Tax Court Rules on Taxation of Refundable State Credits

The federal tax treatment of refundable state tax credits that are allocated to a taxpayer was recently clarified by the US Tax Court in Maines v. Comm’r. This case helps define when a state tax credit is taxable income for federal tax purposes and, if considered taxable, at what point the tax credit is “earned” by the taxpayer.

In Maines v. Comm’r taxpayers were allocated three types of refundable New York State tax credits (EZ Investment Credit, EZ Wage Credit and QEZE Real Property Tax Credit) from an S-corporation and a partnership. The taxpayers contended that the refund payments of these credits above their state tax liability were not taxable income and that the credits should be treated as non-taxable overpayments of state tax.

Although New York classified all three as overpayments of state tax that definition is not controlling for federal tax purposes. The court reasoned that because the EZ Investment Credit and EZ Wage Credit do not depend on past tax payments they cannot be refunds of past overpayments and are instead direct subsides despite the label New York puts on them. Importantly, the court found that the refund from the EZ Investment and Wage Credits was income in the year in which they receive the right to the payment of the credit even if they then elect to carry the credit forward to subsequent tax years.

The court discussed the QEZE Real Property Tax Credit separately, because its amount was determined based upon past property tax payments. Under the general tax benefit rule, the court held State tax refunds of prior tax payments are not income unless the taxpayer claimed a federal tax deduction for them in prior years (Tempel, I.R.C. sec 111). In this case the taxpayers claimed a deduction for state property tax so the amount over the state tax liability is income. It did not matter that a separate pass-through entity paid and deducted the taxes prior to calculating its net rental income because the taxpayers benefited. The amount passed through to them was decreased, shrinking their tax liability on their individual federal tax return.

In short, to determine the taxable amount of an allocated refundable credit you first have to look at what the credit depends on, is it a refund of past tax overpayments or is it essentially a subsidy? This is done by looking at the mechanics of the credit, not the label placed on it by the state. If the tax credit is determined to be essentially a subsidy then the amount over the state tax liability is taxable in the year that the taxpayer receives the right to receive it. If the tax credit is determined to be based upon past tax payments then the amount over the state tax liability is income only if the taxpayer took a previous deduction of that past state tax payment.