Did you recently receive a tax assessment from your state’s revenue authority denying your claim of a tax credit for taxes you paid to another state? This is a common issue that tax authorities, such as the Maryland Comptroller or DC Department of Revenue, are focusing. It is also a common place for errors, by both taxpayers and revenue authorities.
Outlined here are the general principles and what to do when you receive an assessment rejecting the credit. In short, do not assume the state is correct! They struggle as much as taxpayers with understanding other state’s rules, so it is worth researching the law and defending your right to take these credits. If you don’t, you’ll be taxed twice on the same income!
Mid-Atlantic Law & Tax assists clients on these topics regularly, both in assessing how to file and in representing clients to appeal incorrect assessments. Contact us at 202-978-2888 or here for a free consultation.
Fundamentals of State Tax Credits for Out-of-State Income
Like the IRS, the state you live in requires you to report the income you make anywhere. This “worldwide income” is the building block for your return and what the IRS and your home state will use to calculate how much in taxes you owe.
Other states, however, can still tax you if you made income within them. They do not tax your worldwide income though. They tax only the income you generated in that state. This could be a rental property you own in the state, wages you were paid while physically in the state, or income allocated to you from a partnership to which you are a partner.
But this raises an issue: double taxation! The income you made in the non-resident state is also being taxed by your home state as part of your worldwide income.
To avoid this, virtually all states provide their residents credits paid to non-resident states. There are limitations and formulas, outside the scope of this post, that sometimes limit it. But the general goal is the same: avoid taxing the same income twice by reducing the amount of taxes you pay to your home state.
Common Errors States and Taxpayers Make
The most common mistake people make in claiming, or assessing, these tax credits is confusing a tax payment or refund with a taxpayer’s tax liability to the non-resident state. The credit you are entitled to is tied to how much you are taxed. That is often different than what amount you owe or receive back when you file your return because you have made payments through the year.
This error seems simple but, particularly with multi-state partnerships, LLCs, and s-corps, it has become complicated. This is because states increasingly allow these entities to pay entity-level taxes as a way to reduce their ownership’s individual taxes. This is done to circumvent the federal limitation on the deductibility of state and local taxes: by paying taxes at the entity level, the entity reduces the income reportable to its owners because entity-paid taxes are deductible at the federal level.
It creates another problem, at the state level, though: double taxation. The entity is paying an entity-level tax on the same net income that is then allocated to the owners who then also pay taxes on their portion of that net income.
States solve this by providing the owners tax credit. (Most states do; some will reduce the owner’s income.) The entity thus pays the state taxes, which is then used to pay the owner’s own liability.
But this whole chain–confusing enough as it is by itself–makes it easy to be confused over what the owner’s state tax liability is. We have seen states use what the entity paid for a partner as the liability; use what the owner paid to cover the full calculated liability; or even say there was no liability because the owner did not pay anything when they filed their return.
The answer is always either (a) the liability shown on the owner’s tax return or (b) the liability calculated in a composite return for the owner. That liability is the full tax burden, disregarding how that burden is paid (whether by the owner or the entity).
What to do When You Receive an Assessment
If you receive an assessment from a tax authority disallowing your tax credit for taxes paid to another state, you should act quickly to respond.
- Deadline to Appeal. Identify the date by which you need to respond. Appeals dates are often non-waivable and can result in you giving up your right to challenge an assessment. Do not miss this date!
- Tax Liability to Non-Resident State. Review your filed return in the non-resident state and identify what your tax liability was. As discussed above, this is not how much you paid with your return or how much you were refunding–it is the tax liability for the year. If you filed a composite return in the non-resident state, you may need to get a copy of your business’s return to identify what your liability was.
- Identify Assessment’s Assumed Tax Liability to Non-Resident State. The assessment often will not directly state what they are using as your tax liability. Read it carefully and identify what the assessment uses as the liability.
- Draft Response. Put together a response for your appeal that outlines, and documents with citation to the non-state return and instructions, why your credit was correct.
Focusing on the tax liability is the key to filing correctly and appealing successfully.
Conclusion
Working through these steps is essential to defending your ability to avoid double taxation. We work with states to get this right, and clients to get the question behind them, all of the time. Contact us at 202-978-2888 or here to get this issue off your hands quickly and efficiently.
