Personal income tax: The other-state tax credit

Editor: Kevin Anderson, CPA, J.D.

Individuals who derive income from multiple state jurisdictions are generally subject to any personal income tax those states impose. To reduce double (or multiple) taxation of the same income, many states permit resident (and sometimes nonresident) taxpayers to take personal income tax credits for net income taxes paid to other states. This item focuses on how states classify certain business taxes for these other-state tax credit purposes, using recent California developments to illustrate how states may analyze this issue.

Net income tax

Generally, a net income tax is a tax on, or measured by, gross income less permissible deductions or exemptions. What constitutes a net income tax for other-state tax credit purposes must be determined under each state’s laws. Rather than relying on statutory definitions of the term, the states generally provide guidance on a tax-by-tax basis concerning what is or is not a net income tax. Minnesota, for example, has issued guidance informing Minnesota taxpayers that the Ohio commercial activity tax, the Texas franchise (business margin) tax, and the $25 minimum Wisconsin recycling surcharge are not taxes based on income (Revenue Notice No. 08-08, Minnesota Department of Revenue, July 21, 2008).

California has similarly issued guidance informing California taxpayers that the Texas franchise tax is not a net income tax under California law because it is a tax on, or measured by, gross receipts (Legal Ruling 2017-01, California Franchise Tax Board, Feb. 22, 2017). New Jersey has issued guidance informing New Jersey taxpayers that the New York City unincorporated business tax (UBT) is an income tax imposed on the same income as an individual proprietor’s business or individual partner’s distributive share of the partnership’s business income; therefore, it can be included in New Jersey’s calculation of credit for taxes paid to other jurisdictions (“NYC Unincorporated Business Tax & the Philadelphia Business Privilege Tax,” New Jersey Division of Taxation, Jan. 1, 2000).

Net income taxes can also include city taxes paid at the local level. For example, New York City taxes C corporations and flowthrough entities at the entity level with the UBT, the business corporation tax, or the general corporation tax. New York City imposes UBT on unincorporated trades or businesses, which can be treated as doing business in the city through another entity.

If California intends to prohibit California taxpayers from claiming credits for UBT or similar taxes, it must do so in a way that ensures that the taxing scheme is constitutional. The Supreme Court addressed this issue in Comptroller of the Treasury of Maryland v. Wynne, 575 U.S. 542 (2015), in which the state of Maryland instituted a personal income tax scheme comprising a “state” and “county” tax for residents and a “state” and a “special nonresident tax” in lieu of the county tax for non-residents. The state taxes were imposed at graduated rates, while the county tax rate varied by county but was capped at 3.2%. The special nonresident tax was imposed at the lowest county rate set by any Maryland county. Resident taxpayers were permitted to claim a credit against their state liability but not their county liability.

The Court held the tax scheme unconstitutional for three reasons. First, it failed the internal-consistency test because, if Maryland’s scheme were adopted by every state, the differential between the county and special nonresident taxes would cause interstate taxpayers to pay tax at a higher rate than intrastate taxpayers. Second, Maryland’s scheme failed the “external-consistency” test because it created the risk of multiple taxation. Third, it discriminated against interstate commerce because it denied residents a credit on income taxes paid to other states and so taxed income earned interstate at a rate higher than income earned intrastate, the Court held.

California’s denial of the credit for UBT paid could potentially raise the same issues as those described in Wynne.

Taxes paid to nonstates

Although the other-state tax credit is generally referred to as a credit for taxes paid to another state, whether other jurisdictional net income taxes are creditable must be determined under each state’s laws. Some states provide statutory guidance that expressly identifies whether nonstate net income taxes are creditable. Other states clarify general statutory language with regulatory guidance or provide less formal guidance through state taxing authorities’ policy announcements.

Connecticut, for example, provides that “[a]ny resident or part-year resident of this state shall be allowed a credit against the tax otherwise due … in the amount of any income tax imposed on such resident or part-year resident for the taxable year by another state of the United States or a political subdivision thereof or the District of Columbia on income derived from sources therein and which is also subject to tax” (emphasis added) (Conn. Gen. Stat. §12-704(a)(1)). See also Illinois (Ill. Admin. Code tit. 86, §100.2197(b)(2)); Maine (Me. Rev. Stat. tit. 36, §5217-A); Michigan (Mich. Admin. Code R. 206.16(1)); Missouri (Mo. Rev. Stat. §143.081); Nebraska (Neb. Rev. Stat. §77-2730); New Jersey (N.J. Rev. Stat. §54A:4-1); New Mexico (N.M. Stat. §7-4-2.H); New York (N.Y. Tax Law §620-A); and North Dakota (North Dakota Office of State Tax Commissioner, Income Tax Newsletter, p. 3 (January 2016)). These states also include political subdivisions (e.g., cities and counties) among the jurisdictions to which net income taxes paid are creditable.

Conversely, Louisiana, North Carolina, and West Virginia are examples of states that are more restrictive in their approach to this issue. Louisiana has issued policy guidance that provides that taxpayers may not claim credits for taxes paid to cities or foreign countries (2022 Louisiana Resident Individual Income Tax Return, instructions, p. 3). North Carolina’s regulatory guidance provides that “[n]o credit is allowed for income taxes paid to a city, county, or other political subdivision of a state or to the federal government” (17 N.C. Admin. Code §06B.0607(b)). West Virginia has similarly issued regulatory guidance that provides that “[n]o credit, however, shall be allowed for personal income taxes imposed by a county, municipality, borough, township or any other political subdivision of a state or for any taxes other than personal income taxes” (W. Va. Code St. R. §110 21-20.1).

California’s position on UBT

The remainder of this item focuses on the California Franchise Tax Board’s (FTB’s) position that the New York City UBT is not creditable because it is not a net income tax and is not paid to a state. The California Office of Tax Appeals (OTA) is currently considering the Appeal of Mather (Appeal No. 18093787), which concerns the deemed denial of refund claims based on a California other-state tax credit claimed for amounts paid for New York City’s UBT and metropolitan commuter transportation mobility tax.

In Mather, the taxpayer contends that it can utilize the other-state tax credit provisions under Cal. Rev. & Tax. Code Section 18001, pertaining to the UBT. The crux of the taxpayer’s argument is that the UBT is a net income tax imposed by New York state, not the city. The taxpayer primarily argues that all taxing authority from local jurisdictions comes from New York state, as per the New York State Constitution, and that all laws and regulations for the UBT are enacted by the New York state legislature, as opposed to New York City.

The FTB provides numerous arguments why amounts paid as part of the UBT should not be eligible for the other-state tax credit. For example, the FTB initially argued that the UBT is not a net income tax but rather a gross income tax (Respondent’s Opening Brief, p. 16). The rationale for the FTB’s argument appears to be that under New York City Administrative Code Section 11-507(3), deductions are not allowed for amounts paid or incurred to a proprietor or partner for services or for the use of capital. That provision is comparable to California Rev. & Tax. Code Sections 24421–24449, which also contain applicable addition and subtraction modifications. Having addition modifications does not make a net income tax any less of a net income tax where certain deductions are not permitted.

The FTB also makes the novel argument that because the UBT is not imposed on every taxpayer doing business in New York City, as per New York City Administrative Code Section 11-503, it is not a universal tax imposed on all taxpayers and thus would not qualify for the other-state tax credit. It should be noted that the provision provides jurisdictional standards for taxpayers doing business in New York City and includes specific exemptions, analogous to the Interstate Income Act of 1959, P.L. 86-272, that favor certain taxpayers.

One could make the observation that any state that uses a factor presence nexus standard with a threshold above the amounts in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), as giving rise to nexus also does not tax all would-be taxpayers deriving income from within the state. As such, following the FTB’s logic, paying tax to any state imposing a nexus threshold above the amounts recognized in Wayfair would not qualify for the other-state tax credit.

The FTB further argues that the UBT is not a state tax because it does not become part of New York state’s general fund but, rather, is earmarked exclusively for New York City. However, what is important is that the tax in question be paid to another “state” and not necessarily that it be a “state income tax,” as defined under Cal. Code Regs. Title 18, Section 18001-1(a). Since 1956, the term “state” includes states of the United States, the District of Columbia, and the possessions of the United States but does not include the United States or foreign countries.

California’s position on whether the UBT is creditable under the state’s other-state tax credit provisions is continuing to develop, but Mather provides interesting insight into the FTB’s analytical process for supporting its positions in this area. The OTA has authority to issue precedential and nonprecedential opinions in income tax cases, so Mather could provide some much-needed guidance in this area. Further, a taxpayer-friendly decision (i.e., an opinion that concludes that the UBT is a California-creditable income tax) could result in opportunities for numerous California taxpayers that derive income from New York City sources and are subject to UBT on that income.

Editor notes

Kevin Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Anderson at 202-644-5413 or kdanderson@bdo.com.