Individual Income Tax Insights: What’s in a Name? Taxable Income, Federal Court Finds

Based on recent U.S. Tax Court rulings, it seems that taxpayers should not only rely on how a refundable state tax credit is classified at the state level; rather, it is necessary to consider the controlling federal interpretation as to whether it will be deemed federal taxable income.

On March 11, the U. S. Tax Court held in Maines v. Commissioner that certain refundable New York state tax credits under the Empire Zone Program are taxable income to the taxpayers for federal tax purposes. The court held that the New York label of credits as overpayments of past tax for certain refundable credits is not controlling for federal tax purposes and the refunded portion of the credits were deemed to be taxable accessions to wealth.

Two of the particular state credits at issue in Maines include New York’s Empire Zone Investment Credit and Empire Zone Wage Credit, both of which the court determined did not originate from past tax payments. The court held these refunds “are like direct subsidies,” thus taxable, rather than agreeing with New York’s label classifying credits as a refund for overpayment of taxes.

The court further analyzed the New York Qualified Empire Zone Enterprise Credit for real property, which stands as a credit against state income tax for the amount of real property taxes paid. Although it found this credit actually was a refund of real property taxes paid to the state, it was nonetheless taxable based on the tax benefit rule. Under this rule, a taxpayer is allowed to exclude a refund from his income only if he never received a benefit, such as a corresponding deduction, in any prior year.

The holding in Maines brings to light a much larger issue in that federal tax law does not have to comply with a state’s label or interpretation of a tax refund, which will likely prove to have broader implications and could potentially impact other state tax credits as well. The court placed a strong emphasis on its ability to define the substantive application and effect of state credits rather than just relying on the purported origin and state given name.

Maines was cited just six days later when the court held in Elbaz v. Commissioner, that a taxpayer who itemizes deductions must include state income tax refunds in income for the year received if the taxpayer deducted state income tax payments made in the prior year. Both Maines and Elbaz involve state credits received by pass-through entities that resulted in an increase of individual income taxable at the federal level for the shareholder or partner. 

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: How will these recent U.S. Tax Court rulings impact taxpayers claiming other refundable state credits?

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