Friday, October 24, 2014

Has Maryland Been Caught Reaching Into The Tax Cookie Jar?



There are several states that impose a county tax in addition to a state income tax. Maryland is one of those states, and it has attracted attention to itself with the Maryland v Wynne. This case will soon go before the Supreme Court, which will decide whether Maryland has run afoul of the Commerce Clause of the Constitution.

That sounds esoteric.

It is not that bad, though, as long as we stay out of the weeds.

Let’s start this tax tale with an S corporation shareholder. His name shall be Clark. You may remember that “S” corporations do not pay tax (except in rare circumstances). Instead the corporation “passes through” its income to its shareholders, who in turn report their proportionate share of the corporate income on their individual tax returns.

Let’s say that Clark and his wife live in Maryland.

Let’s say that the S corporation does business both inside and outside Maryland. This means that Clark gets to pay income tax to all the states where the S corporation does business. This happens all the time, much to the chagrin of the tax professional who gets to prepare the paperwork.

Clark's corporation does business in North Carolina,. Clark pays tax to North Carolina (remember: the shareholder pays the income tax for an S corporation). Clark then takes a tax credit on his Maryland income tax for the taxes paid North Carolina. As long as North Carolina is not more expensive than Maryland, there is no-harm-no-foul, except for the professional fees to sort all this out.

And there we encounter the rub.

You see, Maryland divides its tax between a “state” tax and a “county” tax. And it makes a difference.

Enter Brian and Karen Wynne (the Wynnes). They are shareholders in Maxim Healthcare Services, Inc., an S corporation that files returns in 39 states. They themselves live in Howard County, Maryland. When they filed their 2006 Maryland tax return, they claimed taxes that they paid the other 38 states as a credit against their Maryland tax.

And the Maryland State Comptroller changed their numbers and sent them a bill. This lead to Appeals, then Maryland Tax Court, followed by the Circuit Court and – now - the Supreme Court.

The Comptroller’s argument? The Wynnes could not claim a credit for taxes paid other states against the county portion of the Maryland tax. Maryland changed its law in 1975, which was like … a really, really long time ago. Why are we even going there? How can one reasonably offset a state tax against a county tax?

I have to disagree.

Take two people living in Maryland. Have one invest in an S corporation that does all its business inside Maryland. Have the other invest in an S that does all its business in Maine. Unless the other state’s income tax rate is less that the Maryland state income tax rate, the first investor will pay less tax than the second investor. Tell me, how is that fair? Is the state not burdening interstate commerce by taxing the second investor (who invested outside Maryland) more than the first (who invested exclusively within Maryland)? And there you have the core of the challenge under the Commerce Clause.

Let’s use some numbers to make this concrete.

Say that the S corporation income allocable to Maine is $1,000,000. 

(1) The top Maine income tax is 7.95%, so let’s say the Maine income tax will be $79,500.
(2) The top Maryland state income tax rate is 5.75%, so the state income tax will be $57,500.
(3) The Maryland county tax rate is 3.2%, so the county income tax will be $32,000.
(4) This makes the total tax to Maryland $89,500. This exceeds the Maine tax by $10,000.

One offsets the $79,500 paid Maine against the $89,500 otherwise paid Maryland, and it all works out, right?

This is where you get hosed. According to Maryland, you cannot take the excess $22,000 (that is, $79,500 – 57,500) and claim it against the county tax. After all, it is a …. county tax. It does not make sense to offset Maine’s state tax against Maryland’s county tax.

Uhhh, yes it does.

Let us play games with this, shall we? I live in Kentucky, for example. Kentucky has 120 counties. Only Texas and Georgia have more counties, and I wonder why anybody would want more. I understand this goes back to rural times, when travel was more arduous. Nowadays it doesn't make much sense. How much money is wasted on duplication of facilities, county commissions, staff and services that accompanies all these counties?

Let’s say that Frankfort finds itself in a financial bind. Some hotshot realizes that disallowing a resident credit to Kentuckians with income outside the state would help to bridge that financial bind. Said hotshot proposes to carve the Kentucky state income tax into two parts: the state part and the county part. When the county part arrives, Frankfort will just pass it along to the appropriate county. Considering that Frankfort is shuttling monies to the counties already, all one has done is rearrange the furniture.

Except that Frankfort now keeps more money by disallowing a resident credit against all those county taxes. After all, it does not make sense to allow a state tax credit against county tax, right? Pay no attention that Frankfort itself would have created the distinction between state and county income tax. Why that was ... a really, really long time ago. Why are we even going there?

Could Maryland possibly, just possibly, be cynical enough to be playing out my scenario?

I’ll bet you a box of donuts that they are.

So Maryland v Wynne is before the Supreme Court, which will review whether Maryland has violated the “dormant” Commerce Clause. The Maryland Association of Counties has joined in (I will let you guess on which side), and the case has attracted considerable attention from tax practitioners and government policy wonks. There is, for example, some interesting tension in there between the Due Process and Commerce Clauses, for those who follow such things.

The case is scheduled for hearing the second week of November.

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