Taxpayer Appeals Loss in Rare Constitutional Challenge to Composite Return Statute

Bloomberg Tax

Authored Article

Author(s) , Kelvin M. Lawrence

Cases challenging the constitutionality of state pass-through entity (PTE) nonresident owner withholding or composite return statutes are extremely rare. However, a recent Alabama Circuit Court decision, Black Eagle Minerals, LLC v. Alabama Department of Revenue, Case No. CV-2018-900328.00 (Cir. Ct. Montgomery County, Ala., July 27, 2020), highlights why such challenges may be more common when PTE composite returns are mandatory.

The case shows a deep fissure in the constitutional jurisprudence addressing jurisdiction to tax nonresident owners, and the dual nature of pass-through entity taxes as simultaneously being taxes on the entities and on their owners. Perhaps the Alabama appellate courts will soon offer some clear guidance.

The Long Shadow of International Harvester

The U.S. Supreme Court decision most cited in support of the states’ power to impose withholding taxes on the nonresident owners of an entity doing business within their borders is International Harvester Co. v. Wisconsin Department of Taxation, in which the U.S. Supreme Court held a state does not violate the Due Process Clause when it taxes an entity by taxing income earned in the state when that income is distributed to its shareholders as a dividend. However International Harvester is misunderstood for at least two reasons.

First, the tax in International Harvester was applied to both resident and nonresident shareholders; so there was no claim of discrimination against nonresidents, leaving the case to be decided solely on Due Process Clause grounds. As a result, there are unanswered Commerce Clause questions surrounding the powers sanctioned by International Harvester.

Second, the Court allowed the state to, in effect, tax the nonresident owners by imposing a tax on the corpo-ration itself as doing business in the state. The case did not allow states to directly tax nonresident owners if they did not otherwise purposefully avail themselves of the benefits and protections of the taxing state. See Shaffer v. Heitner; cf. Corrigan v. Testa (finding PTE’s in-state business activity sufficient purposeful avail-ment to tax nonresident owner’s distributive share of PTE income, but insufficient to tax capital gain from sale of interests in that PTE).

Republished with permission. The complete article, "Taxpayer Appeals Loss in Rare Constitutional Challenge to Composite Return Statute," was published by Bloomberg Tax on September 15, 2020.