate than intrastate commerce. Second, the tax failed the “external consistency” test because it created a risk of multiple taxation.
Examples of Refund Opportunities
The Supreme Court’s ruling opens the door to refund claims across the country, because cities and counties rarely allow credits for taxes paid to nonresident jurisdictions where a resident’s income is taxed, and resident states rarely allow credits for taxes paid to nonresident cities and counties.
Refunds for all open tax years (generally 2014, 2013, and 2012) are available. Those who extended their 2011 returns may have until October 15, 2015 to amend their 2011 returns.
Example 1: John is a resident of a city that imposes an earnings tax. He earned $200,000 in 2014; $150,000 from his resident state and city and $50,000 from work in a nonresident state to which he paid income tax of $2,500 (5 percent tax rate on $50,000). John’s total income tax in his resident state was $9,500 (6 percent of $200,000 minus the $2,500 credit for taxes paid to the nonresident state). John also paid his resident city’s earnings tax of $2,000 (1 percent tax rate on $200,000). John is allowed to claim a credit against the city tax for the taxes paid to the nonresident state. The amount of the credit is $500 (the lesser of the $500 owed to the city on the portion earned out of state, or the full $2,500 paid to the nonresident state). These are effectively the facts of the Wynne case.
Although the next example does not reflect the specific facts of the Wynne case, the court’s logic suggests this interpretation and the resulting tax credit is warranted.
Example 2: Mary lives in her resident state, but she works in a nonresident city that imposes an earnings tax in the nonresident state. She earned $200,000 in 2014; $150,000 from her resident state and $50,000 from work in the nonresident state to which she paid income tax of $2,500 (5 percent of $50,000). She also paid the nonresident city’s earnings tax of $500 (1 percent of $50,000). Mary’s total tax in her resident state was $9,500 (6 percent of $200,000 minus the $2,500 credit for taxes paid to the nonresident state). Under the Wynne decision, Mary is entitled to a credit from her resident state of $500 (the $500 owed to the city on the earnings from there). Without the credit, Mary is being double-taxed on the income earned from the city.
The big winners from the Wynne decision are the professional athletes and performers who earn income from multiple states and reside in or travel to work in cities with earnings taxes, such as New York, Philadelphia, Cleveland, Baltimore, and St. Louis. These professionals will be entitled to refunds from their resident states or the cities.
Additional Implications of the Wynne Case
The conclusions to three of the other arguments the Supreme Court addressed in Wynne are worth noting:
- A tax on gross receipts, such as a city earnings tax, should not be distinguished from an income tax.
- A tax on a corporation should not be treated differently from a tax on an individual.
- The measure of constitutionality is the amount of tax imposed on a taxpayer engaging in interstate commerce compared to one who is not so engaged, not the comparative amount of tax collected by the states from those engaging in interstate commerce and those who are not.
In other words, the focus is on the amount of tax paid by taxpayers, not the state’s tax collections; and the Supreme Court defines income and taxpayer broadly.
Arguably, the taxes some jurisdictions impose on intangibles, such as stocks and bonds—particularly if the tax is calculated on interest, dividend, and capital gain income—fall under the refund potential of the Wynne decision.
Furthermore, statutes that lead to the double taxation of investment income (for example, the 1998 New York Court of Appeals decision in John Tamagni v. Tax Appeals Tribunal of the State of New York), will likely be tested again, because of the state’s restrictive definition of income (wages only) for calculating a resident state income tax credit.
State, city, and county governments will be evaluating how to respond to the Wynne decision in the coming months. They will be publishing the procedures affected taxpayers need to follow to obtain their refunds and preparing for the unbudgeted financial demands on their treasuries. As advisers, we need to inform our clients of their rights under the Wynne decision and assist them with their refund claims.
FPA Knowledge Circles are gathering places for like-minded members who want to engage in dialogue about best practices and innovations on particular topics.
With more than 300 members, the Estate Planning Knowledge Circle is an active place where recent online discussions have focused on the topics of distributions from an ILIT, and naming a trust as a beneficiary on an IRA.
The next Estate Planning Knowledge Circle call is:
Oct. 22, 2015 at 1 p.m. eastern
Dial in: 1-205-201-1912 *4705017#