Tax Tribunal Strikes Down Limitation on Credit for Taxes Paid to Other States

State and Local Tax Alert: Alabama Edition

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Readers may recall that Alabama Act 2012-427 permitted Alabama residents that owned interests in multistate pass-through entities (e.g., LLCs, partnerships, and S corporations) to claim a credit against their Alabama income tax liability for certain taxes paid by the entity to other states. This claim could be either on behalf of the nonresident owners as an income tax withholding or as a composite return filing obligation, or for certain entity-level taxes levied on the pass-through entity itself (e.g., Texas’ margin tax and Tennessee’s excise tax). The Act did not impose any additional restrictions on the calculation of the credit for taxes paid to other states.

However, shortly after the passage of Act 2012-427, the Alabama Department of Revenue (ADOR) changed the credit calculation on Form CR and promulgated a regulation, Rule 810-3-21-.03, effective January 1, 2013, which imposed new restrictions on the credit calculation. Specifically, the Rule requires the allowable credit for taxes paid to other states on non-Alabama income to be calculated by multiplying the tax paid to other states by a fraction: total non-Alabama AGI divided by total Alabama AGI (the “percentage limitation”). This new credit computation effectively limited the amount of credit available based on Alabama’s effective tax rate (i.e., the rate after a taxpayer claims his or her federal income tax deduction). By limiting the amount of the credit available for taxes paid in other states, many Alabama residents were unable to receive the full benefit of their FIT deduction.

Last week, Chief Tax Tribunal Judge Bill Thompson concluded that the formula limitation imposed by Rule 810-3-21-.03 exceeded the scope of the statute on which it was purportedly based, Ala. Code § 40-18-21. In Moody v. Alabama Dep’t of Revenue, the husband-wife taxpayers appealed a final assessment issued by the ADOR on income earned in the state of Mississippi. The taxpayers reported only $2,065,702 in Alabama adjusted gross income (AGI) for the 2013 taxable year, while reporting $601,536 in non-Alabama AGI for the same tax year. They claimed a credit for 2013 Mississippi income tax paid in the amount of $29,439. Upon review, the ADOR reduced the allowable credit to $18,145, based on the percentage limitation in Rule 810-3-21-.03.

Judge Thompson explained that Ala. Code § 40-18-21 plainly provides that a tax credit is allowed for income tax paid by an Alabama resident to another state, but in an amount equal to the lesser of the actual tax paid or the amount of tax that would be due to the state of Alabama on an equivalent amount of income, applying Alabama tax rates. Judge Thompson found that the additional percentage limitation imposed by Rule 810-3-21-.03 unlawfully reduced the credit and resulted in double taxation of a portion of the taxpayers’ non-Alabama source income. Thus, the final assessment was voided.

It is not known whether the ADOR will appeal the ruling to circuit court. However, the Tax Tribunal’s decision potentially opens an avenue for many taxpayers to claim refunds for prior open tax years, based on a recalculation of the credit for taxes paid to other states, either by the taxpayer directly or by their pass-through entities on their behalf, or to states with net income-based taxes imposed directly on pass-through entities.