INCOME TAX - DEDUCTIBILITY OF EXPENSES INCURRED TO CARRY OBLIGATIONS OF STATES OTHER THAN MICHIGAN

RAB-89-8. This Bulletin describes the Michigan income tax treatment of a resident taxpayer who receives income or dividends and who incurs expenses on obligations issued by another state. This Bulletin focuses on the differences between the taxation of individuals and estates/trusts.

Introduction

To determine the tax treatment of income and expenses derived from obligations issued by a state other than Michigan, one must first consider who the taxpayer is. The Michigan Income Tax Act, MCL 206.1, et seq., defines "person" to include "any individual, firm, association, corporation, receiver, estate, trust or any other group or combination acting as a unit . . . ." [MCL 206.16] Under the Act, the "taxable income" of these various "persons" may differ. MCL 206.30 provides the general rules for establishing Michigan taxable income for persons other than corporations, estates, or trusts. MCL 206.36 provides the general rules for establishing Michigan taxable income for resident estates and trusts.

General Rule

Under the Provisions cited above, MCL 206.30 and MCL 206.36, both groups of taxpayers begin with an identical income tax base. MCL 206.30(1) indicates that " 'taxable income' . . . means adjusted gross income as defined in the internal revenue code subject to the following adjustments . . . ." (Emphasis added.) MCL 206.36(1) provides that " 'taxable income' . . . means federal taxable income as defined in the internal revenue code subject to the following adjustments . . ." (Emphasis added.) The terms "adjusted gross income" as used in MCL 206.30 and "federal taxable income" as used in 206.36 are considered identical starting points for purposes of determining the Michigan income tax base. The difference between the tax base of an individual and of an estate or trust is the result of differences in the specific "add back" provisions of the two sections.

Treatment of Individual Taxpayers

As indicated above, MCL 206.30 governs the income tax treatment of individuals. An individual's income tax base begins with federal adjusted gross income, and is modified by the "add backs" and "deductions" allowed by this provision. Specifically, MCL 206.30(1)(a) states that an individual must:

. . . add gross interest income and dividends derived from obligations or securities of states other than Michigan, in the same amount that was excluded from federal adjusted gross income less related expenses not deducted in computing federal adjusted gross income because of section 265(a)(1) of the internal revenue code. (Emphasis added.)

Therefore, an individual must, in an amount equal to that deducted from federal adjusted gross income, add back all income and dividends derived from obligations of other states. From this added-back amount, an individual taxpayer may deduct certain expenses that, under IRC Sec. 265(a)(1), were not deductible for federal purposes. Section 265(a)(1) of the Internal Revenue Code states:

No deduction shall be allowed for-

1. Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Section 265 of the Internal Revenue Code, when combined with Section 30(1)(a) of the Michigan Income Tax Act [MCL 206.30(1)(a)] permits individuals to deduct, from Michigan taxable income, those expenses incurred in holding obligations from other states. This deduction does not include interest expense incurred in holding these obligations. [IRC Sec. 265 (a)(2)]

Treatment of Trusts and Estates

Section 36 of the Michigan Income Tax Act [MCL 206.36] indicates that the tax base of a resident estate or trust begins with federal taxable income, and is modified by various add backs and deductions. Specifically, MCL 206.36(1)(a) provides that an estate or trust must:

Add gross interest income and dividends derived from obligations or securities of states other than Michigan, in the same amount which has been excluded from federal taxable income less related expenses not deducted in computing federal taxable income because of section 265 of the internal revenue code. (Emphasis added.)

Therefore, an estate or trust must, in an amount equal to that deducted from federal adjusted gross income, add back all income and dividends derived from obligations of other states. However, from this added-back amount, an estate or trust may deduct those expenses deductible under Section 265 of the Internal Revenue Code. Deductions for estates and trusts are not limited in the same manner that deductions for individuals are limited. This is because individuals may deduct only those expenses enumerated in IRC Sec. 265(a)(1). Under MCL 206.36(1)(a), estates and trusts may also deduct interest expenses not deducted in computing federal taxable income because of IRC Sec. 265(a)(2). However, an interest expense deduction is not permitted when, under IRC Sec. 671, the grantor or another person is treated as the owner of any portion of the trust. This is because such a trust is not a taxable entity. Rather, the income, credits and deductions of the trust are taxed and allowed to the grantor or other person in an individual capacity.[IRC Sec. 671, Fed.Treas. Reg. 1.671-4]

Examples

1. Taxpayer A is receiving interest income from investments in obligations of a state other than Michigan. Taxpayer A incurred interest expense directly related to the production of this income. This interest income is not included in Taxpayer A's federal adjusted gross income as per IRC Sec. 103(a).

   For Michigan income tax purposes, Taxpayer A must begin with federal adjusted gross income. [MCL 206.30(1)] The interest income from the non-Michigan obligations must be added back to the Michigan tax base. [MCL 206.30(1)(a)] Taxpayer A cannot deduct from the Michigan tax base the interest expense incurred on these obligations. [IRC Sec. 265(a)(1)]