Update: key ruling affecting Maryland taxpayers with out-of-state income – tax refund opportunity now available

Maryland residents who pay income tax to other states may be entitled to a refund of local income taxes paid in prior tax years. The U.S. Supreme Court in Comptroller of the Treasury of Maryland v. Wynne et ux. recently affirmed a Maryland Court of Appeals ruling that the state’s personal income tax violates the U.S. Constitution’s dormant Commerce Clause, which precludes states from passing legislation that improperly burdens or discriminates against interstate commerce. As a result of the ruling, Maryland taxpayers may claim an income tax credit for taxes paid to other states against their county income tax.

Taxpayers may file up to three years of amended returns to claim the credit and refunds. For most taxpayers, this will include tax years 2012 through 2014. However, taxpayers who filed protective claims may seek refunds, plus statutory interest, dating back as far as tax year 2006. The ruling will cost the state millions of dollars in revenue as residents who report out-of-state income may now reduce future tax liabilities and seek refunds for prior years. The Maryland Office of the Comptroller estimates approximately 55,000 taxpayers may be eligible to claim refunds under the ruling.

This case involved longtime Maryland residents, Brian and Karen Wynne, who reported pass-through income earned in numerous states. The couple claimed an income tax credit on their Maryland income tax returns for taxes paid to 39 nonresident states. While Maryland allowed the Wynnes a credit against their state income tax, it denied the credit against their county income tax and assessed a tax deficiency. The couple challenged the denial as a violation of the Commerce Clause and prevailed in state court. Maryland subsequently appealed the decision to the U.S. Supreme Court.

Maryland levies a state income tax and collects county income taxes in each of the state’s 23 counties and the city of Baltimore. While Maryland allows residents to claim a credit against the state tax for taxes paid to other jurisdictions, it does not allow taxpayers to do so for county taxes. Therefore, income earned by Maryland residents outside the state is taxed twice, which creates an incentive for taxpayers to opt for intrastate rather than interstate economic activity.

Therefore, through the dormant Commerce Clause (described above), a state cannot tax a transaction or incident more heavily when it crosses state lines than when it occurs entirely within the state, or impose a tax that discriminates against interstate commerce either by providing a direct commercial advantage to local business, or by subjecting interstate commerce to the burden of multiple taxation.

The “internal consistency” test assumes that every state has the same tax structure. The Supreme Court concluded Maryland’s personal income tax failed the test. The Court reasoned that if every state were to adopt Maryland’s structure, taxpayers earning out-of-state income would be taxed twice on their out-of-state income while taxpayers earning income solely in their resident state would be taxed only once, violating the dormant Commerce Clause. Furthermore, the Court held Maryland’s tax structure was “inherently discriminatory” and effectively “operated as a tariff,” which is “the paradigmatic example of a law discriminating against interstate commerce.”

Imminent guidance from Maryland is anticipated regarding the procedural aspects of securing refunds.

[For clients, the Tax Accounting Group will be pursuing and tracking refunds, and communicate with our clients accordingly.]

This case has received significant attention and has potential repercussions beyond Maryland, although the case only addresses Maryland tax. The question of whether another jurisdiction can impose tax on its residents’ entire income even when that income may be subject to taxes elsewhere, may have far-reaching implications. For example, Philadelphia does not permit residents to claim credits for taxes paid to other jurisdictions. Consequently, Philadelphia residents who paid taxes on wages to other jurisdictions may wish to consider filing for refunds based on taxes they have paid to those jurisdictions. Similarly, businesses which pass through income to individual Philadelphia residents may also wish to consider filing for refunds.

It may seem as if a similar refund opportunity exists for New York City residents based on the Wynne decision since, like Philadelphia, it does not offer its residents a credit opportunity for taxes paid to other jurisdictions. However, since New York City does not tax non-residents, unlike Philadelphia, the success of any challenge similar to the one raised in the Wynne case is less likely.

However, there may be an argument that since New York State and New York City taxes its residents on all of their investment income, it may be prudent to file protective refund claims for open years in order to protect any tax refund rights with respect to the double taxation of income by both New York City and New York State. The one caveat to consider is that the Wynne decision refers only to earned income, and, although some may argue that class of income is irrelevant, decisions of the courts are often driven by such details.