Steven N.J. Wlodychak is the former indirect (state and local) tax policy leader for EY’s Americas Tax Policy and a retired principal in EY’s National Tax Department in Washington, D.C.
In this installment of The Hissing Goose, Wlodychak reviews a ruling in which the Maine Board of Tax Appeals upheld a Maine Revenue Services decision that a Maine resident was not entitled to a tax credit against his Maine personal income tax for his share of a new passthrough entity tax paid to another state.
I told you so.
In what may be the first, but certainly not likely the last, state tax ruling confusing and complicating the tax calculus relating to the new state passthrough entity (PTE) taxes, the Maine Board of Tax Appeals (BTA) upheld a decision of the Maine Revenue Services (MRS) holding that a Maine resident was not entitled to a tax credit against his Maine personal income tax for his share of a new PTE tax paid to another state.1 If other states follow Maine’s lead, this ruling effectively illustrates the worst-case scenario for PTE owners with multistate activities trying to use these state-sponsored schemes to obtain a federal state and local tax deduction in excess of the annual $10,000 limitation imposed by IRC section 164(b)(6) that I’ve been warning about for months: A resident state refusing to honor the PTE tax imposed by another state, perversely resulting in the PTE owner paying more in overall taxes well in excess of the federal tax savings the state-sponsored PTE workarounds were intended to provide.2 Even more outrageous, the BTA issued its opinion in March, but it wasn’t even made public until Tax Notes published it on September 23.3 So much for state tax agency transparency!
This ruling highlights for taxpayers and state tax policy leaders alike that there is a serious systemic problem with the administration of state personal income taxes that has dogged individuals engaged in multistate operations for years: The jumbled and negative approach to relief for taxes paid to other jurisdictions (in the form of a resident state tax credit, an exclusion of income taxed by another jurisdiction, or some other method) by residents subject to tax on all their earnings, “from whatever source derived,” because the home state tax authority or court finds some obscure reason to conclude that another state’s tax system isn’t sufficiently similar to its own. Even more aggravating is that the ruling demonstrates that the resident state administrative agencies and federal and state courts recognize that there is a “double tax” problem that they say is not their responsibility to fix, citing a lack of authority under the limited language of the federal or state constitutions, federal law, or agreement among the states to remedy the double tax problem. The coming flood of these cases because of the rapid rise of these state PTE taxes should goad taxpayers to work with their federal and state legislators to finally develop a meaningful, enforceable, and nondiscriminatory solution that both respects nonresident state determinations of their own tax systems and corrects the double tax problem for resident individuals.
The facts behind this ruling should be familiar to everyone following these state PTE tax laws and are simple enough. The taxpayer, a Maine resident, owned and operated a limited liability company that was treated as an S corporation for federal income tax purposes (the Company). The Company operated in Connecticut.
In 2018, in response to the enactment of the federal SALT deduction limitation, Connecticut became the first state to enact a so-called workaround tax imposed directly on PTEs.4 The objective of the Connecticut law is to impose a direct tax at the entity-level on the “trade or business” of the PTE in order for the individual owners to qualify for a federal income tax deduction in excess of the SALT deduction limitation. Instead of flowing the income through to the owners, who declare the income on their personal income tax returns and pay state income taxes at the individual level (which would be subject to the $10,000 SALT deduction limitation), these taxes are paid by the PTE and arguably not subject to the SALT deduction limitation. In Notice 2020-75,5 the IRS essentially blessed this approach.
Unlike the subsequent PTE taxes enacted by other states, the Connecticut PTE tax is mandatory (there is no election). Moreover, like the PTE tax laws in many (but not all) states, the Connecticut PTE tax law provides that if a nonresident’s only Connecticut-source income is derived from the ownership of an entity that is subject to the state’s PTE tax, he is not required to file a Connecticut personal income tax return.6 The facts described in the BTA opinion are not clear on whether the taxpayer filed a Connecticut personal income tax return for the tax year in question, but the BTA references and acknowledges that the Connecticut PTE and personal income tax laws provided a credit against the taxpayer’s Connecticut personal income tax liability for the taxpayer’s share of the Connecticut PTE tax paid by the Company. Regardless, the MRS found that because of the effect of the Connecticut PTE tax credit, the taxpayer “had no income tax liability to” Connecticut.7
The taxpayer claimed a Maine resident state tax credit for the PTE tax that the Company paid to Connecticut on his Maine resident personal income tax return.8 Upon examination, the MRS denied the credit and assessed additional taxes, interest, and penalties.9
The taxpayer appealed to the BTA on two theories: That he qualified under the statute for the credit for the PTE tax paid to Connecticut based on two complementary theories; and that if statutory relief was denied, Maine’s tax scheme was unconstitutional.10
The BTA first described the reliance of the Maine income tax laws on the determination of an individual’s federal taxable income. It also included a summary and redacted excerpt from the Maine statute setting out the credit for taxes paid to other states as follows:
Maine tax law provides a credit against the individual’s Maine income tax liability:
for the amount of income tax imposed on that individual for the taxable year by another state of the United States . . . with respect to income subject to tax under this Part [Maine Personal Income Tax] that is derived from sources in that taxing jurisdiction. [Me. Rev. Stat. tit. 36,] section 5217-A.11 [Emphasis added (which will become important in the final statutory analysis by the BTA as described below).]
Rejecting the taxpayer’s statutory argument, the BTA cited the Maine Supreme Judicial Court (SJC) decision in Goggin v. State Tax Assessor12 issued in 2018 — coincidentally the same year as the tax year in question in this ruling. In Goggin, the Maine high court ruled that the other state tax credit was unavailable to Maine resident taxpayers for their share of business taxes paid to New Hampshire by an LLC that they owned. Summarizing the SJC ruling, the BTA concluded that the “plain meaning of the [Maine tax credit] statute ‘excludes taxes that are imposed on, and paid by, business entities’” (citing to Goggin, 2018 ME 111, at paragraph 16). Looking to the exact language of the Goggin opinion, according to the BTA, the SJC found that the New Hampshire taxes were imposed on the entities themselves, not the taxpayers as individuals — a requisite finding, according to the SJC, necessary for the Maine’s other state tax credit statute to apply. The BTA emphasized that based on the SJC ruling, Maine’s other state tax credit statute requires that the taxes be levied against the individuals as individuals.
SALT practitioners should, of course, be familiar with New Hampshire’s somewhat unique system of taxation of individuals — namely, that the state does not have a personal income tax. Instead, New Hampshire imposes both a “business enterprise tax”13 and a “business profits tax”14 on business entities operating in the state, regardless of form. Thus, while resident and nonresident individuals do not pay a direct personal income tax, they are indirectly subject to a New Hampshire business tax on their distributive share of income apportioned or allocated to the state, and potentially on their compensation paid by the business enterprise.
Nevertheless, in applying the Maine other state tax credit to the facts of this case and relying on the SJC opinion in Goggin, the BTA found that “even though the Company’s income passed through to the Taxpayer, the Maine [other state tax] credit statute is limited by its terms to taxes imposed on individuals.”15
The taxpayer also argued that absent the Connecticut personal income tax credit for the PTE tax paid to Connecticut, unlike in Goggin, he, in fact, had a direct personal income tax liability to Connecticut offset by the Connecticut PTE tax credit. Regardless, the BTA rejected that argument as well.16 It observed that under the Maine statute as determined by the SJC in Goggin, the determination of the credit for taxes paid to other states was to be made after the application of all credits (except withholding and estimated tax payments) (citing to an administrative bulletin of the MRS).17 Since the taxpayer had no Connecticut individual income tax liability, the BTA rejected the taxpayer’s claim that he was entitled to credit for any tax paid to Connecticut against his Maine tax liability.
Finally, regarding the taxpayer’s constitutional challenge that the MRS’s application of the tax credit statute violated the commerce clause and permitted double taxation, the BTA, relying on Goggin, rejected that argument as well. Noting that the taxpayer “bears a heavy burden of proving” a statute unconstitutional since legislative acts are presumed constitutional, the BTA applied the internal consistency test as recently described by the U.S. Supreme Court in Wynne.18 Having already concluded that the SJC found in Goggin that if every state had applied the Maine tax credit statute in the same way, it would not result in a “disproportionate taxation of out-of-state income,” the BTA concluded that the taxpayer had failed to demonstrate that the statute violated the commerce clause of the Constitution.19
In light of the BTA’s conclusion, the first thing that owners of PTEs engaged in multistate operations and their advisers should be wary of is whether the resident state of the owner will include their share of the PTE taxes paid to nonresident states in the calculation of the resident or other state tax credit of their home state. As should be obvious, failure to do so will result in the imposition of additional state taxes that could more than offset any benefit from an additional federal SALT deduction. Obviously, this should be of no concern to a resident of a state that doesn’t impose a personal income tax. Otherwise, in effect, the taxpayer has received a 38-cent-per-dollar federal income tax deduction for the PTE tax paid to Connecticut in exchange for a dollar-for-dollar increase in the taxes he’d otherwise be paying to Maine if he’d only been able to pay the Connecticut personal income tax on his distributive share of income from the Company.
The real fear, though, in the administration of these state PTE taxes has to be in the application of these other state tax credits in the states that have adopted a PTE tax. In this recent case, the Maine Legislature has yet to adopt a PTE tax and, as of this writing, it does not appear that one has even been considered or introduced. In that case, some sympathy extends to the MRS and the BTA because the Legislature hasn’t yet acted to provide better statutory guidance (particularly in light of the adverse ruling in Goggin). In those states that have enacted a PTE tax similar to Connecticut’s, like that state, they have already anticipated expanding their other state tax credits to cover the PTE taxes that are “substantially similar” to the PTE tax imposed by the resident state.20 For those states that have enacted these rules, one glaring problem will be the interpretation of exactly what the legislature meant by the phrase “substantially similar.” Take the California PTE tax as an example. One interesting facet of that state’s PTE tax law (which may be a drafting error) is that an otherwise eligible passthrough entity that has a partnership as an owner cannot qualify as an entity eligible to make a California PTE tax election.21 Suppose a California resident invests in a partnership that does not do business in California but has qualified for and elected to pay the PTE tax in New York. Under New York’s PTE tax law (and unlike California’s), the inclusion of a partnership as an owner of a PTE does not disqualify the PTE from electing to pay the PTE tax.22 The only consequence is that in computing the PTE tax base for New York purposes, the share of income attributed to the PTE owner that is itself a partnership is excluded from the determination of the New York PTE tax base. The qualified owners continue to benefit from the PTE tax election, at least for New York purposes. When that California owner now files his resident personal income tax return, is the California Franchise Tax Board going to take a look at the PTE ownership structure and conclude that because the ownership of the PTE includes a partnership which disqualifies the PTE from making a California PTE tax election, the California resident taxpayer is not entitled to a resident tax credit for his share of the PTE tax paid to New York? Certainly, this question will have to be raised in every state, and if the tax authorities are as conservative and restrictive in their readings of their home state’s resident or other state tax credit as the BTA was in its ruling and as the SJC was in Goggin, I think nonresident PTE owners are going to be in for a lot of painful and uncertain litigation.
Moving away from the BTA opinion and state PTE taxes generally, I think the BTA ruling and the SJC opinion in Goggin upon which it is so appropriately reliant raise an even greater and more fundamental concern with the administration and evolution of the resident and other state tax credits under personal income tax systems that can impose tax on all the income of a taxpayer from whatever source derived. Perhaps the “original sin” in Maine rests with the opinion in Goggin and its lack of respect for federalism and of the tax policy choices that are made by other state sovereigns regarding individuals engaged in interstate commerce. From my view, to avoid a double tax, a sovereign that can impose tax on 100 percent of the income of its residents “from whatever source derived” must have a system that accedes to and acknowledges that for federalism to work, it has to provide its residents for a credit or some other form of exclusion for the business taxes paid to other states regardless of the form those taxes take. For example, if a state is going to provide passthrough treatment to its residents on income earned in the state, it has to acknowledge that passthrough treatment should apply everywhere when considering the overall tax liability imposed by other states on the same income. As we’ve learned from so many disappointing state tax administrative and federal and state judicial opinions — Goggin and this new ruling from the BTA being only the latest — it’s clear that the courts are not going to stick their necks out to preserve what state and local tax practitioners believe is a fundamental component of state tax federalism necessary to make our federal system work and to preserve the free flow of commerce that the founders of our federal Constitution envisioned in the 18th century. Whatever bias there may be among tax authorities, legislators, and judges toward states that, in exercising their sovereign authority to develop their own system of taxation, choose not to impose a personal income tax and instead rely upon other taxes to generate revenues, other states, as a matter of tax policy to avoid double taxation, have to accommodate those choices in the administration of their own tax systems on residents who derive income in interstate commerce.
Take, for example, the Texas franchise tax. It’s well known that Texas doesn’t have a personal income tax but has imposed the tax directly on S corporations and LLCs since the inception of such entities and, at least since 2007, on limited partnerships as well.23 In applying its other state tax credit, its sister state, California, has long disallowed its residents the ability to offset their California personal income tax liabilities by the share of the Texas taxes paid at the entity level. Why? You can look at the convoluted and tortured rulings of the California FTB24 for answers, but likely it’s just part of the regular competition between California and its sister state. Likewise, I am not aware of any state that provides a personal income tax credit to an owner of a PTE for their share of Washington business and occupations tax or Ohio commercial activity tax, even though both taxes were constructs or substitutes for an income tax that was either found to be unconstitutional under the state’s own constitution (in the case of Washington) or was a legislative compromise to substitute for an existing state income tax (as in the case of Ohio). Regardless, in my view, it shouldn’t matter how the other state’s business tax was derived; if a state is going to exercise its sovereign power to exact a tax on all (100 percent) of the income of a resident of the state and provide passthrough treatment for an entity under its own tax laws, to respect and recognize the sovereignty of the other states and to further our concepts of federalism, it shouldn’t matter what kind of tax that other state imposes. The resident state should provide an offsetting credit up to the amount that would have been paid had the resident state’s tax laws been in effect in the other state and applying the resident state’s own method of apportioning and allocating nonresident income.
Since the state administrative agencies and courts are unwilling to step in here (including the U.S. Supreme Court, which has some current members who have made quite clear that the commerce clause doesn’t provide taxpayers with any protections against a state in any case,25 and still others even at the other end of the political spectrum who believe the provision of an offsetting state tax credit is merely an exercise of good “tax policy” unenforceable by the Court26), the only answer in a self-governing society like ours appears to be either federal legislation or the enforceable agreement of the states to establish clear ground rules on the respectful treatment of the taxes imposed by other states when a state exercises its sovereign authority to tax 100 percent of the income of its residents “from whatever source derived.” Since Congress appears to have no appetite to act here, the only possibility is an agreement or agreements among the states acknowledging and recognizing their differences (and I acknowledge that there is little hope that any state will jump into the fray to protect out-of-state interests).
No one, including me, challenges the sovereign right of a state to impose tax on 100 percent of the income of an individual resident in the state. But with that right also comes responsibility: For the sake of federalism and the encouragement of free markets, states must recognize that they cannot impose, intentionally or unintentionally, a tax on all the income of a resident and its tax should yield to the taxes imposed by other states on their residents regardless of form. There might be a silver lining in all of this: Just maybe, taxpayers can work with their state legislators throughout the country to understand what is at stake and do the “right thing” in connection with nonresident taxation generally.
FOOTNOTES
1 [Individual Taxpayer] v. Maine Revenue Services, Dkt. No. BTA-2020-1 (Maine Bd. of Tax App. Mar. 20, 2021) (Maine BTA Opinion).
2 See Steven N.J. Wlodychak, “IRS Just Raised State Taxes for Multistate Passthrough Entity Owners,” Tax Notes State, Dec. 14, 2020, p. 1159; see also Wlodychak, “They’re All Different and That’s the Problem: State PTEs,” Tax Notes State, Aug. 2, 2021, p. 455.
3 See “Maine Tax Appeals Board: No Credit for Connecticut Entity Tax,” Tax Notes Today State, Sept. 23, 2021.
4 Conn. Pub. Act 18-49. (The Connecticut PTE tax itself is codified at Conn. Gen. Stat. sections 12-699 to -699a.)
5 See IRS Notice 2020-75.
6 Conn. Gen. Stat. section 12-699(e) (“A nonresident individual who is a member of an affected business entity [i.e., a partnership, S corporation, or LLC treated as either] shall not be required to file an income tax return under the provisions of chapter 229 [of the Conn. Gen. Stat. (Connecticut’s personal income tax)] for a taxable year if, for such taxable year, the only source of income derived from or connected with sources within [Connecticut] for such member . . . is from one or more affected business entities and such nonresident individual member’s tax under chapter 229 would be fully satisfied by the credit allowed to such individual under [the Connecticut PTE tax law].”).
7 Maine BTA Opinion, at 2.
8 Id.
9 Id. In a footnote, the BTA pointed out that the MRS canceled the penalties on reconsideration before the filing of the appeal but did not describe the reasons for the cancellation.
10 Id. at 3.
11 Id. at 2-3.
12 Goggin v. State Tax Assessor, 2018 ME 111, 191 A.3d 341 (Maine 2018).
13 See generally N.H. Rev. Stat. sections 77-E:1 to 77-E:14. The business enterprise tax is based on “taxable enterprise value” but really masks the fact that it operates as a tax on specific compensation paid by a business enterprise.
14 See generally N.H. Rev. Stat. sections 77-A:1 to 77-A:23-a. The business profits tax tends to operate much more like a traditional state income tax.
15 Maine BTA Opinion, at 4.
16 Id.
17 Id.
18 Comptroller of the Treasury of Maryland v. Wynne, 575 U.S. 542, 562-563 (2015); see also Oklahoma Tax Commission v. Jefferson Lines Inc., 514 U.S. 175, 185 (1995).
19 Maine BTA Opinion, at 6.
20 See, e.g., N.Y. Tax Law section 620(b)(1) (“A [New York] resident shall be allowed a credit against the tax otherwise due . . . for any pass-through entity tax substantially similar to the [New York PTE tax] . . . imposed on the income of a partnership or S corporation of which the resident is a partner, member or shareholder for the taxable year by another state of the United States, a political subdivision of such state, or the District of Columbia upon income both derived therefrom and subject to [the New York PTE tax]. . . . (3) However, such credit will be allowed on tax paid only if: (A) the state of the United States, political subdivision of such state, or the District of Columbia imposing such tax also imposes an income tax substantially similar to the tax imposed under this article; and (B) in the case of taxes paid by an S corporation, such S corporation was treated as a New York S corporation.”).
21 See Cal. Rev. & Tax Code section 19902(a)(2) (“For purposes of [the California PTE tax law], ‘qualified entity’ means an entity that meets both of the following requirements for the taxable year: (1) The entity is taxed as a partnership or ‘S’ corporation. (2) The entity’s partners, shareholders, or members in that taxable year are exclusively corporations . . . or taxpayers . . . as defined in [the California personal income tax law], excluding partnerships.”).
22 See N.Y. Tax Law section 860(h)(1) (defining “pass-through entity taxable income” for a partnership as only including income of partner subject to New York personal income tax); and N.Y. Department of Taxation and Finance, TSB-M-21(1)C, (1)I, “Pass-Through Entity Tax” (Aug. 25, 2021) (“A partnership must not include in its [passthrough entity] taxable income any amounts of income, gain, loss, or deduction that flow through to a direct partner that is a partnership or an entity not subject to tax under Article 22 [the New York personal income tax law], even if the income is ultimately taxable to a partner under Article 22 through tiered partnerships.”).
23 See Tex. Tax Code section 171.0002(a) (defining a taxable entity as “a partnership, limited liability partnership, corporation, banking corporation, savings and loan association, limited liability company, business trust, professional association, business association, joint venture, joint stock company, holding company, or other legal entity”).
24 See California FTB Legal Ruling 2017-01, “Tax Treatment Under Parts 10 and 11 of the California Revenue and Taxation Code (RTC) of Taxes Paid to Another State for Purposes of the California Other State Tax Credit (OSTC) and Allowable Deductions,” at 14 (Feb. 22, 2017) (Situation 3 solution concluding that while deductible, the distributive share of the Texas franchise tax is ineligible for purposes of California’s other state tax credit. The ruling also addresses many other specific state and local taxes, including the New York City taxes that the California FTB concludes is a local, and not a state, tax likewise ineligible for credit.).
25 See, e.g., Wynne, 575 U.S. at 578-579 (Thomas, J., dissenting) (“‘I continue to adhere to my view that the negative Commerce Clause has no basis in the text of the Constitution, makes little sense, and has proved virtually unworkable in application, and, consequently, cannot serve as a basis for striking down a state statute.’ McBurney v. Young, 569 U.S. 221, 237, 133 S. Ct. 1709, 185 L. Ed. 2d 758 (2013) (Thomas, J., concurring) (internal quotation marks and alteration omitted); accord, e.g., Camps Newfound/Owatonna, Inc. v. Town of Harrison, 520 U.S. 564, 610-612, 117 S. Ct. 1590, 137 L. Ed. 2d 852 (1997) (Thomas, J., dissenting).”).
26 See, e.g., id., 575 U.S. at 582. (Ginsburg, J., dissenting) (The Constitution does not “require one State, in this case Maryland, to limit its residence-based taxation, should the State also choose to exercise, to the full extent, its source-based authority. States often offer their residents credits for income taxes paid to other States, as Maryland does for state income tax purposes. States do so, however, as a matter of tax ‘policy,’ [Okla. Tax Comm’n v.] Chickasaw Nation, 515 U.S. [450,] 463, n. 12, 115 S. Ct. 2214, 132 L. Ed. 2d 400 (internal quotation marks omitted), not because the Constitution compels that course.”).
END FOOTNOTES