Partner Not Able to Deduct Taxes Imposed by States in Which He Performed no Services as a Business Deduction

The taxpayer in the case of Cutler v. Commissioner, TC Memo 2015-73 argued that because his only connection with various states that were imposing an income tax on him was that he owned an interest in a partnership that operated in those states, he should be able to deduct that taxes paid to those states in computing adjusted gross income, rather than being limited to deducting the taxes as an itemized deduction.

The taxpayer was a partner in a law firm that had offices in Michigan and Virginia in addition offices in the taxpayer’s home state of Missouri.  In addition to the states in which the firm had offices, the firm also had income that was subject to tax by the states of Oregon and Illinois.

However, Mr. Cutler only performed services in Missouri and did not perform services for any clients located in the states other than Missouri.  He paid income taxes to each of those states based on the partnership’s connections with those states and had no other income sourced to any of those states. 

Mr. Cutler reasoned, therefore, that this was simply a business expense that should be deductible in computing adjusted gross income, as would his share of rent paid for office space in any of those locations.  His only connection to those states, and the only reason they were able to extract taxes from him, was because of business carried on in those states.  Thus, it would seem, this is simply an “ordinary and necessary” expense of doing business, just like that rent.

By claiming the deduction on Schedule E, Mr. Cutler was able to reduce both his alternative minimum tax liability and his liability for self-employment taxes.

Seductive as that logic is, neither the IRS nor the Tax Court agreed with his view that these were business expenses.

The Tax Court begins by pointing out the advantages of being able to claim deductions “above the line” and notes that business expenses (at least of a non-employee) generally are granted that preferential position for deduction.

But the Court found that state income taxes are not business deductions.  The Court notes:

Deductions are allowed above the line if they are “attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.”  Sec. 62(a)(1).  The regulations interpret this statutory provision to mean that expenses are deductible above the line when they are “directly, and not * * * merely remotely, connected with the conduct of a trade or business.”  Sec. 1.62-1T(d), Temporary Income Tax Regs., 53 Fed. Reg. 9874 (Mar. 28, 1988).

For example, taxes are deductible in arriving at adjusted gross income only if they constitute expenditures directly attributable to a trade or business or to property from which rents or royalties are derived. Thus, property taxes paid or incurred on real property used in a trade or business are deductible, but state taxes on net income are not deductible even though the taxpayer’s income is derived from the conduct of a trade or business.

The Court goes on to note that substantially identical regulations have been on the books since 1945.  Over that time they have been held to have been deemed to have received Congressional approval (presumably if Congress did not like this result they would have said something in the past 70 years) and have been held as a proper interpretation of the statute.  The Tax Court specifically cites two cases that were both affirmed on appeal by the applicable appellate courts:  Tanner v. Commissioner, 45 T.C. 145,147-148 (1965), aff’d, 363 F.2d 36 (4th Cir. 1966) and Strange v. Commissioner, 114 T.C. 206 (2000), aff’d, 270 F.3d 786 (9th Cir. 2001).

The Tax Court rejected the view that the taxes in question were, effectively, entity level taxes.  Specifically the court rejected the view that because Virginia imposed a withholding tax obligation on the partnership that such a requirement created an entity level tax.  The Tax Court reasoned such a withholding requirement was similar to the requirement for an employer to withhold income taxes on wages.

The Court also specifically rejected the taxpayer’s argument that since he had not performed services in the state, the states would not have the right to tax him (he had no nexus with the states) so the tax must be viewed as on the entity.  The Tax Court noted that, for this partner, he had the authority as a manager to manage partnership business in those states even if did not actually exercise that authority.  Thus the Tax Court found no problem in treating this as an income tax that was only deductible below the line.