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Taxpayer Can't Claim Nonresident State Taxes on Partnership Income as Above-the-Line Deductions.

(Parker Tax Publishing April 30, 2015)

The Tax Court held that because the imposition of state nonresident income taxes fell upon the taxpayer partner and not the partnership, the tax payments were deductible only as itemized deductions. Cutler v. Comm'r, T.C. Memo. 2015-73.


Matthew Cutler is a principle partner in the law firm Harness, Dickey & Pierce, PLC (HDP), which is treated as a partnership for Federal income tax purposes. The firm has offices in Michigan, Missouri, and Virginia, and occasionally operated in Illinois and Oregon. In 2008 and 2009, Cutler worked in HDP's Missouri office and, as a principle, had the authority to direct the firm's operations in all its offices. Although he did not perform services other than at the Missouri office, he nevertheless paid his portion of state nonresident income taxes for those years on HDP's income sourced in the other states.

On his income tax returns for 2007, 2008, and 2009, Cutler treated the nonresident income taxes as unreimbursed partnership expenses on his Schedules E, Supplemental Income and Loss deductions. Accordingly, he claimed deductions from adjusted gross income (AGI) of $11,943, $15,104, and $14,832 for the three years, respectively.

The IRS determined that Cutler was not entitled to deduct the nonresident income taxes on Schedule E, but rather as itemized deductions on Schedule A. The determination increased Cutler's AGI, resulting in increases in self-employment tax and alternative minimum tax.


Under Code Sec. 62(a), AGI is gross income less certain deductions, frequently referred to as "above-the-line" deductions. Deductions are allowed above the line if they are attributable to a trade or business carried on by the taxpayer, provided such trade or business does not consist of the performance of services by the taxpayer as an employee (Code Sec. 62(a)(1)). The regulations clarify that expenses are deductible above the line when they are directly connected with the conduct of a trade or business (Reg. Sec. 1.62-1T(d)).

For example, taxes are deductible in arriving at adjusted gross income only if they constitute expenditures directly attributable to a trade or business. Thus, state taxes on net income are not deductible even though the taxpayer's income is derived from the conduct of a trade or business. (Reg. Sec. 1.62-1T(d)).

Cutler argued that the nonresident income taxes were entity-level taxes imposed on, and therefore immediately connected with, the conduct of his trade or business, and thus were deductible from AGI. Cutler additionally argued that some of the Virginia nonresident taxes, were imposed on his gross income rather than on his net income.

The court first addressed whether the nonresident taxes were entity level taxes. Cutler conceded that the 2007 Virginia nonresident taxes were not imposed on HDP directly. However, because of certain amendments to the Virginia income tax laws that became effective January 1, 2008, he argued that the 2008 and 2009 Virginia taxes were entity-level taxes imposed on HDP's income directly, rather than on his income, and as such he was only liable for the Virginia tax that passed through the partnership to him.

The tax court was unconvinced by this argument, noting that Virginia generally taxes the net income of a nonresident partner receiving Virginia-source income, and a nonresident owner of a passthrough entity is liable in his or her separate or individual capacity for Virginia tax on income that passes through the entity. Accordingly, the court concluded that the 2008 and 2009 Virginia taxes were not imposed directly on HDP.

Cutler next argued, more generally, that all the nonresident income taxes, including the Virginia taxes, were entity level taxes because they were imposed on HDP constructively, rather than on himself. Cutler argued that because he performed no services in those states to generate the taxes in question, he lacked sufficient ties to the states to be taxed by them directly. The tax court disagreed, pointing out that because Cutler was a principle partner in HDP with the authority to manage the firm's business, including its business in Michigan, Virginia, Illinois, and Oregon, he did have sufficient ties to those states, and could be taxed directly. Therefore, the court found that Cutler failed to establish any of the nonresident taxes were directly or constructively imposed on HDP, rather than on himself.

The Court then addressed whether the Virginia taxes were imposed on Cutler's gross income.

Cutler argued that the Virginia taxes were deductible above-the-line because they were imposed on his gross income, rather than on his net business income. To support this claim, Cutler relied on Reg. Sec. 1.62-1T(d), providing that state taxes on net income are not deductible in determining AGI. Cutler reasoned that this meant state taxes on gross income are deductible for AGI. However, the tax court found that this argument failed, primarily because the relevant Virginia statute did in fact impose taxes on net income rather than gross income.

Finding none of taxpayer's arguments persuasive, the Tax Court sustained the IRS's determination that the nonresident taxes were not deductible from Cutler's gross income in determining his AGI, but instead were deductible only as itemized deductions under Code Sec. 164(a)(3).

For a discussion on deducting taxes as business expenses, see Parker Tax ¶ 92,100. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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