Lance S. Jacobs
Howard County Circuit Court Rules that Out-of-State Tax Credit Mechanism Violates the Constitution
A recent ruling by the Howard County Circuit Court, on an appeal from
the Maryland Tax Court, offers the possibility of potential refund
claims for Maryland residents.
An Overview of the Tax Credit Mechanism
Maryland residents are entitled to take a credit for taxes paid to
other jurisdictions as a result of their business activities. Typical
activities that would give rise to such a credit for a Maryland resident
would include extensive travelling as an employee to jurisdictions that
do not have a reciprocal withholding agreement with Maryland, as well
as the ownership of an interest in a pass-through entity, such as an S
corporation, a limited partnership, or an LLC that does business in
The Maryland personal income tax is graduated, with 2011 marginal
rates starting at 2 percent at the lowest income levels and increasing
to a rate of 6.25 percent for incomes exceeding $1 million. Maryland's
23 counties and Baltimore City impose an additional income tax at a flat
rate varying by county but which ranges from 1.25 percent to 3.2
Maryland residents who pay income taxes to other jurisdictions are
entitled to a credit for tax paid to other jurisdictions. This credit is
subject to some limitations and may not exceed the amount of the state
tax paid in a given year. So, for example, if a Montgomery County
resident calculates an initial tax liability of $10,000 in state taxes
and $5,000 in county taxes, while incurring $25,000 in taxes paid to
other jurisdictions, the taxpayer, according to the Comptroller, was
entitled to a credit for $10,000, but would still owe the $5,000 in
county taxes. The Comptroller's theory was that the statutory language
of the credit only applied to the state portion and not the county
The taxpayers in Wynne v. Comptroller, (Howard County Circuit
Court, Case Number 13-C-10-80987) (June 29, 2011) took issue with this
approach, contending that they should be allowed a credit for taxes paid
to other jurisdictions that extends to the county portion of their
income tax. The Howard County Circuit Court agreed, and concluded that
the Comptroller's refusal to extend this credit violated the dormant
Commerce Clause of the United States Constitution.
The Circuit Court undertook an exhaustive 80-page analysis in
reaching its conclusion. While a thorough review of this decision is
beyond the scope of this article, it should be noted, however, that the
Circuit Court did make some interesting comments on the Tax Court's
decision, which have been highlighted herein
In its decision, the Tax Court indicated that it had heard several cases, including Comptroller v. Blanton,1
that analyzed the Constitutional ramifications of the tax credit
mechanism and had determined that the mechanism itself was not
unconstitutional. The Circuit Court disagreed and said that the Tax
Court decided Blanton based upon statutory interpretation
(principally that the county-level tax was not a "state income tax" and
therefore not subject to the credit pursuant to the plain language of
the statute) and did not pass judgment on the constitutionality of the
tax credit mechanism. Interestingly, the Circuit Court did note that in a
2009 decision, Frey v. Comptroller,2
the Court of Special Appeals reached the conclusion that the county tax
was the equivalent of a state tax because it was imposed by the state.
The Circuit Court also summarily dismissed the Comptroller's claim
that the credit mechanism in the instant case did not implicate
interstate commerce, under the theory that the dividend income received
from the S corporation did not involve interstate commerce. The Circuit
Court relied on the Frey decision to dismiss this claim, noting
that the S corporation owned by the shareholders did an interstate
business. It also dismissed the notion that income received from the
pass-through S corporation was passive, noting that both for federal and
state income tax purposes, income received by a pass-through
corporation retains the same characteristics in the hands of the
shareholders as it does when received by the S corporation. The Circuit
Court further noted that, even if the income were considered passive, it
would not be dispositive as to whether the income was received as a
result of interstate commerce.
The Circuit Court also undertook a thorough analysis of the scheme
under the four-prong test for Commerce Clause constitutionality under
the Supreme Court's decision in Complete Auto Transit v. Brady.3
These prongs generally require that a tax, to be sustained under the
Commerce Clause, must be imposed only on a taxpayer with substantial
nexus to the taxing jurisdiction, that the tax not discriminate unfairly
against interstate commerce, the tax be applied consistently, and that
the tax imposed bear a fair relationship to the services provided by the
Of these four prongs, it is clear that the taxpayers, residents of
Howard County, have tax nexus with both Maryland and the county. The
most interesting analysis is under the fair apportionment prong.
has developed a two-fold analysis under this prong - the tax imposed
must be both internally and externally consistent. Under the internal
consistency test, a hypothetical is posed whereby every state imposes a
tax system similar to Maryland's. Under this hypothetical, the analysis
seeks to determine whether a resident taxpayer doing business solely in
Maryland would pay substantially less tax than a similarly situated
resident taxpayer whose entire business was outside of Maryland.
This analysis clearly indicates that the latter taxpayer, the one
whose business operates solely outside of Maryland, would pay more tax
than the taxpayer with a wholly intrastate business. Under this
approach, each taxpayer's Maryland base liability would be the same.
However, since the taxpayer whose business is entirely outside of
Maryland would likewise be subject to similar taxes in the state(s)
where it does business outside of Maryland (including some degree of
county-level tax), he or she ends up paying more tax than the intrastate
taxpayer, since his or her liability would exceed the state portion but
would not be creditable against the county portion of his tax bill. As a
result, the tax credit mechanism fails the internal consistency test.
The Circuit Court likewise concluded that the tax violated the
principle of external consistency because it fails to provide a credit
for fairly apportioned taxes paid to other states at the county level.
Likewise, the Circuit Court determined that the tax credit as applied by
the Comptroller unfairly discriminated against interstate commerce by
providing a significant preference for intrastate commerce as opposed to
interstate commerce. It finally noted that, as a matter of policy, the
failure to provide such a county-level credit would provide a
significant economic incentive to leave the state.
The Circuit Court's opinion provides an analysis of the internal
consistency of the tax credit mechanism that is directly on-point and
consistent with recent cases in other states that have determined that
their statutes violate the internal consistency requirement, including
the cases involving LLC fees in California and the franchise tax (since
repealed and replaced by the margins tax) in Texas. It is likely that
this case will be appealed by the Comptroller; while it is always
difficult to project what will happen in an appeal, it seems that the
reasoning of the Howard County Circuit Court is solid and likely to
withstand appellate scrutiny. Those taxpayers who are partners in
partnerships as well as shareholders in S corporations who are taxable
in other jurisdictions, especially in high-tax jurisdictions like New
York, New Jersey, Massachusetts and California, would be well advised to
review their tax returns for those years that remain open under the
statute of limitations and consider filing protective refund claims with
the Comptroller in order to preserve their rights to refunds.
1 Comptroller v. Blanton, 890 A. 2d 279, 390 Md. 528 (Md. 2006).
2 Frey v. Comptroller, 184 Md. App. 315 (Md. Ct. Spec. App. 2007).
3 Complete Auto Transit, Inc. v. Brady, 430 US 274 (1977).
4 Tyler Pipe Indus., Inc., v. Wash. State Dep't of Revenue, 483 US 232 (1987); Okla. Tax Comm'n v. Jefferson Lines, Inc., 514 US 175 (1995); Frey v. Comptroller, 965 A. 2d 923, 939 (Md. Ct. Spec. App. 2009).
material in this publication was created as of the date set forth above
and is based on laws, court decisions, administrative rulings and
congressional materials that existed at that time, and should not be
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article is republished with permission of Pepper Hamilton LLP. Further
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