Did Maryland tax mutual fund dividends even when the fund's income came from tax-exempt federal government bonds?

Plain-English summary

The Director of the Comptroller's Income Tax Division asked the Attorney General how Maryland should tax distributions from mutual funds (regulated investment companies) that invest in United States government obligations, whose interest is ordinarily exempt from state income tax when received directly by the bondholder. The opinion concluded that this federal exemption did not carry through to a taxpayer who instead owned shares of a mutual fund that itself owned the federal obligations, so distributions a shareholder received from such a fund remained fully taxable under Maryland's income tax law. It reasoned that under longstanding intergovernmental-immunity case law tracing to McCulloch v. Maryland, the constitutional and statutory tax exemption for interest on federal obligations belongs only to the entity that directly owns the obligation, and does not pass through to someone who merely owns an interest in that entity and receives a distribution from it, absent an explicit statutory rule saying otherwise. The opinion contrasted this with mutual fund distributions traceable to state and local government bonds, which Congress had specifically made pass-through tax-exempt in a 1976 amendment to the Internal Revenue Code, a provision Maryland's own tax code followed; because no comparable federal provision extended pass-through treatment to interest on federal obligations, the opinion found the apparent disparity in tax treatment between state and federal bond-fund income to be a product of federal tax law itself, not an unconstitutional discrimination against federal obligations under the doctrine of intergovernmental immunity.

Currency note

This opinion was issued in 1983. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here.

The opinion's conclusion depended on the specific state of the Internal Revenue Code and Article 81 of the Maryland Code as they existed in 1983, including a 1976 federal amendment addressed at length in the opinion. Maryland's income tax statute has since been recodified out of Article 81 into the Tax-General Article, and federal tax treatment of regulated investment company distributions has likely changed further. Verify the current Tax-General Article and current federal tax law before relying on any specific rule about mutual fund taxation described here.

Common questions

If someone owned U.S. Treasury bonds directly, did they owe Maryland income tax on the interest?
No, according to this opinion, and this part of the analysis has not changed: interest on federal obligations received directly by the owner remained exempt from Maryland income tax under Article 81, §280(c)(1), reflecting the interest income's exemption from state taxation under federal law, 31 U.S.C. §3124.

Why did the same federal-bond interest become taxable once it passed through a mutual fund to a shareholder?
The opinion explained that federal and Maryland tax law treat a mutual fund as its own separate taxpayer, and the tax exemption for federal obligation interest belongs only to whoever directly owns the obligation, here, the fund, not to someone who merely owns shares in the fund and receives a distribution from it, unless a specific statute says the exempt character passes through to the shareholder.

Didn't Maryland treat mutual fund dividends from state and local bonds differently, and wasn't that unfair to federal bonds?
The opinion acknowledged this apparent disparity but found it originated entirely in federal tax law: a 1976 amendment to the Internal Revenue Code, 26 U.S.C. §852(b)(5), specifically created pass-through tax-exempt treatment for mutual fund dividends traceable to state and local bonds, and Maryland law followed that federal change, but no comparable provision extended the same treatment to dividends traceable to federal obligations, so the difference was not an unconstitutional discrimination against federal securities.

Background and statutory framework

The opinion applied Article 81, §280(a), which based Maryland taxable income on federal adjusted gross income, and §280(c)(1), which allowed a taxpayer to subtract interest on federal obligations "to the extent . . . exempt from State income taxes under the laws of the United States," itself an application of the intergovernmental immunity doctrine first announced in McCulloch v. Maryland and now codified at 31 U.S.C. §3124. Relying on a line of Supreme Court cases including Cleveland Trust Co. v. Lander, Des Moines National Bank v. Fairweather, and Society for Savings in the City of Cleveland, Ohio v. Bowers, the opinion found this exemption available only to the entity directly holding the federal obligation and receiving the interest, not to someone who instead held an ownership interest in that entity and received a distribution from it, a separation principle also reflected in National Carbide Corp. v. Commissioner of Internal Revenue and other federal tax cases.

The opinion traced how federal tax law, 26 U.S.C. §851 et seq., treats a qualifying mutual fund as a separate, generally non-taxed entity whose distributions retain their character (such as capital gains) only where Congress has expressly so provided, as it did for interest on state and local bonds through a 1976 amendment creating "exempt interest dividends" under 26 U.S.C. §852(b)(5). Before that amendment, the opinion noted, mutual fund distributions traceable to state and local bond interest were fully taxable at both the federal and Maryland level, just as federal-obligation-based distributions still were; Maryland's Comptroller had implemented the change through a 1977 memorandum applying the recodified pass-through rule only to income traceable to Maryland's own obligations. Distinguishing the Connecticut Supreme Court's decision in Woodruff v. Tax Commissioner, which similarly refused to let a mutual fund shareholder claim a state tax exemption not mirrored in federal treatment, from the U.S. Supreme Court's 1983 decision in Memphis Bank and Trust Company v. Garner, which struck down a state tax scheme that directly and expressly favored a state's own bonds over federal bonds, the opinion found Maryland's situation different in kind: the disparity between state-bond and federal-bond mutual fund distributions arose entirely from a distinction Congress itself drew in the Internal Revenue Code, not from any Maryland statute singling out federal obligations for worse treatment, so no unconstitutional discrimination under the intergovernmental immunity doctrine was present.

Citations

Statutes:

• 31 U.S.C. §3124 (federal tax exemption for U.S. government stocks and obligations)
• 31 U.S.C. §3124(a) (exemption of federal obligations from state and local taxation)
• 31 U.S.C. §3124(b) (tax status of federal obligation interest governed by the Internal Revenue Code)
• Article 81, §280(a) (Maryland taxable income based on federal adjusted gross income)
• Article 81, §280(c)(1) (subtraction for interest on federal obligations exempt from state tax)
• Article 81, §280(a)(1) (Comptroller's modification taxing exempt-interest dividends from non-Maryland obligations)
• 26 U.S.C. §851, et seq. (federal taxation scheme for regulated investment companies)
• 26 U.S.C. §§852(b)(3) and (5) (capital gains and exempt-interest dividend pass-through treatment)
• 26 U.S.C. §103(a) (federal exemption for interest on state and local obligations)
• 26 U.S.C. §652(b) (trusts distributing current income)
• 26 U.S.C. §662(b) (estates and trusts accumulating or distributing income)
• 26 U.S.C. §702(b) (partnerships)
• 26 CFR §1.103-4(a) (federal exemption for certain pre-1941 U.S. obligations)
• 26 CFR §1.103-4(b) (federal obligation interest generally included in adjusted gross income)

Cases:

• McCulloch v. Maryland, 17 U.S. (4 Wheat.) 316 (1819)
• Cleveland Trust Co. v. Lander, 184 U.S. 111 (1902)
• Des Moines National Bank v. Fairweather, 263 U.S. 103 (1923)
• Society for Savings in the City of Cleveland, Ohio v. Bowers, 349 U.S. 143 (1955)
• National Carbide Corp. v. Commissioner of Internal Revenue, 336 U.S. 422 (1949)
• Van Allen v. The Assessors, 70 U.S. 229, 234 (1866)
• Putnam's Estate v. Commissioner of Internal Revenue, 324 U.S. 393, 399 (1945)
• Bess Schoellkopf, 32 B.T.A. 88 (1935)
• Smith v. Davis, 323 U.S. 111, 117 (1944)
• Woodruff v. Tax Commissioner, 440 A.2d 854 (Conn. 1981)
• Memphis Bank and Trust Company v. Garner, 459 U.S. 392 (1983)

Source

• Landing page: https://oag.maryland.gov/resources-info/Pages/attorney-general%E2%80%99s-opinions.aspx
• Original PDF: https://oag.maryland.gov/resources-info/Documents/pdfs/Opinions/1983/Volume68_1983.pdf

Original opinion text

Best-effort transcription from a scanned PDF. Minor errors may remain, the linked PDF is authoritative.

Taxation—Income Tax—Regulated Investment Companies (Mutual Funds)—Exempt Interest Dividends—Intergovernmental Immunity—Distributions from Mutual Funds are Subject to State Income Tax Even Though Derived from Funds' Investments in Federal Obligations.

December 21, 1983

Mr. George H. Spriggs, Jr.
Director, Income Tax Division
Comptroller of the Treasury

You have requested our opinion on the proper treatment, for Maryland income tax purposes, of distributions from regulated investment companies (mutual funds) that invest in United States obligations.

As a rule, interest earned on obligations of the United States is, by federal law, exempt from State income tax. 31 U.S.C. §3124. Thus, when such interest is received directly by a taxpayer who owns the obligations themselves, that interest may be subtracted from the taxpayer's federal adjusted gross income for purposes of determining his or her Maryland taxable income. See Article 81, §280(c)(1) of the Maryland Code. Because one's federal adjusted gross income is the basis for determining one's Maryland taxable income, this interest income on federal obligations is exempt from Maryland income tax. See Article 81, §280(a).

Your question is whether the same exemption from State income tax applies when the taxpayer does not directly own or receive interest from the federal obligations, but instead owns shares of and receives distribution from a mutual fund that itself owns the obligations, receives the interest, and then distributes that interest to the taxpayer.

For the reasons given below, it is our opinion that such a distribution from a mutual fund is taxable in Maryland when received, even if the source of that distribution is interest from federal obligations owned by the mutual fund.

I
Article 81, §280

Article 81, §280(a) establishes the general rule that taxable net income, for Maryland tax purposes, is the "taxpayer's federal adjusted gross income as defined in the laws of the United States, . . . with the modifications and less the deductions and personal exemptions provided in this subtitle".

Interest or dividends on United States obligations are normally included in federal adjusted gross income. See 26 CFR §1.103-4(b) (1982) (Internal Revenue).1 Therefore, such interest would be normally included in the taxpayer's Maryland taxable net income. However, Article 81, §280(c)(1) authorizes the subtraction of "[i]nterest or dividends on obligations of the United States and its territories and possessions or of any authority, commission or instrumentality of the United States and any other income to the extent includable in gross income for federal income tax purposes, but exempt from State income taxes under the laws of the United States".

Thus, §280(c)(1) sets forth two categories of income that may be subtracted from a taxpayer's federal adjusted gross income in determining Maryland taxable net income: (i) interest on United States obligations "to the extent . . . exempt from State income taxes under the laws of the United States", as well as (ii) "any other income to the extent . . . exempt from State income taxes under the laws of the United States". These exemptions from State income tax may be broadly characterized as the constitutional exemptions available to certain types of income under the doctrine of intergovernmental immunity.

1 Interest on certain United States obligations, issued before March 1, 1941, is exempt from federal income tax pursuant to terms of the issue. 26 CFR §1.103-4(a).

II
The Doctrine of Intergovernmental Immunity

The doctrine of intergovernmental immunity was first enunciated in McCulloch v. Maryland, 17 U.S. (4 Wheat.) 316 (1819), and is presently codified at 31 U.S.C. §3124. Essentially, 31 U.S.C. §3124(a) provides: "Stocks and obligations of the United States Government are exempt from taxation by a State or political subdivision of a State."2

According to established precedent, this exemption from State tax is available only when the owner of the security directly receives interest from that federal obligation, not when the income from the obligation first is received by one entity or individual, then is paid over to another. Compare Cleveland Trust Co. v. Lander, 184 U.S. 111 (1902), and Des Moines National Bank v. Fairweather, 263 U.S. 103 (1923) (state tax on shareholder's distribution not equivalent to tax on property of corporation; therefore, shareholder not entitled to deduction based on bank's investment in United States obligations) with Society for Savings in the City of Cleveland, Ohio v. Bowers, 349 U.S. 143 (1955) (prohibiting indirect state taxation of bank property that included federal obligations; but recognizing exception for taxation of bank shareholder's "separate property interest from the corporation's ownership of its assets").

This principle of separation between taxable entities and the individuals owning interests in such entities is undisputed, unless "pass-through" treatment of a given type of income is specifically authorized. See National Carbide Corp. v. Commissioner of Internal Revenue, 336 U.S. 422 (1949); Van Allen v. The Assessors, 70 U.S. 229, 234 (1866). See also Putnam's Estate v. Commissioner of Internal Revenue, 324 U.S. 393, 399 (1945); 7 Mertens, Laws of Federal Income Taxation, §§38.04 and 38.05 (rev. 1976).3 The distinction between a taxable entity

2 The exemption was enacted to "prevent taxes which diminish in the slightest degree the market value or the investment attractiveness of obligations issued by the United States in an effort to secure necessary credit". Smith v. Davis, 323 U.S. 111, 117 (1944).
3 See, e.g., 26 U.S.C. §652(b) (trusts distributing current income); §662(b) (estates and trusts accumulating income or distributing corpus); §702(b) (partnerships).

and individuals owning interests in and receiving distributions from that entity has been applied notwithstanding the doctrine of intergovernmental immunity. See, e.g., Bess Schoellkopf, 32 B.T.A. 88 (1935), appeal dismissed, August 25, 1936. Here, the court denied an exemption from federal income tax for certificates of indebtedness issued by a trust, even though the certificates were backed by state and local obligations, the income from which was normally tax exempt.

In light of this separation principle, the exemption from State income tax, available to the entity or individual actually owning the federal obligation, is not "passed through" to a taxpayer who receives a distribution from the entity that actually owns the obligation, absent express authorization. The taxpayer neither owns a United States obligation nor receives interest directly from such obligation, but instead owns shares in a mutual fund (a separate taxable entity) and receives distributions from that fund.

The federal law that regulates the taxation of mutual funds and fund distributions substantiates this distinction. Under the taxation scheme applicable to regulated investment companies, 26 U.S.C. §851, et seq., if a mutual fund meets applicable criteria, it is not subject to a corporate income tax. Distributions generally retain their character as capital gains in the hands of the recipient shareholders. However, these distributions only retain their character as a particular type of income, such as capital gains, because of express authorization in the Internal Revenue Code. See 26 U.S.C. §§852(b)(3) and (5) (capital gains; exempt-interest dividends). See generally Comment, Federal and State Taxation of Municipal Bond Mutual Funds, 37 Md. L. Rev. 619, 623 (1978).

We recognize that this analysis can seem anomalous at first glance: it imposes the tax on the shareholder receiving distributions funded by interest from federal obligations because of the separate tax status of a mutual fund that, in the normal course of events, does not itself pay any tax at all. As noted above, however, the federal tax provisions governing mutual funds are specifically designed to treat such funds as separate entities. This same separation was formerly the basis for imposing both federal and state income tax on distributions from mutual funds that were funded by income from state and local obligations, even though income directly received from such obligations was normally tax exempt.

For example, interest income from state and local obligations is, when directly received, tax exempt. 26 U.S.C. §103(a).4 Prior to the 1976 Tax Reform Act, however, this tax exemption was not recognized, for either federal or state purposes, when the state obligation or bond was owned by a mutual fund that then paid the income from the bond to fund shareholders as a dividend. See Comment, 37 Md. L. Rev. at 629. This was true whether or not the underlying obligation was a Maryland obligation normally exempt from tax. In 1976, 26 U.S.C. §852 was amended. As amended, §852(b)(5) provided, for the first time, a form of pass-through treatment for income from state and local obligations that is received by a mutual fund and, in turn, distributed dividends to its shareholders. If certain qualifications were met, the dividend (termed an "exempt interest dividend") would be exempt for federal tax purposes as if the shareholders had owned the underlying obligations directly.

4 26 U.S.C. §103(a) now provides: "Gross income does not include interest on— (1) the obligations of a State, a Territory, or a possession of the United States, or any political subdivision of any of the foregoing, or of the District of Columbia; and (2) qualified scholarship funding bonds."

The Comptroller's response to this amendment (Income Tax Division, Memorandum Release No. 17 (February 17, 1977)) quite properly interpreted Maryland law, as affected by the 1976 federal amendment: (i) through Article 81, §280(a)(1), the additional modification to federal adjusted gross income, to tax those "exempt interest dividends" that were distributed to non-Maryland obligations; and (ii) to exempt from tax those "exempt interest dividends" that were attributable to Maryland obligations. Thus, in effect, Maryland indirectly taxed both its own and other governmental obligations prior to the federal amendment, and exempted only its own obligations after the amendment. The 1976 federal amendment broke down the separate entity barrier that previously existed for this type of mutual fund dividend, and Maryland law followed suit.

The key point, however, is not that barriers or separate entity status no longer exist. It is, rather, that they do exist unless specifically removed by either federal or state law. Quite clearly, federal law now provides pass-through treatment when a mutual fund receives income from state and local obligations. It is equally clear, however, that no provision in federal law, in the Internal Revenue Code or elsewhere, provides any similar pass-through treatment when a mutual fund receives income from federal obligations. It would therefore be highly incongruous to allow such pass-through treatment for federal obligations, especially when the same treatment and benefits were denied to state obligations by both federal and state tax laws until the 1976 amendment to the Internal Revenue Code.

III
State Law

The refusal to recognize an income characteristic for state taxation purposes when that character is not mandated by federal law has been judicially recognized. See, e.g., Woodruff v. Tax Commissioner, 440 A.2d 854 (Conn. 1981). Here, a taxpayer received distributions from a regulated investment company, but failed to pay the Connecticut capital gains and dividend tax on that amount. The Connecticut revenue authorities contended that he had received a "dividend", taxable under Connecticut law. The taxpayer, however, contended that he had received "interest", exempt from state tax by Connecticut law, because these distributions came from interest received by the mutual fund and then turned over to him. The Connecticut Supreme Court refused to allow the pass-through exemption, holding that the distributions were merely taxable dividends and did not retain the character they possessed when received by the mutual fund. The court noted that, prior to the 1976 Tax Reform Act, pass-through treatment was not available at the federal level for interest on state and local securities, but that the specific amendments of the 1976 Act allowed such pass-through treatment. Woodruff, 440 A.2d at 856. As federal law contains no comparable pass-through treatment for interest received on mutual fund investments, which, for federal purposes, is considered a dividend in the hands of the shareholder, the court found the distribution to be subject to the state capital gains and distribution tax.5

5 The Court observed, in passing: "A review of the federal tax scheme shows that the shareholders are not always taxed on distributions from the regulated investment company as though the distributions were received directly from the source from which the company derives them." Woodruff, 440 A.2d at 856.

Finally, no different result is mandated by the recent case of Memphis Bank and Trust Company v. Garner, 459 U.S. 392 [103 S.Ct. 692] (1983). Here, the Supreme Court held invalid a Tennessee tax on bank earnings that excluded interest income from Tennessee securities but included interest income from federal securities. The Court viewed the disparate treatment of state and federal securities as discriminatory, and it held that such disparate treatment violated the doctrine of intergovernmental immunity as embodied in then 31 U.S.C. §742 (now 31 U.S.C. §3124).

In Maryland, also, an apparent disparity exists in the treatment, for State income purposes, of interest from State obligations as distinct from federal obligations, when that interest is first paid to a mutual fund. However, the discrepancy is the direct result of distinctions drawn by federal law. It is by federal law that income derived from interest on Maryland obligations owned by a mutual fund receives "pass-through" treatment and, as a result, is exempt from State taxation when received by a taxpayer from the mutual fund. See 26 U.S.C. §103(a); Article 81, §280(c)(1); Income Tax Division, Memorandum Release No. 17 (February 17, 1977). By contrast, interest on federal obligations does not receive pass-through treatment under federal law. 26 C.F.R. §1.103-4(b).6 As noted above, however, this disparity arises solely from federal law, and did not even exist until federal law granted a tax exemption for state obligations, through explicit adoption of "pass-through" treatment under 26 U.S.C. §852(b)(5).

6 31 U.S.C. §3124(b) provides, in pertinent part: "The tax status of interest on obligations and dividends, earnings, or other income from evidences of ownership by the Government ... is decided under the Internal Revenue Code of 1954 (26 U.S.C. 1 et seq.)." As indicated in note 4 above, 26 U.S.C. §103(a) specifically excludes from gross income interest on obligations of a State or its political subdivisions, but does not expressly exclude interest on federal obligations.

IV
Conclusion

In summary, it is our opinion that a Maryland taxpayer may subtract from his or her federal adjusted gross income the interest income received from federal securities that he or she owns, in accordance with 31 U.S.C. §3124 and Article 81, §280(c)(1) of the Maryland Code. To this extent, such interest income is exempt from Maryland income tax.

However, income that a taxpayer receives by virtue of distributions from a mutual fund that has invested in tax-exempt United States obligations is not similarly exempt from State income tax. This treatment results directly from (i) the federal treatment of the mutual fund as a separate taxpayer, and (ii) federal classification of the mutual fund's distributions as dividends, for which no specific pass-through treatment is authorized.

Stephen H. Sachs, Attorney General
John K. Barry, Assistant Attorney General
Avery Aisenstark
Chief Counsel
Opinions and Advice