The Minnesota Supreme Court (Court) recently affirmed the authority of the Minnesota Department of Revenue (Department) to adjust a taxpayer's federal adjusted gross income (FAGI) in determining the correct amount of state income tax owed (Wendell v. Comm'r. of Rev).¹ The court also found the Department's imposition of the frivolous-return penalty does not violate the US or Minnesota constitutions.

Background

The case involved a Wisconsin resident who was licensed to practice medicine in Minnesota and received wages and other ordinary business income from Minnesota sources. In 2019, the taxpayer and his wife filed a joint income tax return reporting $0 in FAGI and $0 in Minnesota taxable income. The taxpayer requested refunds of Minnesota tax withheld by his employer, asserting the payments received were not connected with any activity subject to federal income tax.² The Department adjusted the taxpayer's FAGI reported on the 2019 return and determined that no refund was due. The Department also cautioned the taxpayer that a 25% frivolous-return penalty could apply if future returns did not report any Minnesota taxable income.

On their 2020 income tax return, the couple showed a nominal amount of FAGI and $0 of Minnesota taxable income. The Department assessed additional Minnesota income on the taxpayer for 2020 and imposed the frivolous-return penalty. The taxpayer appealed the assessment, arguing the Department lacked the authority to adjust FAGI and challenged the imposition of the frivolous-return penalty. The Department affirmed the assessment, and the taxpayer appealed to the Minnesota Tax Court, which granted the Department's request for summary judgment.

Department can adjust FAGI and impose frivolous-return penalty

The Court observed that Minn. Stat. Section 290.01, subd. 19(b) defines Minnesota "net income" as FAGI with modifications permitted by statute. Accordingly, the Court held that the Department may adjust the FAGI reported to determine the correct amount of Minnesota tax. In so holding, the Court reaffirmed its prior holding in Specktor v. Comm'r. of Rev., 308 N.W.2d 806 (Minn. 1981), which upheld the Department's authority to adjust a taxpayer's reported income derived from FAGI.

The Court also upheld the constitutionality of the 25% frivolous-return penalty. Imposition of the penalty did not violate the Due Process Clause because the Department warned the taxpayer that the penalty would apply if the taxpayer continued to file frivolous returns. The court also held that the penalty did not violate the Excessive Fines Clause because it was proportional to the gravity of the offense it is designed to punish.

Implications

While the result in this case is unremarkable based on its facts, it serves as a reminder that states may be authorized to adjust federal income items. For example, in the context of state research credits, we are seeing states look beyond whether the qualifying activity occurred in the state to whether the expenses were qualified research expenses under IRC Section 41, even when the federal credit was accepted by the Internal Revenue Service.