Opinion
Argued November 18, 1992
Decided December 22, 1992
Appeal from the Appellate Division of the Supreme Court in the Third Judicial Department, Daniel H. Prior, Jr., J.
Kohn, Nast Graf, P.C. (David H. Weinstein and Robert S. Kitchenoff, of the Pennsylvania Bar, admitted pro hac vice, of counsel), Krekstein, Wolfson Krekstein, P.C. (Scott H. Mustin, of the Pennsylvania Bar, admitted pro hac vice, of counsel), and Goodkind, Labaton, Rudoff Sucharow, New York City, for appellants.
Robert Abrams, Attorney-General, Albany (Daniel Smirlock, Jerry Boone and Peter H. Schiff of counsel), for respondents. Dowd Reilly (William F. Dowd, of the New Jersey Bar, admitted pro hac vice, of counsel) and Morrison Foerster, New York City (Paul H. Frankel, Arthur R. Rosen, Saul Heckelman and Hollis L. Hyans of counsel), for New Jersey State Assembly, amicus curiae.
Plaintiffs Lawrence Brady and Barbara Brady are married and reside in New Jersey. Plaintiffs Deborah Labovitz and Judah Labovitz are married and reside in Pennsylvania. At all relevant times, Lawrence Brady and Deborah Labovitz earned income in New York, and Barbara Brady and Judah Labovitz earned income outside New York; in addition, the Labovitzes had a combined adjusted gross income of more than $100,000 and received unearned income from non-New York sources. Both couples filed joint Federal tax returns. Plaintiffs challenge New York's method of determining the nonresident tax on income earned in New York, whereby New York takes into account both New York and non-New York source income in calculating the tax rate to be applied to the New York income.
The laws at issue are Tax Law § 601 (d) and (e), sections of the Tax Reform and Reduction Act of 1987 (L 1987, ch 28) (TRARA). Under Tax Law § 601 (e) (1), the tax of a nonresident is first calculated "as if [the taxpayer] were a resident." Thus, the nonresident's tax base (as that term is used by the parties) is determined by applying the appropriate graduated rate in Tax Law § 601 (a) through (c) to the taxpayer's total income from all sources (less any statutory deductions, exemptions or credits [Tax Law §§ 606, 611 (a)]). The taxpayer's total income is derived from "New York adjusted gross income" (Tax Law § 611 [a]), which is determined by reference to the taxpayer's "federal adjusted gross income" (Tax Law § 612 [a]).
In the trial court and Appellate Division, plaintiffs also challenged Tax Law § 651 (b) (2), which required married nonresidents to file a joint nonresident tax return in New York if they filed a joint Federal return. The Appellate Division found this provision unconstitutional, as it exposed a nonresident spouse with no New York connections to civil and criminal liability in New York by virtue of that spouse's signature on the State tax return. The State has not appealed that determination. The question before us — whether in fixing the tax rate, New York can refer to spousal income included in the total adjusted gross income on the couple's joint Federal return — is unaffected by that holding.
Residents pay their entire tax base. For nonresidents, however, the amount is reduced by the percentage of income earned in New York compared to total income (Tax Law § 601 [e] [1]). Therefore, while residents and nonresidents with the same total income are taxed at the same rate, the nonresident pays tax only on the percentage of income attributable to New York.
Assuming, for example, an effective tax rate of 6% for incomes of $25,000 or less, and an effective tax rate of 7% for incomes above $25,000, a resident with total income of $50,000 would have a tax base of $3,500 and would pay that amount. So would a nonresident with the same income entirely attributable to New York sources. However, a nonresident with $25,000 of New York income and $25,000 of non-New York income, while having the same $3,500 tax base, would pay half that amount — $1,750 — because only half of the income would be subject to the New York tax.
In addition, in 1988 only, the taxpayer's effective rate was increased with reference to unearned income if the taxpayer had New York adjusted gross income over $100,000 (Tax Law § 601 [d]). Thus, the hypothetical resident taxpayer with a total 1988 income of $110,000, including total unearned income of $10,000 from non-New York sources, would have an initial tax base of $7,700. That tax base would be increased by $20, which is derived by multiplying $10,000 by 2% and then multiplying the resulting figure of $200 by (110,000-100,000)/100,000. A resident with such income would be liable for a tax of $7,720. A nonresident, however, would pay only $7,025, since the nonresident's tax base would be apportioned by the percentage of New York income (here 100,000/110,000 or 91%).
Plaintiffs challenge this tax scheme, complaining that New York unconstitutionally disadvantages nonresidents. They urge us not to compare residents and nonresidents of the same total income, but to look only to New York income in reviewing the legality of the tax rate. Thus, plaintiffs argue, the same tax rate must apply to a resident with total income of $25,000 and a nonresident with New York income of $25,000, regardless of the nonresident's total income reported on the tax return.
Plaintiffs seek a declaration, for themselves and a class of similarly situated persons, that these provisions violate due process because presumably higher taxes arising from higher tax rates demonstrate that New York is in effect impermissibly taxing out-of-State income. They also claim the scheme violates the constitutional Privileges and Immunities and Equal Protection Clauses since a New York resident having no income other than New York earnings may pay a lower tax than a nonresident with the same New York earnings who has additional income from other sources.
Supreme Court denied plaintiffs' motion for class certification and granted defendants' motion for summary judgment dismissing the complaint. The Appellate Division modified by declaring Tax Law § 651 (b) (2) unconstitutional and remitting for further proceedings on that issue, but otherwise affirmed. On plaintiffs' appeal from the Appellate Division order, we now affirm.
Our decision on the merits renders it unnecessary to address the denial of class action status insofar as it relates to the claims at issue on this appeal. With respect to the Appellate Division's determination that section 651 (b) (2) is unconstitutional — which is not before us on the merits — both the motion court and the Appellate Division found plaintiffs had not met their burden of establishing that the proposed class action would be the superior method for determining the controversy, pointing particularly to notification burdens weighed against speculative allegations of injury to the putative class. We see no reason to overturn that conclusion.
I.
Plaintiffs first claim that by setting tax rates with reference to adjusted gross income, New York taxes non-New York income, thus taking property in violation of due process. They point to three instances: (1) income of the nonresident taxpayer earned outside New York and included on the taxpayer's Federal return; (2) income of the nonresident spouse earned outside New York and included on the taxpayer's joint Federal return; and (3) for 1988 only, unearned out-of-State income referenced for purposes of the section 601 (d) surcharge on those with a total adjusted gross income over $100,000. Each of these is included in the tax base solely for purposes of rate determination. Thus, the inquiry with respect to each category is the same: in these circumstances, is out-of-State income being impermissibly taxed?We start with the proposition that legislative enactments enjoy a presumption of constitutionality (Montgomery v Daniels, 38 N.Y.2d 41, 54). States, of course, have the power to tax nonresidents on income derived from sources within their borders (Travis v Yale Towne Mfg. Co., 252 U.S. 60, 75; Shaffer v Carter, 252 U.S. 37, 52). Similarly, progressive tax systems, which apportion the tax burden based on the taxpayer's ability to pay, are unquestionably constitutional (Brushaber v Union Pac. R.R., 240 U.S. 1, 25), and indeed are "widespread among the United States and firmly imbedded in the federal tax structure" (Wheeler v State, 127 Vt. 361, 365, 249 A.2d 887, 890, appeal dismissed for want of a substantial Federal question 396 U.S. 4).
Dismissal for want of a substantial constitutional question operates as a decision on the merits (see, Washington v Yakima Indian Nation, 439 U.S. 463, 476, n 20).
It has long been the rule that States may refer to nontaxable out-of-State assets in setting their rates for taxable assets (see, Atlantic Pac. Tea Co. v Grosjean, 301 U.S. 412; Maxwell v Bugbee, 250 U.S. 525). Maxwell involved a New Jersey inheritance tax that required the inclusion of the entire estate of the decedent, wherever located, to determine the rate by which the New Jersey property would be taxed. The actual tax was calculated, as here, by applying the rate applicable to the entire estate, but then reducing the tax to reflect only the percentage of the estate located in New Jersey. The United States Supreme Court found the statute constitutional, holding:
"[T]he subject-matter here regulated is a privilege to succeed to property which is within the jurisdiction of the State. When the State levies taxes within its authority, property not in itself taxable by the State may be used as a measure of the tax imposed * * * In the present case the State imposes a privilege tax, clearly within its authority, and it has adopted as a measure of that tax the proportion which the specified local property bears to the entire estate of the decedent * * * It is in no just sense a tax upon the foreign property." (Id., at 539.)
Similarly, in Grosjean, the Supreme Court upheld a Louisiana license tax on in-State chain stores that was calculated on the basis of the taxpayer's nationwide operation, stating "[i]n legal contemplation the state does not lay a tax upon property lying beyond her borders" (id., at 425).
Since Maxwell and Grosjean, high courts in other States have upheld tax schemes similar to the one at issue here. (See, Stevens v State Tax Assessor, 571 A.2d 1195 [Me], cert denied 498 U.S. 819; Wheeler v State, 127 Vt. 361, 249 A.2d 887, supra; cf., United States v State of Kansas, 810 F.2d 935 [10th Cir] [upholding validity of including nonresident military income — which was not taxable by State — in determining State tax rate]; Aronov v Secretary of Revenue, 323 N.C. 132, 371 S.E.2d 468 [upholding requirement that nonresident taxpayer reduce net operating loss from North Carolina partnership by amount of out-of-State income], cert denied 489 U.S. 1096.)
As in Stevens and Wheeler, the subject matter here regulated is a tax on in-State income, which is within the jurisdiction of the State. When the State levies taxes within its authority, "property not itself taxable can be used as a measure of the tax imposed on property within the state and * * * to do so is 'in no just sense a tax on the foreign property.'" (United States v State of Kansas, 810 F.2d, at 938, supra [quoting Maxwell v Bugbee, 250 US, at 539, supra].)
Plaintiffs' contention that Maxwell and Grosjean have been superseded by Supreme Court cases dealing with business taxation and interstate commerce is without basis. Those cases address the constitutionality of directly taxing multistate corporate income, which turns upon whether such income is attributable to a "unitary" business with a sufficient nexus in the taxing State to justify the exercise of the State's taxing authority. In Allied-Signal, Inc. v Director, Div. of Taxation (504 US ___, 119 L Ed 2d 533 [June 15, 1992]), for example, the issue was whether New Jersey could tax the capital gain realized by a non-New Jersey company on the sale of a New Jersey company. Similarly, Complete Auto Tr. v Brady ( 430 U.S. 274) and its progeny address whether a State can tax interstate corporate income in exchange for the privilege of carrying on its business. As even the dissent acknowledges (dissenting opn, at 606, n 1), neither line of cases controls the present issue. Here, there is no question about which of the jointly reported income is taxable and which not; the question is how to determine the rate on income clearly subject to New York tax.
Thus, plaintiffs' due process challenge was correctly rejected by the courts below.
II.
Plaintiffs' alternative contention — an undifferentiated argument under the constitutional Privileges and Immunities and Equal Protection Clauses — also was properly rejected: TRARA treats similarly situated residents and nonresidents the same.
The Privileges and Immunities Clause of the United States Constitution was designed "'to place the citizens [including residents] of each State upon the same footing with citizens [and residents] of other States, so far as the advantages resulting from citizenship in those States are concerned.'" (Supreme Ct. of Va. v Friedman, 487 U.S. 59, 64, quoting Paul v Virginia, 8 Wall [75 US] 168, 180; see also, Austin v New Hampshire, 420 U.S. 656.) Pursuit of an occupation outside one's home State is certainly a right protected by this clause (see, Hicklin v Orbeck, 437 U.S. 518, 524-525; Austin v New Hampshire, 420 U.S. 656, supra; Toomer v Witsell, 334 U.S. 385, 396). However, to establish an unwarranted burden on their privileges and immunities, plaintiffs must demonstrate disadvantage as against others in a similar position (Stevens v State Tax Assessor, 571 A.2d, at 1197, supra; Wheeler v State, 249 A.2d, at 891, supra). This they have failed to do. (Compare, Austin v New Hampshire, 420 U.S. 656, supra [taxing nonresidents but not residents violates privileges and immunities]; Spencer v South Carolina Tax Commn., 281 S.C. 492, 316 S.E.2d 386 [statute that denied certain deductions only to nonresidents violated privileges and immunities], affd by an equally divided court 471 U.S. 82.)
Plaintiffs would have us compare them to New York residents with a total income equivalent to plaintiffs' New York income alone. Plaintiffs would urge, for example, that a nonresident earning $20,000 in New York, but with reported income of $100,000, should be taxed at the same rate as a resident with an income of $20,000. But plaintiffs' hypothetical taxpayers are not similarly situated in terms of ability to pay. Similarly situated taxpayers are those with the same total income.
Again, plaintiffs have failed to establish that the challenged tax is unconstitutional.
III.
Plaintiffs' real quarrel, in the end, is with the graduated tax. A system of progressive taxation apportions the tax burden based on ability to pay — higher income taxpayers can pay more and are therefore taxed at a higher rate than lower income taxpayers. This system does not implicate the State or Federal Constitution so long as the rates are applied, as here, in a nondiscriminatory manner and only to taxable New York income.
Finally, we note that the dissent is flawed not only in its reliance on recent Supreme Court decisions dealing with corporate tax, but also in its claim to logic, common sense and economic reality. In fact, those considerations — as well as precedent — support the challenged tax, which has the practical effect of equalizing tax rates among persons whose total incomes, as reported to taxing authorities, are the same.
Accordingly, the order of the Appellate Division should be affirmed, with costs, and the certified question answered in the negative.
No State may impose a tax on income earned outside of the State by a nonresident. That is settled constitutional law. Under the statute at issue, New York considers income earned outside of the State for purposes of determining the rate at which it will tax a nonresident's New York income. Because New York has a progressive tax rate structure, the result of including the out-of-State income is a higher tax rate and a higher tax on the New York income. The question in this case is whether by considering the nontaxable out-of-State income in determining the tax rate on the New York income, the State is, in reality, taxing the out-of-State income and doing indirectly what it cannot do directly.
The answer to the question, of course, is the one dictated by logic and common sense: the State is taxing the outside income. Including it results in a higher tax bracket and the nonresident pays more tax on the New York income. But, the State maintains that this is not so. There is a distinction, it says, which "is straightforward and obvious. State taxes on nonresidents may be measured by income outside the State as long as they are not imposed upon such income" (respondents' brief, at 17 [emphasis added]).
While the claimed distinction between taxing out-of-State income and using it as a measure of the tax that is ultimately imposed hardly seems "straightforward" or "obvious", my colleagues are apparently content with it and find satisfactory precedent in two decisions of the Supreme Court — one handed down 73 years ago, Maxwell v Bugbee ( 250 U.S. 525), and the other 55 years ago, Atlantic Pac. Tea Co. v Grosjean ( 301 U.S. 412). I believe that these decisions do not control this case. They do not reflect the Supreme Court's express rejection of labelling and formalism and its adoption instead of economic reality as the current approach to problems involving State taxation of out-of-State income of nonresidents (see, e.g., Mobil Oil Corp. v Commissioner of Taxes, 445 U.S. 425, 440-441; Complete Auto Tr. v Brady, 430 U.S. 274, 279). For this reason, I respectfully dissent.
That these cases address the extraterritorial reach of corporate taxes, as the majority notes (majority opn, at 604), is of no moment. Their significance for present purposes is not their specific holdings but the methodology employed by the Court in analyzing the statutes: i.e., looking to the practical effect and economic realities of the tax in issue.
The case of Maxwell v Bugbee ( 250 U.S. 525, supra) — the basis of the Attorney-General's "straightforward and obvious" distinction between measuring a tax on out-of-State income and taxing out-of-State income — was decided in 1919 by a vote of five to four. The Maxwell majority, adopting the more formalistic approach of that time, dismissed the due process objection to the inclusion of out-of-State property in determining the tax on the privilege of transferring property within the State. It simply announced, without explanation of its reasoning, that the inclusion of the out-of-State property does not result in a tax on it, but "merely affords a measure of the tax imposed" (Maxwell v Bugbee, supra, at 535).
Atlantic Pac. Tea Co. v Grosjean ( 301 U.S. 412, supra), involving a chain store tax based on the total number of stores in the chain, is cited by the majority but is not discussed in the opinion. It adds nothing to the argument (see, Hellerstein, Some Reflections on the State Taxation of a Nonresident's Personal Income, 72 Mich L Rev 1309, 1317, n 53 [Grosjean "may be viewed as a case primarily involving the states' police power to regulate the growth of chain stores"]).
The soundness of the Maxwell decision has been questioned by the Court itself (see, Frick v Pennsylvania, 268 U.S. 473, 495 [Maxwell "is on the border line, as is evidenced by the dissent of four members of the Court"]; see also, Hellerstein, Some Reflections on the State Taxation of a Nonresident's Personal Income, 72 Mich L Rev 1309, 1317, n 53 [Maxwell riddled with "dubious logic"]; Lowndes, Rate and Measure in Jurisdiction To Tax — Aftermath of Maxwell v. Bugbee, 49 Harv L Rev 756, 770 [it is difficult "to imagine anything more iniquitously unfair than the application of the Maxwell v. Bugbee formula to income taxation"]).
Justice O.W. Holmes, Jr., viewing the substance of the statute in Maxwell and its effect on the taxpayer with the frank realism for which he was noted, dissented. Joined by Chief Justice White and Justices VanDevanter and McReynolds, Justice Holmes wrote:
See, e.g., Holmes, The Path of the Law, 10 Harv L Rev 457; Summers, Pragmatic Instrumentalism in Twentieth Century American Legal Thought, 66 Cornell L Rev 861, 866-869; Frank, Mr. Justice Holmes and Non-Euclidean Legal Thinking, 17 Cornell LQ 568; Hantzis, Legal Innovation Within the Wider Intellectual Tradition: The Pragmatism of Oliver Wendell Holmes, Jr., 82 Nw U L Rev 541; Lyons, Legal Formalism and Instrumentalism — A Pathological Study, 66 Cornell L Rev 949 (Professor Lyons writes, at 949: "Holmes and those who followed in his wake believed they were rejecting a rigid and impoverished conception of the law [often called 'formalism'] which had, in their view, adversely affected judicial practice. They spawned a collection of doctrines that Professor Summers dubs 'pragmatic Instrumentalism' — fittingly so-called both because they viewed the law as an eminently practical instrument and because they were so strongly influenced by the philosophical pragmatists William James and John Dewey").
"It seems to me that when property outside the State is taken into account for the purpose of increasing the tax upon property within it, the property outside is taxed in effect, no matter what form of words may be used. It appears to me that this cannot be done, even if it should be done in such a way as to secure equality between residents in New Jersey and those in other States" (Maxwell v Bugbee, supra, at 544 [emphasis added]).
Consistent with Justice Holmes' pragmatic approach, in the past half century, the Supreme Court has moved away from its earlier reliance on the Maxwell-type of formalism and embraced a method of analysis based on "the practical effect of a challenged tax" (Mobil Oil Corp. v Commissioner of Taxes, supra, at 443) and on "economic realities" rather than "formal phrasing" (Complete Auto Tr. v Brady, supra, at 278-280 [overruling Spector Motor Serv. v O'Connor, 340 U.S. 602, which had deemed "irrelevant any consideration of the practical effect of the tax" ( 430 US, at 278)]; see also, Allied-Signal, Inc. v Director, Div. of Taxation, 504 US ___, ___, 119 L Ed 2d 533, 545-546; ASARCO Inc. v Idaho State Tax Commn., 458 U.S. 307, 319; Exxon Corp. v Wisconsin Dept. of Revenue, 447 U.S. 207, 223-224; Wisconsin v J.C. Penney Co., 311 U.S. 435, 444).
If the tax in question is analyzed with the candor employed by Justice Holmes in his Maxwell dissent and by the Supreme Court in its recent decisions, there can be no question that the practical effect of including out-of-State income for the purpose of increasing the rate on the in-State income is a tax on the out-of-State income. The majority does not dispute this proposition. Instead, it cites State cases, which, with no explication, have accepted the Maxwell procedure of deciding by labelling (see, majority opn, at 603 [citing Stevens v State Tax Assessor, 571 A.2d 1195 (Me); Wheeler v State, 127 Vt. 361, 249 A.2d 887]). That Vermont and Maine have cited Maxwell with approval, of course, does not mean that the decision is regarded with favor by the Supreme Court. The Vermont Supreme Court, it should be noted, decided Wheeler in 1969, prior to the Supreme Court cases expressly renouncing the formalistic approach. In Stevens, the Supreme Court of Maine merely followed Wheeler in its uncritical acceptance of Maxwell. Whether the Court will again resort to the Maxwell-type of labelling in order to uphold a taxing scheme — where out-of-State income of the taxpayer and the taxpayer's spouse is used to increase the tax on the taxpayer's in-State income — only the Supreme Court can tell us. If the answer should be "yes", then I respectfully submit that the answer would be inimical to Justice Holmes' commonsense appraisal of the tax in Maxwell and to the Court's recent method of analyzing State taxation due process problems by looking at the practical effect and the economic realities rather than "formal phrasing" (Complete Auto Tr. v Brady, supra, at 280; see, e.g., Mobil Oil Corp. v Commissioner of Taxes, supra, at 443). A statute which includes out-of-State income of the taxpayer and the taxpayer's spouse for the purpose of increasing the tax on the in-State income and which results in such increase imposes a tax on the out-of-State income in violation of the Due Process Clause — no matter how the tax is described. To pretend that it does not endorses a due process violation and works a distinct unfairness on taxpayers such as the New Jersey and Pennsylvania residents in this case.
Indeed, the decision in Wheeler does not address the issue of whether out-of-State income is a permissible consideration in setting the rate of tax on in-State income (see, Hellerstein, Some Reflections on the State Taxation of a Nonresident's Personal Income, 72 Mich L Rev 1309, 1318). The decision, as far as it concerned due process, addressed only whether Vermont had in fact taxed Wheeler's out-of-State income.
Avoiding a due process challenge by proclaiming that the statute "merely affords a measure of the tax imposed" as in Maxwell is the sort of formalism in decision-making which the Court repudiated in J.C. Penney: "[T]he descriptive pigeon-hole into which a state court puts a tax is of no moment in determining the constitutional significance of the exaction. 'In whatever language a statute may be framed, its purpose must be determined by its natural and reasonable effect.' Henderson v. Mayor of New York, 92 U.S. 259, 268. Such has been the repeated import of the cases which only recently were well summarized by the guiding formulation for adjudicating a tax measure, that 'in passing on its constitutionality we are concerned only with its practical operation, not its definition or the precise form of descriptive words which may be applied to it.' Lawrence v. State Tax Commission, 286 U.S. 276, 280" (Wisconsin v J.C. Penney Co., 311 US, at 443-444, supra).
Judges TITONE, BELLACOSA and SMITH concur with Judge KAYE; Judge HANCOCK, JR., dissents and votes to reverse in a separate opinion; Acting Chief Judge SIMONS taking no part.
Order affirmed, etc.