Wynne-ing Isn’t Everything:Remedies for Unconstitutional Taxes

by Jeffrey A. Friedman, Pilar Mata and Mary C. Alexander

Jeffrey A. Friedman Pilar Mata Mary C. Alexander

Taxpayers that engage in litigation generallyseek to win, but a state tax win is akin to salt in awound when the decision is applied only prospec-tively. For example, in Maryland State Comptrollerof the Treasury v. Wynne,1 the Maryland comptrolleris seeking to undermine a recent taxpayer victory byattempting to apply the decision prospectively fornonparties. In this installment of A Pinch of SALT,we examine the requirements and ramifications ofstates’ attempts to apply prospective-only remediesto unconstitutional taxes and why Wynne is not anappropriate case for prospective-only relief.

Wynne-ing the Battle, but Losing the War?

Brian Wynne, a Maryland resident and owner of a2.4 percent interest in an S corporation operatingand paying taxes in 39 states, appealed a Marylandcomptroller assessment asserting that he failed topay a county income tax.2 Maryland treats incomeearned by a subchapter S corporation as passedthrough to its shareholders, and the Maryland andcounty income taxes reach all income of a Marylandresident.3 Although Maryland allows a creditagainst the state income tax for income taxes paid toother states, it does not allow a similar credit

against the county tax.4 The court of appeals con-cluded that the ‘‘failure of the Maryland income taxlaw to allow a credit against the county tax’’ violatedthe U.S. Constitution’s dormant commerce clausebecause it was not fairly apportioned and it discrimi-nated against interstate commerce.5 The court rea-soned that Maryland’s tax scheme discouraged resi-dents from engaging in income-earning activities inother states and that taxpayers would be taxed at ahigher rate on income earned through out-of-stateactivities than on income earned on in-state activi-ties.6

Wynne advocated that the county income tax, thecredit, or some part of the Maryland tax schemeshould be struck down. However, the court of ap-peals concluded that the county income tax andcredit were not, in and of themselves, unconstitu-tional — rather, what was unconstitutional was thelack of a credit applied to the county income tax.7The court noted that Maryland had repealed asimilar credit in 1975 and that it was that amend-ment that rendered the Maryland scheme unconsti-tutional.8 The court then directed the circuit court torecalculate Wynne’s tax liability in a manner consis-tent with its opinion.9

Maryland’s Do-Over

On February 27 the Maryland comptroller filed amotion for reconsideration with the court of ap-peals.10 The comptroller is requesting the court toreconsider its decision that the Maryland taxscheme is unconstitutional, or to declare that its

1Md. Comptroller v. Wynne, No. 107, Sept. 2011, 2013 Md.LEXIS 17 (Md. Jan. 28, 2013).

2Id.3Id. at *7-9.

4Id. at *4-6.5Id. at *41.6Id. at *38.7Id. at *44.8Id.9Id.10Motion for Reconsideration for Appellant, available at

http://services.taxanalysts.com/taxbase/eps_pdf2013.nsf/DocNoLookup/5128/$FILE/2013-5128-1.pdf.

State Tax Notes, April 1, 2013 41

decision will operate only prospectively for nonpar-ties.11 The comptroller reasons that the taxationscheme at issue is not facially discriminatory be-cause the ‘‘same concerns do not arise when theasserted clash is between one state taxing a resi-dent’s income and another state taxing some or partof that income as a non-resident.’’12

In support of prospective application, the comp-troller claims that the court of appeals’ ruling wouldexpand the tax credit in a manner that the GeneralAssembly did not intend and that the General As-sembly and local governments should have the op-portunity to mitigate the effect of implementing acounty-level credit.13 The comptroller’s main argu-ment for a prospective application, however, is thatthe cost to the local governments would be toogreat.14

The comptroller’s position wouldtreat similarly situated taxpayersdifferently by providing the creditto Wynne for past years butdenying other taxpayersretroactive relief.

The comptroller’s position would treat similarlysituated taxpayers differently by providing thecredit to Wynne for past years but denying othertaxpayers retroactive relief. The comptroller’s questto limit nonparties to prospective-only relief ignoresa long line of U.S. Supreme Court cases addressingthe appropriate remedy for unconstitutional taxes.

When Remedies Do Not Provide ReliefIn McKesson Corp. v. Division of Alcoholic Bever-

ages & Tobacco,15 the U.S. Supreme Court held thatprospective-only relief was insufficient when a tax-payer had involuntarily paid a discriminatory taxand was not given a pre- deprivation opportunity tocontest the tax before payment.16,17 Florida, there-fore, was required to provide ‘‘meaningful backwardlooking relief ’’ to the taxpayer.18 The Court deter-mined that Florida could meet the meaningful

backward-looking relief requirement by offering re-funds to the discriminated class, assessing backtaxes on the favored class, or using some combina-tion of the two.19

However, the Supreme Court has acknowledgedthat prospective-only relief may be permissible insome instances, based on a three-part test developedby the Court in Chevron Oil Co. v. Huson:

First, the decision to be applied nonretroac-tively must establish a new principle of law,either by overruling clear past precedent onwhich litigants may have relied, or by decidingan issue of first impression whose resolutionwas not clearly foreshadowed. Second, . . . wemust . . . weigh the merits and demerits ineach case by looking to the prior history of therule in question, its purpose and effect, andwhether retrospective operation will further orretard its operation. Finally, we [must] weig[h]the inequity imposed by retroactive applica-tion, for where a decision of this Court couldproduce substantial inequitable results if ap-plied retroactively, there is ample basis in ourcases for avoiding the injustice or hardship bya holding of nonretroactivity.20

The Court applied this test in a pair of casesinvolving highway use taxes. In American TruckingAssociations, Inc. v. Scheiner (ATA I),21 the Courtheld that Pennsylvania’s flat highway use tax wasunconstitutional because it discriminated againstinterstate commerce, and overruled precedents thathad previously upheld similar taxes. The ArkansasSupreme Court thereafter held that Arkansas’ssimilar tax was unconstitutional in light of ATA Ibut refused to refund taxes placed in escrow afterthe decision in ATA I.22 In American Trucking Asso-ciations, Inc. v. Smith (ATA II),23 the Court held thatATA I should be applied prospectively but that theATA II taxpayers were entitled to refunds for thepost-ATA I escrowed amounts.

The decision in ATA II to provide prospectiverelief was not without controversy; the dissent ar-gued that the decision should be remanded to theArkansas Supreme Court to determine the meaning-ful backward-looking relief to which the taxpayerswere entitled under McKesson.24 Justice AntoninScalia ultimately cast the deciding vote in ATA II.25

While expressing sympathy for the dissent’s position‘‘that prospective decisionmaking is incompatible

11Id.12Id. at 5. Emphasis in original.13Id. at 10.14Id. at 9-11.15496 U.S. 18 (1990).16Id. at 36-37.17Even when a taxpayer is provided with a pre-deprivation

remedy to challenge the tax before payment, the taxpayermay not be entitled to retain the withheld payments if thejurisdiction opts to remedy the discrimination by imposingthe tax on the favored class rather than by granting a refund.See, e.g., Hellerstein and Hellerstein, para. 4.17[1][b].

18Id. at 39.

19Id. at 40-41.20Chevron Oil Co. v. Huson, 404 U.S. 97 (1971).21483 U.S. 266 (1987).22American Trucking Ass’ns, Inc. v. Gray, 746 S.W.2d 377

(Ark. 1988).23496 U.S. 167 (1990).24Id. at 225 (Stevens, J., dissenting).25Id. at 200 (Scalia, J., concurring).

A Pinch of SALT

42 State Tax Notes, April 1, 2013

with the judicial role, which is to say what the law is,not to prescribe what it shall be,’’ he ultimately feltcompelled to join the plurality based on his ‘‘dis-agreement with [the] Court’s ‘negative’ CommerceClause jurisprudence.’’26

Although prospective application may be permit-ted in some cases, in James B. Beam Distilling Co. v.Georgia,27 the U.S. Supreme Court ruled that ‘‘se-lective prospectivity’’ is not permissible. The ques-tion in James B. Beam was how to apply a decisionthat a Georgia liquor excise tax violated the com-merce clause.28 The Georgia Supreme Court hadbased its determination that prospective applicationwas appropriate on a U.S. Supreme Court decisionthat a similar tax was unconstitutional in BacchusImports, Ltd. v. Dias (Bacchus).29,30 Applying theChevron test, the state supreme court reasoned thatBacchus had established a new rule and that thebalance of the equities weighed in favor of the statebecause of the ‘‘severe financial burden’’ that retro-active application would create.31

The Supreme Court rejected the state supremecourt’s prospective-only treatment because Bacchusitself had been applied retroactively to the taxpayerin that case.32 Justice David Souter stated that‘‘once retroactive application is chosen for any as-sertedly new rule, it is chosen for all others whomight seek its prospective application.’’33 The Courtthus rejected ‘‘selective prospectivity,’’ in which anew rule announced in a case would be applied tothe litigants but the old rule would be applied to allothers, stating that ‘‘when the Court has applied arule of law to the litigants in one case it must do sowith respect to all others not barred by proceduralrequirements or res judicata.’’34 Further, JusticesHarry Blackmun, Thurgood Marshall, and Scalia,while agreeing with Souter’s conclusion, argued thatprospectivity, whether ‘‘pure’’ or ‘‘selective,’’ is be-yond the Court’s power.35 They reasoned that toapply ‘‘principles determined to be wrong to litigantswho are in or may still come to court’’ would violate‘‘the integrity of judicial review.’’36

California’s Creative RemediesFew cases have been deemed to meet the stand-

ards set forth in Chevron and ATA II, so courts

frequently fashion remedies based on the principlesset forth in McKesson. California’s litigation over theconstitutionality of its dividends received deduction(DRD) and qualified small business stock provisionsoffers two examples.37

Historically, California had provided an 80 per-cent DRD, but only if the dividends were paid fromincome that was subject to California tax.38 InFarmer Brothers v. Franchise Tax Board,39 the Cali-fornia Court of Appeal determined that the DRDfavored dividend-paying corporations doing busi-ness in California and paying California taxes overdividend-paying corporations that did not do busi-ness in California and paid no taxes in California.40

Thus, the deduction was ‘‘facially discriminatoryunder the commerce clause’’ because it discrimi-nated between transactions on the basis of an inter-state element.41

Applying the options set forth in McKesson, theFranchise Tax Board opted to bifurcate the remedyinto a combination of refunds and assessments.42

For periods closed by the statute of limitations, andfor which the FTB could not assess additional taxesvia the denial of a DRD, the FTB provided refunds.43

However, for periods open under the statute oflimitations, the FTB opted to deny the DRD for alltaxpayers and issued assessments.44

The FTB’s decision to eliminate the DRD forperiods open under the statute of limitations waschallenged in Abbott Laboratories v. Franchise TaxBoard.45 The California Court of Appeal determinedthat the state’s DRD could not be salvaged bystriking the discriminatory component and savingthe remaining DRD, and that doing so would beconsidered ‘‘judicial policymaking’’ that ‘‘encroacheson the Legislature’s function and violates the sepa-ration of powers doctrine.’’46 The court of appealthus upheld the FTB’s decision to provide ‘‘meaning-ful backward looking relief ’’ by issuing refunds foryears when the statute of limitations was closed,and issuing assessments to the favored class foryears when the statute of limitations remainedopen.47

The FTB is seeking to impose a similar remedy inresponse to the California Court of Appeal’s decision

26Id. at 204-205 (Scalia, J., concurring).27501 U.S. 529 (1991).28Id.29468 U.S. 263 (1984).30James B. Bean Distilling Co. v. Georgia, 382 S.E.2d 95,

96-97 (Ga. 1990).31Id.32James B. Beam, 501 U.S. at 543 (opinion of Souter, J.).33Id.34Id. at 544.35Id. at 548 (opinion of Blackmun, J.); James B. Beam, 501

U.S. at 549 (opinion of Scalia, J.).36Id. at 547-548 (opinion of Blackmun, J.).

37Farmer Bros. v. Franchise Tax Bd., 108 Cal. App. 4th 976(Cal. Ct. App. 2003).

38Calif. Revenue and Taxation Code section 24402.39Farmer Bros., 108 Cal. App. 4th 976.40Id. at 986-987.41Id.42Memorandum, Cal. Franchise Tax Bd., May 17, 2004.43Id.44Id.45Abbott Laboratories v. Franchise Tax Bd., 175 Cal. App.

4th 1346 (Cal. Ct. App. 2009).46Id. at 1361.47Id. at 1360-1362.

A Pinch of SALT

State Tax Notes, April 1, 2013 43

in Cutler v. Franchise Tax Board,48 in which thecourt held that California’s statute excluding ordeferring gain from the sale or exchange of qualifiedsmall business stock (QSBS) was unconstitutional.California’s QSBS provision generally mirrors thefederal law; however, the provision also conditionedthe exclusion or deferral on the requirement that atleast 80 percent of the company’s payroll be withinCalifornia at the time that the stock was purchasedand at least 80 percent of the assets and payroll bewithin California during the taxpayer’s holding pe-riod for the stock.49 The court of appeal held that the80 percent limitation was unconstitutional.50

As it did regarding the DRD, the FTB took theposition that the QSBS exclusions and deferralspreviously allowed under California law were in-valid.51 Therefore, taxpayers who took advantage ofthe QSBS provision in years still open for assess-ment under the statute of limitations must recom-pute their taxable income for each open year withoutexcluding or deferring gains from the dispositions ofQSBS.52 Typically, those taxpayers will owe addi-tional tax and interest but will not be subject topenalties.53 The QSBS exclusion or deferral will bepermitted for tax years closed by the statute oflimitations for all taxpayers that meet the QSBSrequirements other than the 80 percent require-ments, entitling taxpayers that have filed timelyclaims to refunds.54 Notably, to avoid impendingassessments for years open under the statute oflimitations, the California State Legislature is con-sidering legislation that would retroactively enactsimilar incentives that do not discriminate againstinterstate commerce.55

ConclusionState and local governments have a wide range of

options when determining a remedy for an uncon-stitutional tax. Most commonly, those involve acombination of refunds to and assessments on thefavored class. That combination is arguably less

than fair to taxpayers who have spent years andhundreds of thousands of dollars on litigation, but atleast it offers a compromise.

The three-part Chevron test sets ahigh bar to warrantprospective-only application, andthe comptroller has made nomeaningful attempt to show that ithas been met.

In contrast, there is no support for the remedyadvocated by the Maryland comptroller in Wynne.The three-part Chevron test sets a high bar towarrant prospective-only application, and the comp-troller has made no meaningful attempt to showthat it has been met. Striking down a taxationscheme that taxes interstate commerce more heavilythan intrastate commerce does not create a new ruleof law or case of first impression, and continuing todeny a credit against the county income tax isinconsistent with established commerce clause prin-ciples. The comptroller’s claim that implementing acounty credit for past years will cost Marylandmoney is not a sufficient basis for upholding adiscriminatory and unfairly apportioned tax, albeittemporarily. Obviously, that holding would allowjurisdictions to impose unconstitutional taxes with-out the responsibility (or fear) of having to returnthem.

Finally, adopting a remedy that provides Wynne acredit against its county income tax, but applies thedecision prospectively only for similarly harmedtaxpayers, cannot be reconciled with the U.S. Su-preme Court’s rejection of ‘‘selective prospectivity.’’James B. Beam called for consistent treatmentamong taxpayers in different states who contesteddifferent taxes. The Maryland Court of Appealsshould reject the comptroller’s motion forreconsideration. ✰

48208 Cal. App. 4th 1247 (Cal. Ct. App. 2012).49Id. at 1251.50Id. at 1261.51See, e.g., Qualified Small Business Stock (QSBS) Gains

— FAQs, available at https://www.ftb.ca.gov/law/Qualified_Small_Business_Stock_and_Cutler _Decision.shtml.

52Id.53Id.54Id.55California AB 901, 2013-2014 Reg. sess. (Cal. 2013),

introduced by Assembly member Bob Wieckowski (D).

Jeffrey A. Friedman is a partner, Pilar Mata is counsel,and Mary C. Alexander is an associate with SutherlandAsbill & Brennan LLP’s State and Local Tax Practice.Sutherland’s SALT Practice is composed of more than 25attorneys who focus on planning and controversy associatedwith income, franchise, sales and use, and property taxmatters, as well as unclaimed property matters. Suther-land’s SALT Practice also monitors and comments on statelegislative and political efforts.

A Pinch of SALT

44 State Tax Notes, April 1, 2013