Were payments to a nonresident member from Virginia franchise LLCs treated as Virginia-source income?

Subject

Virginia Source Income

Plain-English summary

A State A resident received payments from two LLCs operating Virginia franchise businesses. He characterized the payments as passive interest on loans and said he had no management role or Virginia business activity.

The available documents pointed the other way. He signed the loan agreement as a member of one LLC, payments were based on a percentage of net sales, and federal partnership records characterized the amounts as partnership payments. Virginia concluded that amounts determined by partnership income appeared to be Virginia-source income rather than ordinary fixed payments for the use of capital.

The taxpayer did not provide records requested to establish the actual nature of the payments. Because an assessment is presumed correct and the taxpayer bears the burden of proof, Virginia upheld the assessments. It nevertheless gave him 30 more days to supply the listed documentation before payment and collection continued.

What this means for you

• Calling an arrangement a loan does not control if payment is tied to a Virginia business's sales or income and the recipient is treated as an owner.
• Federal partnership reporting and the written agreement can determine how Virginia characterizes the income.
• Refusing or failing to produce requested records can leave an estimated assessment in place.

Common questions

Did Virginia finally determine that every payment was Virginia-source income?

The ruling said the payments appeared Virginia-source on the available record and upheld the assessment because contrary documentation was not supplied.

Did the taxpayer get another chance to prove his position?

Yes. He received 30 days to provide the requested records.

Citations and references

• Va. Code §§ 58.1-301, 58.1-302, and 58.1-325(A), conformity and nonresident Virginia-source income.
• Va. Code §§ 58.1-205, 58.1-219, and 58.1-1826, record requests, presumption of correctness, and failure to provide information.
• Treas. Reg. § 1.707-1(c), partnership payments for services or use of capital.
• P.D. 05-38, payments determined with regard to partnership income.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 07-101

Original ruling text

June 27, 2007

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek correction of the Virginia individual income tax assessments issued to * (the "Taxpayer") for the taxable years ended December 31, 2001 and 2002. I apologize for the delay in responding to your letter.

FACTS

The Department obtained information from the Internal Revenue Service (I.R.S.) indicating that the Taxpayer, a resident of * (State A), received income from two limited liability companies (LLCA and LLCB) operating franchise businesses in Virginia for the 2000 and 2001 taxable years. A review of the Department's records indicated that the Taxpayer had not filed a Virginia nonresident individual income tax return for the taxable years at issue. The Department determined that the income was taxable and issued assessments for the 2001 and 2002 taxable years based on the available information.

The Taxpayer contends that the loans to LLCA and LLCB provided investment income rather than business income. The Taxpayer states he is not the franchisee to whom the loans was made, he had no management role in the operation of the businesses and he performed no business activity in Virginia. Further, the Taxpayer points out that federal law provides that interest from an investment is passive, not business income; therefore, the income from the loan is not Virginia source income. Consequently, the Taxpayer requests abatement of the assessments issued for the 2001 and 2002 taxable years.

DETERMINATION

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Virginia Code will have the same meanings as provided in the Internal Revenue Code unless a different meaning is clearly required. Virginia "conforms" to federal law because it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI).

Virginia Code § 58.1-302 defines income and deductions from Virginia sources to include items of income, gain, loss and deduction attributable to: (1) the ownership of any interest in real or tangible personal property in Virginia; and (2) a business, trade, profession or occupation carried on in Virginia. Furthermore, Virginia Code § 58.1-325 A provides:

The Virginia taxable income of a nonresident individual, partner or beneficiary shall be an amount bearing the same proportion to his Virginia taxable income, computed as though he were a resident, as the net amount of his income, gain, loss and deductions from Virginia sources bears to the net amount of his income, gain, loss and deductions from all sources.

Under Treasury Reg. § 1.707-1 c, payments made by a partnership to partners for services or the use of capital are not treated as paid to a person who is not a partner if such payments are determined without regard to the income of the partnership. Such payments are treated as ordinary income by the individual receiving the payment. Therefore, guaranteed payments are treated as ordinary income and are not treated as income from a trade or business for Virginia income tax purposes. On the other hand, payments determined with regard to the income of the partnership are not treated as ordinary income if based on the income of the partnership. Such income, received by a partner from a partnership, would therefore be considered income from Virginia sources. See Public Document (P.D.) 05-38 (3/16/2005).

The business loan agreement provided shows that the Taxpayer was a signatory on the loan as a member of LLCA. Under the agreement, interest on the loan is based on a percentage of the net sales over a five-year period, or until repaid. The Taxpayer states that the business loan agreement with LLCB is identical.

Information provided by the I.R.S. characterized the income from the partnerships as guaranteed payments, rather than simple interest payments, reported on the federal Form 1065 Schedule K-1s and the Schedule K-1 provided to the Taxpayer. In accordance with P.D. 05-38, payments made by a partnership to partners for services or use of capital are not treated as ordinary income if determined with regard to the income of the partnership. As such, the income appears to be Virginia source income.

In order to ascertain the facts in the case and the nature of the income, the Department requested additional information. The Taxpayer did not provide the requested information or documentation to substantiate that the payments were not Virginia source income.

The Department has the authority to investigate any books and records of a taxpayer in order to ascertain the proper tax liability. See Va. Code § 58.1-219. Further, Va. Code § 58.1-205 provides that in any proceeding relating to the interpretation of the tax laws of Virginia, an "assessment of a tax by the Department shall be deemed prima facie correct." As such, the burden of proof is on the Taxpayer to show that the transactions with the two partnerships did not result in income from Virginia sources. Further, Va. Code § 58.1-1826 precludes a court from granting relief to taxpayers seeking correction of erroneous state tax assessments in cases in which the erroneous assessment was attributable to the taxpayer's willful failure or refusal to provide the Department with necessary information as required by law.

Because the Taxpayer has failed to furnish information required by law, I must uphold the Department's assessments of tax and interest issued to the Taxpayer for the 2001 and 2002 taxable years. I will, however, grant the Taxpayer one more opportunity to provide the information requested to substantiate his claim. The documentation must be provided within 30 days from the date of this letter. Otherwise, the Taxpayer should remit payment of tax and interest within 30 days to avoid the accrual of additional interest. A list of the information requested is enclosed along with a schedule showing the current balance of the assessments.

Please send the additional information or payment to the Department's Office of Policy and Administration, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203, Attn: *. If you have any questions regarding this determination, you may contact at **.

The Code of Virginia sections cited, along with other reference documents, are available online at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions about this determination, you may contact * at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-689104566E