Could state-level court cases affect your bank?
Recently, two court cases - of particular interest to banks and their shareholders - were appealed to the U.S. Supreme Court. Both involve interpretation of the commerce clause.
Kentucky
Davis v. Department of Revenue: Is it constitutionally valid for the state of Kentucky to tax interest income earned on bonds of other states while providing an exemption from tax for interest earned on Kentucky bonds?
Davis originally contended that the Kentucky Department of Revenue violated the U.S.commerce clause — specifically the well-established command that forbids states against engaging in “economic protectionism.” Economic protectionism is the practice of using regulatory or legislative measures to support in-state economic interests by hindering out-of-state competitors. Basically, states may not tax transactions occurring across state lines more heavily than if the transaction occurred completely within the state’s own borders.
Initially, the circuit court ruled in favor of the Kentucky Department of Revenue. Davis appealed this decision and the Kentucky Court of Appeals reversed the circuit court’s decision. The court of appeals found the act of taxing only out-of-state bonds is clearly an action subject to the commerce clause. This ruling has been appealed to the U.S. Supreme Court,which will hear the case in its next term. A decision is expected sometime before next summer.
If the Supreme Court affirms the ruling in favor of Davis,states may be prohibited from taxing interest earned on tax-exempt obligations issued by other states and their political subdivisions if “in-state” interest is exempt from tax. This would significantly impact S corporation shareholders with nonresident tax-exempt interest passed through to them by an S corporation. Shareholders may ultimately be able to file refund claims for prior years and should consult with their tax advisors regarding the potential of filing protective claims for tax years that may close prior to the Supreme Court’s ruling.
West Virginia
During the 1998 and 1999 tax years, MBNA paid West Virginia taxes; however,after payment of the taxes, MBNA filed for a refund with the West Virginia tax commissioner, claiming the commissioner lacked jurisdiction to tax MBNA. MBNA argued that since they didn’t have any property or employees in West Virginia, they didn’t have an economic presence in the state and should not be subject to tax. The commissioner denied the refunds based upon the fact that MBNA regularly engaged in business within the stateunder applicable state statutes. The commissioner determined that West Virginia residents having credit cards issued by MBNA were sufficient to create an “economic presence” within the state.
The West Virginia Court of Appeals ruled the physical presence test makes little sense in today’s increasingly interconnected world. When the commerce clause was enacted,companies usually had contact with a state through employees, offices or warehouses. The economy has subsequently changed. Instead, the court determined that a better test would be whether an entity had an economic presence in the state. The court ruled — qualitatively and quantitatively — MBNA’s economic presence was substantial; therefore, West Virginia could tax MBNA even absent of a physical presence within the state.
This could have an enormous impact on S corporation banks and their shareholders. If a state can tax an entity simply because a customer with a credit card resides within the state,that financial institution could also be taxed by a state with a loan customer residing in the state. If more states begin to assert that merely making loans to their residents creates a sufficient presence within the state to justify taxing that entity and its shareholders, it could greatly expand the number of states the individual shareholders are required to file in, as well as increase the overall tax liability of the bank and its shareholders.
What do these cases mean for your bank?
These legal developments have the potential to dramatically change the taxation of S corporation banks and their shareholders. Monitor the issues presented in these two cases over the next year and discuss the specific impact of the determination with your tax advisors.
Note: Although the Supreme Court agreed to hear the Kentucky case, it declined to hear the West Virginia case.
Gerald Kissell is a managingdirector with RMS McGladrey. For more information, contact him atgerald.kessell@rsmi.com.
