The parameters of the substantial justification test as established by the Supreme Court in Lunding v. New York Tax Appeals Tribunal.

• Author: Royal, Amy

1. INTRODUCTION

   The Privileges and Immunities Clause of the United States Constitution prohibits a state from enacting laws designed to discriminate in favor of citizens of that state over citizens of other states.(1) The United States Supreme Court has often decided the constitutionality of state taxing statutes based on the Privileges and Immunities Clause.(2)

   In the recent case of Lunding v. New York Tax Appeals Tribunal,(3) the Supreme Court, in a six to three decision, ruled that a New York State statute which effectively denied a nonresident taxpayer a deduction from his New York State income tax for alimony payments made to a former spouse, violated the Privileges and Immunities Clause.(4) Such tax treatment discriminated against the nonresident taxpayer because New York tax statutes permitted a state resident to deduct such alimony payments against his income before computing his New York State income tax.(5)

   According to the majority opinion of the Court, a state, under its taxing system, must provide substantial equality of treatment for nonresident and resident taxpayers.(6) Nonetheless, the Court recognized the Privileges and Immunities Clause does not require exact equality of treatment between nonresident and resident taxpayers.(7) If a state fails to provide identical tax treatment for nonresidents, the state must provide a substantial reason or justification for the disparate treatment afforded the nonresident, and must also furnish an explanation of the manner in which such discriminatory treatment of the nonresident relates to the state's reason or justification.(8)

   The Court's test for satisfying the requirements of the Privileges and Immunities Clause requires any discriminatory treatment of nonresidents be reasonable in effect and predicated on a substantial justification other than nonresidence.(9) Although the Court formulated this test, it failed to clearly articulate the parameters under which the rule could be applied. The Court blurred the boundaries of its standard by distinguishing alimony payments, which it characterized as a personal deduction, from other personal deductions, such as mortgage interest payments and real property taxes.(10) The Court suggested that states may permissibly discriminate against nonresident taxpayers by disallowing mortgage interest deductions and real estate tax deductions only for homes located outside of the taxing state.(11) The Court asserted that alimony payments are largely determined by an individual's income, wherever earned, whereas mortgage interest and real estate taxes can be attributed to geographic location of the property.(12) However, it failed to articulate why the physical situs, outside of New York, of the source of the personal expense deduction necessarily made the discriminatory treatment reasonable in effect and also established a substantial justification for such discrimination.

   In dissent, Justice Ginsburg questioned the majority's view which seemed to base the deductibility of certain personal expenses solely on the geographic situs of the source of the expense.(13) She challenged the rationale for denying a nonresident a deduction for a personal expense based solely on the location of the source which produced the expense.(14) She argued that income, wherever earned, has a greater correlation to an individual's spending habits and abilities than the geographic location of items purchased with respect to where the personal expenditure is made.(15) Notwithstanding this observation, Justice Ginsburg ultimately determined the alimony payments of Lunding were personal expenses which neither took place, nor provided any benefit to New York.(16)

   The Supreme Court failed to explain why the situs of the personal expense could dictate its deductibility. Apparently, a substantial justification for discrimination against a nonresident could exist if the personal expense of the nonresident was situated outside the taxing state. The Court, however, failed to resolve a number of issues. For example, it did not identify other potential substantial justifications for discrimination against a nonresident. It did not explain whether a personal deduction could be allowed to a resident and denied to a nonresident on a basis other than the geographic location of the source of the expense. More precisely, the Court never clearly determined whether a state had the right to create legislation that would treat residents and nonresidents differently with respect to personal tax deductions in an attempt to encourage specific social behavior in its residents.

   This Note focuses on the limitations of the Supreme Court's "substantial justification" test. Part II of this Note summarizes the facts of the case and reviews its history through the New York courts.(17) Part III argues the Supreme Court should have provided a more detailed explanation of its test.(18) The Court never articulated nor identified the fundamental state interests or policies that could justify discrimination against nonresident taxpayers. Without further clarification of this test, lower courts, in applying this test to the extreme, could possibly permit the denial of all personal deductions to nonresident taxpayers if the taxing state identifies as its fundamental policy, some specific social behavior it seeks to encourage in its citizens. Since the contours of this test remain unsettled, Part IV of this Note attempts to identify more precisely what the parameters of a "substantial justification" should be.(19)

2. FACTS AND HISTORY OF LUNDING V. NEW YORK TAX APPEALS TRIBUNAL

   Christopher Lunding (the taxpayer) was a resident of the State of Connecticut.(20) He maintained a law practice in New York City and derived a significant amount of his income from this practice.(21) Lunding had been divorced.(22) His former spouse was also a resident of Connecticut,(23) and in 1990, Lunding paid her $108,000 in alimony.(24)

   Lunding, with his then current wife, filed a nonresident personal income tax return for New York in 1990.(25) On this tax return, Lunding deducted 48.0868% or $51,934 of his 1990 alimony payment.(26) This percentage was based on the pro rata amount of his 1990 income earned in New York.(27) In other words, the taxpayer allocated as a deduction on his 1990 New York tax return the amount of alimony payments equal to the percentage that his 1990 New York income bore to his total income for 1990.(28)

   The existing New York statute on taxation did not authorize such an allocation and, as a result, denied nonresident taxpayers a deduction for any alimony payments.(29) New York, however, did permit residents of the state to deduct alimony payments in computing their New York income tax.(30) New York denied nonresident taxpayers a deduction for alimony payments under a rather complex and convoluted method of computing the New York income tax for nonresidents.(31) Under this taxing scheme, nonresident taxpayers were required to compute their New York income tax "as if" they were a resident of New York.(32) In other words, the theoretical or "as if" income was determined in exactly the same method as if the nonresident had been a resident.(33) Initially, therefore, a nonresident, like a resident, was allowed a deduction for alimony payments.(34) The "as if" income was next multiplied by the appropriate tax rate to establish the tax base for the nonresident.(35) The final step in the calculation was to multiply this tax base by the "New York source fraction."(36) The numerator of this fraction was the New York source income which included "items of income, gain, loss and deduction ... derived from or connected with New York sources."(37) New York Tax Law section 631(b)(6) specifically provided that alimony payments did not constitute a deduction in computing New York source income.(38) The denominator of this fraction was New York adjusted gross income.(39) New York adjusted gross income was computed by allowing a deduction for alimony payments.(40) The overall effect of multiplying the "as if" income by the tax rate and then by the New York source fraction was to deny a nonresident taxpayer an alimony deduction.(41)

   Lunding directly challenged the constitutionality of the New York statute subsection that caused the numerator of the New York source fraction to be computed without a deduction for alimony payments.(42) The taxpayer argued that since the statute plainly discriminated against nonresidents, and since no valid substantial reason had been established to justify such discrimination, the statute ([sections] 613(b)(6)) violated the Privileges and Immunities Clause.(43)

   The Appellate Division of the New York Supreme Court ruled that section 613(b)(6) violated the Privileges and Immunities Clause.(44) Although the court acknowledged the Privileges and Immunities Clause permitted a disparity in treatment of nonresidents based on valid reasons, it concluded, in the instant case, "there exists no substantial reason for the disparate treatment."(45)

   The New York Court of Appeals reversed the appellate division's ruling and determined that section 613(b)(6) did not violate the Privileges and Immunities Clause.(46) The New York Court of Appeals, interpreting prior United States Supreme Court cases, concluded that since the taxing state can only impose a tax on a nonresident based on income earned within that state, such limitation constitutes a sufficient justification for confining a nonresident's deductions from such in-state income to expenses attributable to sources which produce the income earned within that state.(47) The court, again relying on another United States Supreme Court case,(48) determined the Privileges and Immunities Clause did not demand absolute equality of tax treatment for nonresidents, but simply required that a substantial reason must exist for such different tax treatment and that any discrimination against a nonresident taxpayer must have a...