Nonresidents entitled to deduct alimony payments.

In a decision with implications for those states that treat non-residents differently from residents in a wide variety of tax matters, the US. Supreme Court ruled that state tax laws denying a nonresident a deduction for alimony payments made outside the state were unconstitutional under the privileges and immunities clause of the US. Constitution. The Court said the clause demanded a "rule of substantial equality" in treating nonresident taxpayers.

Christopher H. Lunding, a Connecticut resident, earned substantial income from his law practice in New York. He challenged a New York State law that denied nonresidents a deduction for alimony payments made outside New York, on the grounds the law violated the Constitution.

New York State's nonresident income tax computation involves several steps. Starting with federal adjusted gross income (the US. tax code allows a deduction for alimony), nonresident taxpayers must compute their tax liability "as if" they resided in New York. They then determine their tax using the rates applicable to residents. After the tax is computed, nonresidents derive an "apportionment percentage" to be applied based on the ratio of New York source income to federal adjusted gross income. The denominator of the ratio--federal AGI--includes a deduction for alimony paid. The numerator--New York source income--includes net income from property, employment or business operations in New York but specifically disallows any alimony deduction.

Nonresidents multiply the "as if" resident tax by the apportionment percentage to compute their actual New York tax liability. Because there is no upper limit on the percentage, when a nonresident's New York source income, which does not include an alimony deduction, exceeds federal AGI, the taxpayer is liable for more than 100% of the "as if" resident tax. In other words, the nonresident may end up with a greater tax liability than a resident because an alimony deduction is denied.

In ruling against Lunding's challenge, the New York State Court of Appeals said the privileges and immunities clause did not mandate absolute equality and the clause was not violated when "there is a substantial reason for the difference in treatment, and the discrimination practiced against nonresidents bears a substantial relationship to the state's objective." (Lunding v. New York, 89 NY 2d, at 289.) The court reasoned that because New York residents were subject to the burden of taxation on all their income, regardless of source, they should be entitled to a deduction for all expenses, including alimony. But the court concluded that Lunding's alimony deductions were "wholly linked to personal activities outside the state" and thus more appropriately allocated to his state of residence. The New York court was satisfied there was a substantial reason for the difference in tax treatment.

Result: For the taxpayer. On appeal, the US. Supreme Court said the privileges and immunities clause provided that "the citizens of each state shall be entitled to all privileges and immunities of citizens in the several states." One right the clause protects is that of a citizen of any state to "remove to and carry on business in another without being subjected in property or person to taxes more onerous than citizens in the latter state are subjected to." (Shaffer v. Carter, 252 US 37). The Court said the clause demanded "a rule of substantial equality of treatment for resident and nonresident taxpayers." (Austin v. New Hampshire, 420 US 656). The Court was not persuaded that New York had presented a substantial reason for the difference in treatment of alimony deductions for nonresidents and was troubled that New York required nonresidents to compute their tax as if they were residents while forbidding them a deduction available to residents.

The Court also rejected the New York State Court of Appeals characterization of alimony as linked to activities wholly outside the state. According to the Court, alimony is an obligation of some duration that is determined mostly by a person's income, wherever earned. The alimony obligation "may be of a personal nature, but it cannot be viewed as geographically fixed in the manner that other expenses, such as business losses, mortgage interest payments, or real estate taxes might be." In reversing the New York decision, the Supreme Court said that requiring nonresidents to pay more tax than similarly situated residents, solely on the basis of their liability for alimony payments, violated the rule of substantial equality of treatment.

* Lunding v. New York, no. 96-1462 (1/21/98).

Prepared by Roy Whitehead, Jr., JD, LLM, associate professor of business law, and Donna Smith, CPA, assistant professor of accounting, both of the University of Central Arkansas, Conway.