DFA Hearing Highlights Proration Tax Trap for Nonresident Individuals with Tax Credits

If there's one thing that it would seem safe to assume, it is that a credit is a dollar-for-dollar reduction in tax liability, right? Not for nonresident individuals filing in Arkansas. A recent Department of Finance and Administration administrative hearing decision, no. 17-113 (Dec. 16, 2016), illustrates the state's problematic proration requirement for tax credits claimed by nonresident individuals.

The taxpayers appear to have been a nonresident married couple filing jointly. They owned an interest in an entity that received Historic Rehabilitation Tax Credits, a popular program that incentivizes historic preservation. These credits flowed through to the taxpayers, and on their return they claimed that the credits wiped out their Arkansas income tax liability.

The DFA adjusted their return and wiped out 75% of the credits' value under the proration rule. This rule, codified at Arkansas Code Annotated section 26-51-435, requires that a nonresident receive only the value of credits based on the ratio of Arkansas adjusted gross income to adjusted gross income from all sources. You can see how this works mathematically in lines 36 to 36D of Form 1000NR.  The taxpayers in this hearing, for example, must have received approximately 25% of their total adjusted gross income from Arkansas sources, and so they took a 75% haircut.

From a policy perspective, Arkansas's proration rule makes some sense for credits are designed to reduce overall tax burdens, perhaps something like an adoption expense credit. However for credits designed to incentivize behavior in Arkansas, like this rehabilitation credit or economic development incentive credits (Advantage Arkansas, ArkPlus, etc.), the result is nonsensical. Why would Arkansas want to give a dollar-for-dollar tax reduction to residents for undertaking desirable activities, while not extending the same credit to nonresidents?

Individuals and passthrough entities planning activities in reliance on state credits need to take this proration rule into consideration. In particular, as a planning strategy to avoid this issue, passthrough entities having both resident and nonresident individual owners might consider whether there can be special allocations of Arkansas tax credits to resident individuals who can fully utilize the credits.

Nonresident taxpayers facing proration issues also should bear in mind that there may be constitutional arguments against Arkansas's rule as constituting unconstitutional discrimination against nonresidents. It seems problematic for the state to offer 100% credits to residents while only giving partial credits to nonresidents having out-of-state income. Essentially the system penalizes nonresidents for their out-of-state income. Tax structures that discriminate against nonresidents are vulnerable to challenge under the dormant Commerce Clause.

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