On Monday, May 18, the Supreme Court struck down as unconstitutional a Maryland tax law that has the effect of double-taxing income residents earn in other states. Ultimately, the Court's ruling could have a significant effect on similar laws in other states.
In most states, income earned outside one's state of residence is taxed both in the state where the income is earned and in the taxpayer's state of residence. To guard against double taxation, states generally permit residents to claim a credit for income taxes paid on out-of-state earnings.
Maryland taxes personal income up to a maximum of 5.75%. It also collects and distributes a "piggyback" income tax of up to 3.2% for each of the 23 counties and Baltimore. Maryland allows its residents to claim a credit for income taxes paid to other states on their Maryland tax return, but does not apply the credit to local taxes. The Supreme Court Justices agreed with the Maryland Court of Appeals that the tax is invalid because it discourages residents from earning money outside of Maryland. This 5-4 ruling may affect similar tax laws in nearly five thousand local jurisdictions in other states, including New York, Indiana, Pennsylvania and Ohio.
The Court's unusual split was not along ideological lines. Writing for the Court, Justice Samuel Alito, who was joined by Chief Justice John Roberts and Justices Anthony Kennedy, Stephen Breyer and Sonia Sotomayor, said the tax "is inherently discriminatory" under the Constitution's dormant Commerce Clause. While the Clause gives Congress the power to regulate commerce among states, the provision was also intended to ban states from passing laws that restrict or burden interstate commerce.
The case arose after Maryland residents Brian and Karen Wynne challenged their tax bill. While they paid $123,363 in Maryland state income tax, they were blocked from claiming a credit on $84,550 that they had paid in income taxes to 39 other states. Brian Wynne's out-of-state income resulted from his ownership stake in Maxim Health Care Services, a home care and medical staffing company that operates nationwide. The Wynnes argued that Maryland was unfairly subjecting them to double taxation and taxing earnings that have no connection to the state.
State officials argued that under the Due Process Clause of the Constitution, states have a historic right to tax the income of their residents no matter where earned. The credit for taxes paid to other states was excluded from Maryland's local piggyback taxes, the state claimed, to ensure that all residents pay an equitable share for local government services, such as schools and public safety.
The Supreme Court ruling means that Maryland taxpayers who tried to claim the credit for taxes paid to other states on the local portion of their income tax returns are likely eligible for refunds with respect to all open tax years. Maryland officials estimate the ruling will cost the state about $200 million. The decision also will cost local governments about $42 million annually.
The decision may have reverberating effects on taxes in other states as well. For example, New York State collects income taxes on New York City residents but does not permit a credit for taxes paid to other jurisdictions on the City's tax computation. Another example of a New York State tax position that may now be in jeopardy is the State's "convenience of the employer" rule, which taxes New York telecommuters. New York imposes state income tax on certain individuals who work from homes located outside of New York. These workers may face double taxation by being subjected to New York income tax in addition to the income tax of their home state.
While in the near term the Court's ruling will cost Maryland millions, it will be important to keep close tabs on how states and other taxing authorities react to this decision, as the fallout may be far-reaching.
Please contact RCharron@friedmanllp.com for more information.