When did a Virginia shareholder change domicile, and how were a lump-sum payment and S corporation income taxed?

Subject

Residency, Corporate Payments

Plain-English summary

A Virginia resident owned 50% of an S corporation that wholly owned a Virginia operating LLC and also held an interest in another S corporation. The taxpayer claimed to have moved to State B by September 30, 2003 and assigned a December lump-sum payment and all pass-through income to State B.

Virginia found the domicile change occurred December 1, when the State B lease became effective. Preliminary trips did not establish a new domicile, and the first affirmative relocation action was signing the lease in mid-November, followed by the home sale, property shipment, licensing, registration, and physical move.

The taxpayer described the lump sum as advance compensation for future independent-contractor work outside Virginia. Virginia rejected that characterization because the taxpayer controlled the related entities and supplied no written agreement or objective arm's-length evidence. The Department said it would consolidate related accounts to correct the distortion of Virginia income.

The S corporation income also required correction. Corporation A had to include the Virginia LLC's activities in its apportionment, and Virginia-source income stayed Virginia-source in the shareholder's hands. Corporation B's income would be treated entirely as Virginia-source unless the taxpayer showed that it operated outside Virginia. Income for the Virginia-resident portion of the year was prorated by resident days absent better timing records, and Virginia-source income after the move required a nonresident return.

What this means for you

• A domicile change requires both abandonment of Virginia and actual acquisition of a new permanent or indefinite home; planning trips alone may not establish the date.
• Closely controlled payments need written terms and objective arm's-length support.
• Moving during the year does not convert Virginia-source pass-through income into out-of-state income.

Common questions

What date did Virginia accept as the move date?

December 1, 2003, the effective date of the State B lease.

Was the lump sum accepted as advance pay for future out-of-state services?

No. Virginia found no written agreement or objective evidence of an arm's-length transaction.

How was income timed within the part-year resident period?

Unless better documentation showed when it was earned, Virginia treated the income as generated evenly through the year and prorated it by days of Virginia residence.

Citations and references

• Va. Code §§ 58.1-302, 58.1-303, and 58.1-325, domicile, part-year residency, and nonresident income.
• Va. Code §§ 58.1-408 through 58.1-421, corporate allocation and apportionment.
• Va. Code §§ 58.1-445 and 58.1-446 and 23 VAC 10-120-350, related-business consolidation and adjustment.
• 23 VAC 10-110-40, part-year resident taxation.
• P.D. 88-165, P.D. 97-343, and P.D. 06-99, S corporation sourcing, disregarded-entity attributes, and income timing.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 07-99

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 individual income tax assessment issued to * (the "Taxpayer") for the taxable year ended December 31, 2003.

FACTS

The Taxpayer, a Virginia resident, was a 50% shareholder in an S Corporation incorporated in * (State A). The S Corporation (Corporation A), in turn, was the sole owner of a limited liability corporation (VLLC) that is commercially domiciled and operating in Virginia. In addition, the Taxpayer is a shareholder in another S Corporation (Corporation B).

In November 2003, the Taxpayer signed a lease for a residence in * (State B) effective on December 1, 2003. Within the next month, the Taxpayer sold his Virginia home, shipped his personal property to his residence in State B, registered his vehicle in State B, acquired a State B driver's license, registered to vote in State B, and moved into his State B residence.

In December 2003, the Taxpayer received a lump sum payment from Corporation A. The Taxpayer filed a Virginia part-year return claiming he ceased residing in Virginia by September 30, 2003. The Taxpayer sourced all salary received from VLLC and an unrelated employer in 2003 to Virginia. All pass-through income received from Corporation A, Corporation B and the lump sum payment from Corporation A was sourced to State B.

Under audit, the Department determined that the lump sum payment was income from Virginia sources and assessed additional tax and interest. The Taxpayer contests the assessment, asserting that the lump sum payment was a prepayment of compensation for future services to be conducted outside of Virginia that was made under an arm's length arrangement with VLLC.

DETERMINATION

The assessment made by the Department relates solely to an adjustment for the lump sum payment received by the Taxpayer. A review of the Taxpayer's 2003 individual income tax return, however, reveals numerous errors not addressed by the auditor. These issues will be addressed below, along with a determination on the appropriate tax treatment of the lump sum payment.

Residency

Two classes of residents, a domiciliary resident and an actual resident, are set forth in Va. Code § 58.1-302. The domiciliary residence of a person means that the permanent place of residence of a taxpayer is Virginia and the place to which he intends to return is Virginia even though he may actually reside elsewhere. For a person to change domiciliary residency to another state or country, that person must intend to abandon his Virginia domicile with no intention of returning to Virginia. Concurrently, that person must acquire a new domicile where that person is physically present with the intention to remain there permanently or indefinitely. An actual resident of Virginia means a person who, for an aggregate of more than 183 days of the taxable year, maintained his place of abode within Virginia. A Virginia domiciliary resident, therefore, working in other parts of the country who has not abandoned his Virginia residency continues to be subject to Virginia taxation. Additionally, a person who is not a domiciliary resident of Virginia, but who stays in Virginia for an aggregate of more than 183 days is also subject to Virginia taxation.

In order to change from one legal domicile to another legal domicile, there must be (1) actual abandonment of the old domicile, coupled with an intent not to return to it, and (2) an acquisition of a new domicile at another place, which must be formed by personal presence and an intent to remain there permanently or indefinitely. The burden of proving that the domicile has been changed lies with the person alleging the change.

In determining domicile, consideration may be given to the individual's expressed intent, conduct, and all attendant circumstances including, but not limited to, financial independence, profession or employment, income sources, residence of spouse, marital status, sites of real and tangible property, motor vehicle registration and licensing, and such other factors as may be reasonably deemed necessary to determine the person's domicile. A person's true intention must be determined with reference to all of the facts and circumstances of the particular case. A simple declaration is not sufficient to establish domicile.

The Department determines a taxpayer's intent through the information provided. The taxpayer has the burden of proving that he or she has abandoned his or her Virginia domicile. If the information is inadequate to meet this burden, the Commissioner must conclude that he or she intended to remain indefinitely in Virginia.

The Taxpayer clearly has performed enough actions to change his domicile from Virginia to State B. The issue in this case is the timing of the actual change. The Taxpayer reported on his 2003 Virginia part-year individual income tax return that he changed domicile on September 30, 2003. The Taxpayer states that starting in August of 2003, he made several trips to State B in order to start the relocation process. The Taxpayer's first affirmative action to change domicile, however, did not occur until mid­November 2003 when he entered into the lease for a residence in State B. All other actions to change domicile, such as acquiring a State B driver's license, registering his vehicle in State A, and selling his Virginia residences occurred after the mid-November date. After reviewing all the evidence, I conclude that the Taxpayer did not change his domicile from Virginia to State B until December 1, 2003, the effective date of the lease.

Lump Sum Payment

The Taxpayer states that his employment with VLLC was terminated in August 2003, and he subsequently entered into a contract as an independent contractor to exclusively investigate and pursue business opportunities on behalf of the VLLC in State B. The Taxpayer contends that the lump sum payment made by VLLC in December 2003 was a prepayment for services that were to be performed in 2004.

In order for there to be an accurate reflection of income, the transaction between the Taxpayer and VLLC needs to be made at arm's length. The Taxpayer was an officer of both Corporation A and VLLC. He and a partner are the sole owners of Corporation A, which in turn wholly owns VLLC. It does not seem plausible that the Taxpayer could maintain an arm's length relationship when dealing with VLLC, when he maintained significant control as an officer of both entities.

Moreover, there is no written agreement between the Taxpayer and VLLC memorializing the independent contractor agreement with VLLC. Without such an agreement, it is impossible to determine whether or not the lump sum payment was made at an arm's length rate.

Without any external or objective evidence and given the Taxpayer's relationship with VLLC, the Department finds that the lump sum payment paid by VLLC to the Taxpayer was not an arm's length transaction for the exploration of possible business opportunities in State B's region.

Virginia Code § 58.1-445 provides:

In any case of two or more related trades or businesses liable to taxation under this chapter owned or controlled directly or indirectly by the same interests, the Department may, and at the request of the taxpayer shall, if necessary in order to make an accurate distribution or apportionment of gains, profits, income, deductions or capital between or among such related trades of businesses, consolidate the accounts of such related trades or businesses.

Title 23 of the Virginia Administrative Code (VAC) 10-120-350 provides that consolidation of this nature is appropriate in situations in which federal taxable income is accurately stated, but the income from Virginia sources taxable by Virginia is inaccurately stated. While the statute and the regulation do not specifically define when Virginia taxable income is considered to be inaccurately stated, the Department and the courts have provided guidance on this issue in applying Va. Code § 58.1-446. Under this statute, the Department may equitably adjust the tax of a corporation when there exists any arrangements that "improperly . . . reflect the business done or the Virginia taxable income earned from business done in this Commonwealth . . . ."

The Department finds that the lump sum payment to the Taxpayer does not reflect an arm's length transaction and the arrangement grossly misstates the Taxpayer's Virginia income. The effect of the lump sum payment significantly reduced Virginia taxable income in 2003 so as to improperly reflect the appropriate assessment of income tax. Under Va. Code § 58.1-445, the Department will consolidate the accounts of the Taxpayer, the partner, and Corporation A in order to more properly reflect the Taxpayer's income subject to Virginia tax.

Pass Through Entity Income

The Taxpayer had income that flowed through from VLLC through Corporation A. In addition, he had flow-though income from Corporation B. On his 2003 Virginia part-year income tax return, he allocated all of this flow-through income to State B.

Corporations (including S corporations) that have income from business both within and without Virginia are required to compute their Virginia source income in accordance with the corporate statutory formula set forth in Va. Code §§ 58.1-408 through 58.1-421. As such, S corporations generally must allocate dividends to the state of commercial domicile and apportion all other income. Income is apportioned using a three-factor formula based on the property, payroll and sales within Virginia. See Public Document (P.D.) 88-165 (6/29/1988).

For federal income tax purposes, Corporation A will be considered the owner of all VLLC's assets and liabilities. Consequently, for income reporting and apportionment purposes, the Department will regard Corporation A as having the attributes and conducting the activities of VLLC. Thus, Corporation A will include the income or loss of VLLC in determining Virginia taxable income and VLLC's property, payroll and sales in determining income apportioned to Virginia. See P.D. 97-343 (8/28/1997).

Income received by an S Corporation, which is determined to be income from Virginia sources, will remain Virginia source income in the hands of the shareholders. Shareholders of an S Corporation that are individuals report such income on their individual income tax returns in kind and remit the tax on behalf of the S Corporation.

Based on the information presented, Corporation A operated both in Virginia and a border state. Therefore, Corporation A must file an income tax return for the 2003 taxable year showing the amount of income apportioned to Virginia.

The information provided does not clearly indicate whether Corporation B was operating outside Virginia during the 2003 taxable year. Accordingly, all of the income of Corporation B will be considered to be income from Virginia sources, unless the Taxpayer can show that the Corporation B's income should be apportioned.

Part-Year Income

Virginia Code § 58.1-303 B states:

Any person who, on or before the last day of the taxable year, changes his place of abode to a place without the Commonwealth with the bona fide intention of continuing actually to abide permanently without Virginia shall be taxable as a resident for only that portion of the taxable year during which he was a resident of Virginia and his personal exemptions shall be reduced to an amount which bears the same ratio to the full exemptions as the number of days during which he was a resident of this Commonwealth bears to 365 days.

Title 23 VAC 10-110-40 provides that individuals who are residents of Virginia for only part of a taxable year are only taxed as residents for that portion of the year that they reside in Virginia.

In this case, the Taxpayer attributed all the income that flowed through from Corporation A and Corporation B to State B. A significant portion of the income of Corporation A and Corporation B, however, was generated while the Taxpayer still resided in Virginia.

The information provided does not indicate exactly when the income related to Corporation A or Corporation B was earned. In such cases, the method used should be the one that provides the most accurate reflection of actual income while residing in Virginia. Unless specifically documented otherwise, the Department will consider income from property owned or business, trade, profession or occupation to be generated evenly throughout the year. See P.D. 06-99 (9/29/2006).

For purposes of this case, the ordinary income apportioned to Virginia from Corporation A and Corporation B must be prorated by multiplying the amount of income by the ratio of days of residence in Virginia to 365 days. Moreover, interest and dividends passed through from the two S Corporations must also be prorated by multiplying the amounts by the ratio of days of residence in Virginia to 365 days.

Nonresident Income

Pursuant to Va. Code § 58.1-303 C, a part-year resident who, as a nonresident of Virginia for any portion of the taxable year, derived income from any property owned or from any business, trade, profession or occupation carried on in Virginia is subject to Virginia income tax as a nonresident as provided under Va. Code § 58.1-325. Because the Taxpayer derived income from Corporation A and Corporation B after moving to State B, he must file a Virginia nonresident individual income tax return for the portion of the year he did not reside in Virginia and pay tax on any income derived from Virginia sources.

CONCLUSION

Based on the foregoing, the audit will be returned to the audit staff to adjust the assessments as noted above. The auditor will contact the Taxpayer regarding the information required to apportion the income of Corporation A and Corporation B, and determine the Taxpayer's income tax liability while he was not a resident of Virginia during the 2003 taxable year.

After the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit payment for the outstanding balance as shown on the revised bill within 30 days from the date of the bill to avoid the accrual of additional interest.

The Code of Virginia sections and regulation cited, as well as 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 regarding this determination, you may contact * in the Department's Office of Policy and Administration, Appeals and Rulings, at **.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-886360715B