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Tax Court: Partner Cannot Deduct State Non-Resident Income Tax

legal matters

The U.S. Tax Court ruled that state non-resident income taxes paid by an attorney on his law firm’s income sourced in four states cannot be deducted on Schedule E of his Form 1040 and are not deductible in arriving at adjusted gross income (AGI). These taxes can only be claimed below the line as itemized deductions.

Tax Law Basics

Under Internal Revenue Code Section 62(a)(2), deductions are allowed “above the line” as an adjustment to arrive at gross income if they are “attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.” Regulations interpret this rule to mean that expenses are deductible above the line when they are directly, and not merely remotely, connected with the conduct of a trade or business.

For example, taxes are deductible in arriving at AGI only if they constitute expenses directly attributable to a trade or business or to property from which rents or royalties are derived. Therefore, property taxes paid or incurred on real property used in a trade or business are deductible, but state taxes on net income are not deductible even though the taxpayer’s income is derived from conducting a trade or business.

Certain other deductions, including those for state and local income tax, can be subtracted from AGI in computing taxable income. These itemized deductions are often referred to as below-the-line deductions.

Above-the-line deductions generally can be claimed in addition to itemized deductions or the standard deduction and offer the added benefit of reducing AGI, which in turn is used as a measure to limit other tax benefits. In contrast, below-the-line deductions are subject to income limitations. In some cases, they can be deducted only to the extent they exceed a specified floor amount.

Facts of the Case

An attorney was a principal in a law firm organized in Michigan as a professional limited liability company and treated as a partnership for federal income tax purposes. During the years at issue he worked in the law firm’s Missouri office, and the firm earned income sourced in Missouri, Michigan, Virginia, Illinois and Oregon. The Tax Court noted that the attorney “had the authority, along with other principals” to direct the operations of the law firm.

The attorney did not perform services in Michigan, Virginia, Illinois, or Oregon or work for clients based in those states. He nevertheless paid state non-resident income taxes on his law firm’s income sourced in these states. On Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., of Forms 1065, U.S. Return of Partnership Income, for the years at issue, the law firm reported the attorney’s share of ordinary business income as self-employment earnings.

On his federal income tax returns for the years at issue, the attorney reported this income and claimed deductions for Michigan, Virginia, Illinois and Oregon state nonresident income taxes as unreimbursed partnership expenses on Schedules E, Supplemental Income and Loss. These deductions amounted to $11,943 in 2007, $15,104 in 2008, and $14,832 in 2009.

The IRS determined that the attorney should have claimed the state non-resident income taxes as itemized deductions on Schedule A of his tax return, thereby increasing his AGI, with associated increases in self-employment tax and alternative minimum taxable income.

Arguments Rejected

The Tax Court agreed with IRS that the state non-resident income taxes are not deductible above the line. The court rejected each of these arguments that the attorney put forth:

1. The attorney argued that the 2008 and 2009 Virginia taxes were entity-level taxes imposed directly on the law firm, rather than on him. The Tax Court disagreed, pointing out that Virginia generally taxes the net income of a non-resident individual, partner or beneficiary receiving Virginia-source income. A non-resident owner of a pass-through entity is liable in the owner’s separate or individual capacity for Virginia tax on income that passes through the entity.

2. The attorney also contended that all the non-resident taxes, including Virginia’s, were constructively imposed on the law firm rather than him. He claimed this was because he performed no services in any of the states generating the non-resident income taxes in question.

In addition, the attorney argued that any other construction of the various states’ tax statutes raised significant doubts about the constitutionality of the states’ taxing powers because he lacked a sufficient nexus to those states to be taxed by any of them. The court stated that the facts did not establish that the attorney lacked any nexus with Virginia or any of the other states in question. To the contrary, the record convinced the court that the attorney, as a principal of the law firm, had the authority to manage the firm’s business, including its business in Michigan, Virginia, Illinois and Oregon.

3. Finally, the attorney argued that the 2008 and 2009 Virginia taxes are deductible from gross income because they were imposed on his gross income rather than his net business income. The court stated the attorney’s argument failed because the Virginia taxes were imposed on net income, rather than gross income. Virginia rules call for the calculation of the Virginia taxable income of a non-resident individual, partner or beneficiary as determined by comparing the “net amount” of income, gain or loss from Virginia sources and the “net amount” of such items from all sources. (Cutler, TC Memo 2015-73)

Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.