Alabama Legislature Passes Bill to Address Calculation of Credit for Taxes Paid to Other States

State & Local Tax Alert: Alabama Edition

Client Alert

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Gov. Kay Ivey signed House Bill 384, into law last Wednesday, March 28, ending a debate that has lasted for almost a decade over the scope of the individual income tax credit for certain taxes paid to other states. The Business Council of Alabama led the effort on the taxpayer side, supported in great part by the Alabama Society of CPAs. This bill should provide certainty regarding how Alabama residents (and their tax preparers) calculate the credit for certain income and gross receipts-based taxes they paid to other states, either directly or because of their ownership of a pass-through entity (such as an LLC or S corporation) doing business in those states. But there are special filing deadlines, as described below.

The act confirms that the credit for taxes paid to another state shall not be used to offset the portion of a taxpayer’s income tax liability that is attributable to Alabama sources. In other words, the credit may only be used to offset a taxpayer’s income tax liability that is truly attributable to income from other states.

This legislation is the result of litigation, Moody v. Alabama Department of Revenue, invalidating Rule 810-3-21-.03, which the Alabama Tax Tribunal found was an additional limitation on the credit not authorized by the enabling statute, Ala. Code § 40-18-21. This compromise legislation essentially codifies the rule, which has been in effect since 2013, but only on a prospective basis. Thus, refunds may be due for calendar years 2013 through 2017 subject to the applicable statutes of limitations and further subject to a special filing deadline in the act that requires refund claims for pre-2017 years to be filed with the ADOR by June 30, 2018. The act assumes that taxpayers will file their 2017 Alabama individual tax returns without the additional limitation on the tax credit imposed by the rule and the current Schedule CR.

Background and Litigation over the Tax Credit Calculation

Alabama residents have historically been allowed to claim a credit for taxes they paid to other states. The credit has been the lesser of (1) the tax actually paid to the other state or (2) the tax that would be due to Alabama on that income, using Alabama’s 5 percent individual income tax rate. Because of the relatively unique deduction for federal income taxes (FIT) claimed on their Alabama tax returns, however, Alabama residents have a relatively low effective tax rate.  

The ADOR promulgated the rule, effective in 2013, which imposed an additional limitation on the credit and effectively denied taxpayers the use of their full FIT deduction, which is authorized by the Alabama Constitution as well as by statute. However, the Alabama Tax Tribunal ruled in early 2017 that the additional limitation in the rule was invalid, and exceeded the scope of the enabling statute. The ADOR appealed that ruling to Baldwin County Circuit Court but later agreed to dismiss its appeal, with prejudice, and to issue the refund requested by Mr. and Mrs. Moody. (Our firm was privileged to represent the Moodys in the Circuit Court appeal).

Since that time, many taxpayers have filed refund claims with the ADOR, asserting a larger credit for taxes paid to other states based on the statute rather than the rule. Additionally, the ADOR has entered assessments against a number of taxpayers who followed the Moody ruling in calculating their tax credit.

Summary of Next Steps:

  • This act is effective for tax years beginning on and after January 1, 2018, i.e., prospectively only.
  • The ADOR is directed to grant valid refunds for tax years 2013 through 2016, but only if refund claims are timely filed by June 30, 2018 (yes, that’s a Saturday).
  • For the 2017 tax year, taxpayers and return preparers should calculate the tax credit without the additional limitation in the rule and file their returns accordingly.
  • The ADOR is also to dismiss all assessments and appeals related to the calculation of the tax credit that were based on the limitation contained in the rule and to so notify the taxpayer.

Jeannine Birmingham, president and CEO of the ASPCA, concluded: “After many years of discussion and debate, we’re pleased to finally have resolution on how to calculate the Alabama tax credit for income tax paid on income earned in another state.” 

If you have any questions regarding Act 2018-465 or the events leading up to it, feel free to contact any of the authors of this SALT Alert.