It was a big year for the U.S. Supreme Court, which issued decisions on hot-button social issues and Obamacare. But for us tax folks, no case was of more importance than the Court’s May 2015 decision in Comptroller of the Treasury of Maryland v. Wynne, which struck down an aspect of Maryland’s personal income tax scheme related to resident credits. The question presented by Maryland’s Comptroller to the Court in its petition for review was pretty straightforward:
Does the United States Constitution prohibit a state from taxing all the income of its residents—wherever earned—by mandating a credit for taxes paid on income earned in other states?
While the Court answered this question in the negative, it nonetheless struck down Maryland’s income tax as unconstitutional. In doing so, the Court pretty much made clear that in most circumstances, a resident credit will be required in order to eliminate double taxation, particularly in situations where states also tax nonresidents on the same type of income under consideration. Whatever the case, the Court’s decision has sent reverberations through the state tax community, and everyone is trying to figure out what it means for future cases. We won’t endeavor to answer all those questions in this article, but to figure things out, we at least have to have a grasp on what the Court was talking about in the first place. So we’ll give that a shot in this article, and address some of the more pertinent questions we’ve been getting on New York issues in light of the Court’s decision.
Background
During 2006, the year at issue in Wynne, Maryland’s personal income tax on residents had two components: a “state” income tax and a “county” income tax. Residents of Maryland (like residents of New York) were subject to tax on their worldwide income; however, those that paid income tax to another jurisdiction for income earned in that jurisdiction were allowed a credit against the “state” component of Maryland’s tax scheme, but not the “county” component. Meanwhile, nonresidents that earned income from Maryland sources were subject to the “state” income tax as well as a “special nonresident tax” in lieu of the “county” tax on their Maryland-sourced income.
The taxpayers in Wynne were Maryland residents. They held stock in an S corporation that operated and filed returns in 39 states. The Wynnes reported the flow-through income from the S corporation on their 2006 Maryland income tax returns and claimed a resident credit against both the state and county components for taxes they paid to the other states. The Maryland State Comptroller disallowed the credit against the county component of the tax and the Wynnes appealed.
After several levels of appeals, Maryland’s Court of Appeals (the state’s highest court) decided in favor of the Wynnes, finding that the tax violated the Commerce Clause of the U.S. Constitution under the Court’s prior decision in Complete Auto Transit, Inc. v. Brady. The Maryland State Comptroller then petitioned the U.S. Supreme Court to review the case. Ultimately, the Supreme Court affirmed the Maryland Court of Appeals’ decision in a sharply divided 5:4 opinion.
How the Supreme Court arrived at the affirmance in Wynne is at least as interesting as the result itself. The Supreme Court ruled that Maryland’s income tax scheme violates the Commerce Clause because Maryland taxes nonresidents’ Maryland-sourced income but allows no credit to Maryland residents on the county component for taxes paid to other states on income sourced in those other states. This, the Court said, is “internally inconsistent” and thus violates the dormant Commerce Clause of the U.S. Constitution. But, as we’ll discuss in this article, the implications of Wynne extend beyond Maryland’s income tax.
The Dormant Commerce Clause
The Commerce Clause grants Congress power to “regulate Commerce . . . among the several States.”Justice Alito, who wrote the opinion for the majority in Wynne, explained that while the Commerce Clause “is framed as a positive grant of power to Congress,” the Supreme Court has “held this language to contain a further, negative command, known as the dormant Commerce Clause, prohibiting certain state taxation even when Congress has failed to legislate on the subject.” The Supreme Court has interpreted the dormant Commerce Clause to require that taxes on interstate commerce be nondiscriminatory and fairy apportioned.
In Complete Auto, the Supreme Court established a four-pronged test to determine whether a state tax violates the Commerce Clause. To survive a Commerce Clause attack, the state taxing statute must: (1) be “applied to an activity with a substantial nexus with the taxing State,” (2) be “fairly apportioned,” (3) “not discriminate against interstate commerce,” and (4) be “fairly related to the services provided by the State.”
It is not insignificant that the Wynne Court relied so heavily on Complete Auto’s construction of the dormant Commerce Clause. Complete Auto concerned a gross receipts tax imposed on a corporation and, until Wynne, the Supreme Court only extended these protections to corporations in the context of gross receipts taxes, not to individuals challenging taxes on net income. Nonetheless, in quoting Complete Auto, the Wynne Court appears to have put both distinctions to rest. As to the gross receipts tax vs. net income tax distinction, the Court stated in Wynne that “[w]e see no reason why the distinction between gross receipts and net income should matter, particularly in light of the admonition that we must consider ‘not the formal language of the tax statute but rather its practical effect.’” And as to the corporate taxpayer vs. individual taxpayer distinction, the Court opined that “[w]e have long held that States cannot subject corporate income to tax schemes similar to Maryland’s, and we see no reason why income earned by individuals should be treated less favorably.”
The Internal Consistency Test
During oral arguments, Chief Justice Roberts (who joined the majority in striking down the tax) observed that “if each State did what we’re talking about, people who work in one State and live in another would pay higher taxes overall than people who live within one State and work in the same State.” What the Chief Justice was getting at with this observation is the “Internal Consistency Test,” which has long been used – albeit not in this context – to determine whether taxes that result in double taxation violate the Commerce Clause. Indeed, double taxation is not categorically unconstitutional unless it discriminates against interstate commerce or otherwise offends the Constitution.
The Internal Consistency Test allows a court to distinguish between (i) a tax structure that is inherently discriminatory and (ii) one that might result in double taxes only as a result of two nondiscriminatory state schemes. The former is unconstitutional; the latter is harsh but permitted.
As the Wynne Court explained, the test involves a hypothetical exercise that “allows courts to isolate the effect” of a particular state’s tax for Commerce Clause purposes. The Court has also stated in its decision in Oklahoma Tax Commission v. Jefferson Lines that the test “asks nothing about the degree of economic reality reflected by the tax” and instead, “simply looks to the structure of the tax at issue to see whether the adoption of a rule by all States would place interstate commerce at a disadvantage as compared with commerce intrastate.”
The Internal Consistency Test is applied to the state’s entire tax structure “as a whole”; it is not limited to the aspects of the tax alleged to be problematic. Thus, in Wynne, even though the taxpayers were personally affected only by the lack of resident credit for the “county” tax on residents, the Court nonetheless examined all “three separate categories of income” (i.e., the “county” tax on residents’ in-state income, the “county” tax on residents’ income earned in other states, and the “special nonresident tax” on nonresidents’ Maryland-source income). Ultimately, Maryland’s tax on nonresidents was the deciding factor, even though it wasn’t imposed on taxpayers like the Wynnes.
The Wynne Court used the following hypothetical to illustrate why Maryland’s tax fails the Internal Consistency Test:
Assume that every State imposed the following taxes, which are similar to Maryland’s “county” and “special nonresident” taxes: (1) a 1.25% tax on income that residents earn in State, (2) a 1.25% tax on income that residents earn in other jurisdictions, and (3) a 1.25% tax on income that nonresidents earn in State. Assume further that two taxpayers, April and Bob, both live in State A, but that April earns her income in State A whereas Bob earns his income in State B. In this circumstance, Bob will pay more income tax than April solely because he earns income interstate. Specifically, April will have to pay a 1.25% tax only once, to State A. But Bob will have to pay a 1.25% tax twice: once to State A, where he resides, and once to State B, where he earns the income.
To illustrate the hypothetical:
| | April | Bob |
| State A | 1.25% | 1.25% |
| Hypo State B | 0 | 1.25% |
| Total Bill | 1.25% | 2.50% |
According to the Wynne court, this double tax on Bob made the Maryland scheme “internally inconsistent” because if every state had Maryland’s rules, taxpayers like Bob would pay more tax just because their business crossed state lines. In the hypothetical, it is critical that State A (and therefore hypothetical State B) taxes nonresidents. Because State A allows no resident credits for the tax paid to State B, Bob is subject to double taxation.
Of course, if we tweak this hypothetical a little such that State A allows a credit against the tax imposed on Bob by State B for income he earned there, we end up with a different calculation. To illustrate:
| | April | Bob |
| State A | 1.25% | 0 |
| Hypo State B | 0 | 1.25% |
| Total Bill | 1.25% | 1.25% |
In this example, Bob still pays tax in hypothetical State B but he receives a credit against such tax from State A. So he pays the same tax as April. Indeed, the Supreme Court observed that “Maryland could cure the problem with its current system by granting a credit for taxes paid to other States . . . .”
Of course, allowing the resident credit is not the only means of rectifying the tax. As the Court clarified, “we do not foreclose the possibility that it could comply with the Commerce Clause in some other way.” The Court, however, ended its analysis there, leaving the meaning of “some other way” open, and simply stated that “we do not decide the constitutionality of a hypothetical tax scheme that Maryland might adopt because such a scheme is not before us.” But perhaps the “other way” Maryland could cure its tax would be to cease imposing the tax on nonresidents. To illustrate:
| | April | Bob |
| State A | 1.25% | 1.25% |
| Hypo State B | 0 | 0 |
| Total Bill | 1.25% | 1.25% |
In this example, Bob and April both pay tax in State A. But because State A doesn’t tax nonresidents, we assume that hypothetical State B doesn’t either, so Bob ends up paying the same tax as April. Eliminating the tax on nonresidents means that Bob is no longer taxed by hypothetical State B.
One more point for good measure. Don’t get lost in the differences between the rules in two states. As noted above, the purpose of the Internal Consistency Test is to distinguish between: (i) a tax structure that is inherently discriminatory and (ii) one that might result in double taxes only as a result of two nondiscriminatory state schemes. The former is unconstitutional; the latter is not. So let’s assume that State A imposes a 1.25% tax on all residents, regardless of where the income was earned, and that State A does not tax nonresidents and provides no resident credits (which is internally consistent per above). This time, however, assume State B is a real state, and it does tax nonresidents. Here’s how the hypothetical looks:
| | April | Bob |
| State A | 1.25% | 1.25% |
| Actual State B | 0 | 1.25% |
| Total Bill | 1.25% | 2.50% |
This stinks for Bob. And there is double tax. But NOT because State A’s scheme fails the test - only because of what State B is doing. This is a critical distinction to keep in mind. If double tax arises because of what another state is doing, it probably doesn’t violate the Internal Consistency Test.
The Aftermath
Clearly Wynne has great implications for Maryland, where counties statewide are bracing themselves to collectively pay upwards of $240 million in refunds. But as we noted earlier in this article, the implications of Wynne extend beyond Maryland’s income tax. We’ll outline the takeaways and discuss some of the questions that remain below.
Protections for All Types of Taxpayers on All Types of Income Taxes
The Wynne Court seems to have put the kibosh on the idea that the dormant Commerce Clause applies only to corporate taxpayers and only with respect to taxes on gross receipts. Justice Ginsburg pointed out in the principal dissent that the Court long recognized “that ‘the difference between taxes on net income and taxes on gross receipts from interstate commerce warrants different results’ under the Commerce Clause.” But as we noted previously, the majority, quoting Complete Auto, stated that “[w]e see no reason why the distinction between gross receipts and net income should matter, particularly in light of the admonition that we must consider ‘not the formal language of the tax statute but rather its practical effect.’” Evidently, the Court no longer recognizes the need to treat the two types of taxes differently.
Furthermore, Wynne makes abundantly clear that the dormant Commerce Clause’s protections are available to individuals. The Court seemed to acknowledge this doctrinal shift, stating that “[w]e have long held that States cannot subject corporate income to tax schemes similar to Maryland’s, and we see no reason why income earned by individuals should be treated less favorably.”
Source-State No Longer Trumps Residency-State
Before celebrating the apparent expansion of the Commerce Clause’s protections to all types of taxpayers and all types of income taxes, it should be recognized that other protections might have been lost under Wynne and, as such, the risk of permissive double taxation is potentially heightened. One thing the Court made clear is that double taxation - even on earned income - can be constitutional.
Certainly every state in the Union is free to formulate its own income tax system. While some income taxes are imposed on the basis of residency, others are imposed on the basis of source. So when State A taxes based on residency and State B taxes based on source, a resident of State A working in State B will potentially be subject to both taxes due to the overlap between the residency-based and source-based taxes. Pre-Wynne, it was thought to be well-settled that the state imposing tax based on residency (here, State A) owed a credit against the tax imposed by the state taxing based on source (State B). But the Wynne Court declared that such practice is not necessarily required under the Commerce Clause. Instead, the Court outright rejected the notion asserted in Justice Ginsburg’s dissenting opinion that “requires a State taxing based on residence to ‘recede’ to a State taxing based on source” and instead declared that “[w]e establish no such rule of priority.”
Thus, so long as a state taxes only the income of residents, it need not yield to the source state. For example, if State A taxes its residents’ worldwide income and State B taxes nonresidents’ income earned in State B, a resident of State A working in State B will be subject to both states’ taxes. And if, in light of Wynne, State A decides to stop giving its residents credit for tax paid to State B on income earned in State B, State A’s tax would likely still be internally consistent under Wynne.
But recall that Complete Auto established a four-pronged test to determine whether a state tax violates the Commerce Clause. Under the test, a state taxing statute must: (1) be “applied to an activity with a substantial nexus with the taxing State,” (2) be “fairly apportioned,” (3) “not discriminate against interstate commerce,” and (4) be “fairly related to the services provided by the State.” If State A decides to stop granting residents credits for tax paid to State B on income earned in State B, is State A’s tax “fairly apportioned”? This prong is not exactly addressed under the Internal Consistency Test.
The Wynne Court cited its earlier decision in Mobil Oil Corp. v. Commissioner of Taxes for the proposition that “[o]ur cases have held that tax schemes may be invalid under the dormant Commerce Clause even absent a showing of actual double taxation.” The taxpayer in Mobil Oil, a New York corporation with a New York “corporate domicile,” was doing business in several states. One of these states, Vermont, imposed a corporate income tax by means of an apportionment formula upon foreign source dividend income the taxpayer received from its subsidiaries. This, the taxpayer argued, violated the Commerce Clause; however, the Supreme Court disagreed.
As the Court explained in Mobil Oil, the dormant Commerce Clause precludes one state from taxing all of a taxpayer’s income on a residency-basis when another state has the power to tax an apportioned share of that income on a source-basis. Because Wynne appears to have eliminated the distinction between corporate and individual taxpayers, does that rule now apply in the residency context?
This question was not reached in Wynne. It was enough that Maryland’s tax failed the Internal Consistency Test, so there was no need to examine this issue. Even so, the Wynne Court’s holding focused on three of its prior decisions, Central Greyhound Lines, Inc. v. Mealey, Gwin, White & Prince, Inc. v. Henneford, and J. D. Adams Mfg. Co. v. Storen, which it described as “particularly instructive.” These three cases struck down unapportioned gross receipts taxes on grounds that the taxes in question burdened interstate commerce by exposing it to the risk of double taxation, to which intrastate commerce was not exposed. Applying these three cases and Mobil Oil in the residency context, one could argue that a state is precluded from taxing a resident’s worldwide income on the basis of residency (without providing resident credits) if another state has the power to tax an apportioned share of the person’s income on the basis of source. While a resident credit provides an apportionment mechanism, states that tax on the basis of residency may not allow for resident credits. Thus, is New York State allowed to tax an individual’s worldwide income on the residency-basis if another state is also taxing their income on the source-basis? Or is that prohibited under Mobil Oil?
Statutory Residency Post-Wynne
Some commentators posit that New York’s statutory residency may no longer be viable under Wynne. They argue that Wynne undermines the 1998 decision of New York’s high court in Tamagni v. Tax Appeals Tribunal. The taxpayer in Tamagni was domiciled in New Jersey and was also a statutory resident of New York, where he worked as an investment banker.
In Tamagni, the Court of Appeals held that the dormant Commerce Clause was inapplicable to residency-based taxes because such taxes were not taxing commerce, but were instead taxing a person’s status as a resident. Indeed, Tamagni concluded that statutory residency was not subject to dormant Commerce Clause scrutiny. But Wynne clearly applies the dormant Commerce Clause to residency-based taxes.
Perhaps anticipating the day when the Supreme Court would issue a ruling like Wynne, the Tamagni Court also held that even if the dormant Commerce Clause applied, the Internal Consistency Test was not violated because “the tax does not fall on any interstate activity, but rather on a purely local occurrence--the taxpayer’s status as a resident of New York State.” But this analysis may not stand under Wynne.
So at a minimum, if your client has paid double taxes on intangible income as a result of being classified as a statutory resident, pay close attention to what happens in future litigation, which might not be far away. If the statute of limitations for claiming a refund is upon you, a refund claim (which, in New York, must be applied for via an amended return) is probably advisable.
Credit for NYC/Yonkers Taxes?
Like Maryland, New York taxes residents on worldwide income and imposes a few local income taxes (i.e., in New York City and Yonkers). New York’s resident credit scheme is also similar to the Maryland scheme that was deemed unconstitutional; however, instead of not allowing a credit for taxes paid to other jurisdictions against a county tax, New York does not allow a credit for taxes paid to other jurisdictions against the New York City or Yonkers tax.
But there are significant differences between New York’s tax model and that of Maryland. For example, Maryland also imposes their local tax on nonresidents; New York does not impose the New York City tax on nonresidents. That might cause a court to view the New York City situation much differently. On the other hand, with the Wynne Court clearly saying that the Commerce Clause analysis applies to personal income taxes, might a court require that the “fair apportionment” rules that apply to taxes on on multistate corporations (and require states to allow some form of apportionment to pass an “external consistency” test) also apply to taxes on individual personal income? If so, then perhaps a New York City resident could argue that imposing a full 100% tax on income earned elsewhere violates another aspect of the Commerce Clause test.
In any case, the impact of this is probably pretty low, given how high the New York State tax rate is before New York’s local taxes are considered. Very rarely does a New York City resident taxpayer have source income in another state that is taxed above New York’s state-wide rate of 8.82%. One obvious example would be a New York City resident with source income in California, which imposes a tax rate of around 13%. That taxpayer might consider mounting a challenge against the New York scheme after Wynne. On the other hand, Yonkers imposes an income tax on nonresidents, and Yonkers residents paying tax to jurisdictions outside New York State might find that Wynne gives them strong support for a refund claim.
While it doesn’t appear that there is any automatic refund right in light of Wynne, there at least now is a question that some New York court is sure to be asked. So stay tuned, and file protective claims if needed. Yonkers residents paying taxes in jurisdictions outside of New York certainly ought to file refund claims.
Conclusion
It’s a rare day when the Supreme Court rules on a residency issue. In the aftermath, it seems inevitable that the implications of Wynne will be tested in jurisdictions outside of Maryland. With so many questions and issues raised by the Court’s opinion, it might be necessary for the Court to revisit the case. We can’t wait!
Timothy P. Noonan, JD, is the practice group leader of Hodgson Russ LLP’s New York Residency Practice, and he is one of the leading practitioners in this area of the law. He has handled some of the most high-profile residency cases in New York over the past decade, including the Gaied case discussed here, one of the first New York residency cases to ever reach New York’s highest court. He also co-authored the 2014 edition of the CCH Residency and Allocation Audit Handbook, and he is often quoted by media outlets, including the Wall Street Journal, New York Times, and Forbes, on residency and other state tax issues. As the “Noonan” in “Noonan’s Notes,” a monthly column in Tax Analysts’ State Tax Notes, Tim is also a nationally recognized author and speaker on state tax issues. He can be reached at 716-848-1265 or tnoonan@hodgsonruss.com. 
Ariele R. Doolittle, Esq., is an associate with Hodgson Russ LLP and formerly was a law clerk at the New York State Division of Tax Appeals and Tax Appeals Tribunal. She can be reached at 518-433-2407 or adoolitt@hodgsonruss.com.