Could Virginia residents claim a foreign-source-income subtraction passed through from an S corporation in 2005?

Subject

Subtraction for foreign source income repealed

Plain-English summary

Virginia denied the couple's 2005 foreign-source-income subtraction because the individual subtraction had been repealed effective for taxable years beginning in 2003. The S corporation had incorrectly reported the subtraction on its pass-through return and the owners' Form VK-1.

The corporate foreign-source subtraction did not solve the problem. S corporations were exempt at the entity level, and owner-level pass-through modifications were limited to those allowed under Va. Code § 58.1-322. That section no longer contained the individual foreign-source subtraction.

The Department's reduction of the couple's refund was upheld.

What this means for you

• Entity-level corporate deductions do not automatically pass through to individual owners.
• Check the owner-level modification statute for the taxable year.
• A Form VK-1 does not create a subtraction that the law no longer allows.
• Repeal dates matter even when the underlying income remains foreign-source.

Common questions

Q: Why did the corporate subtraction not pass through?
A: S-corporation owners could receive only modifications authorized by the individual-income-tax statute.

Q: When was the individual subtraction repealed?
A: For taxable years beginning on and after January 1, 2003.

Citations and references

• Va. Code §§ 58.1-322, 58.1-402 C 8, 58.1-401, and 58.1-391 A.
• 2003 Va. Acts ch. 980.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 08-109

Original ruling text

June 20, 2008

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This is in reply to your letter in which you seek correction of the individual income tax assessment issued to * (the "Taxpayers") for the taxable year ended December 31, 2005.

FACTS

The Taxpayers, a husband and a wife, were Virginia residents that reported a subtraction for foreign source income on their 2005 Virginia income tax return. The foreign source income was passed through from * (the "S Corporation"), in which the husband is a shareholder.

The Department audited the return and disallowed the subtraction. The Taxpayers appeal the adjustment to their return, contending that they may claim a foreign source income subtraction on their individual income tax return.

DETERMINATION

For many years, Virginia provided a foreign source income subtraction to individual income taxpayers. However, the General Assembly repealed the subtraction, formerly Va. Code § 58.1-322 C 7, effective for taxable years beginning on and after January 1, 2003. See Chapter 980, 2003 Acts of Assembly .

Virginia Code § 58.1-402 C 8 provides a subtraction to corporations for foreign source income as defined in Va. Code § 58.1-302 to the extent such income is included in federal taxable income. The Taxpayers contend that, because corporations are entitled to the subtraction, foreign source income passed through to an individual from an S corporation must be allowed as a subtraction in determining the proper Virginia taxable income of the S corporation on an individual taxpayer's return.

Virginia Code § 58.1-401 exempts "electing small business corporations" from Virginia corporation income tax. As a result, S corporations are not subject to tax in Virginia. Instead, the income of such corporations is taxed to the shareholders upon distribution. Effective for taxable years beginning on and after January 1, 2004, all pass­through entities, including S corporations, are required to file an annual information return with the Department setting forth their income and a list of their owners. See Chapter 3, Acts of Assembly , 2004 Special Session I. Specifically, Virginia Code § 58.1-391 A provides:

In determining Virginia taxable income of an owner, any modification described in § 58.1-322 that relates to an item of pass-through entity income, gain, loss or deduction shall be made in accordance with the owner's distributive share, for federal income tax purposes, of the item to which the modification relates. [Emphasis added.]

Under this statute, any subtraction available under Va. Code § 58.1-322 will flow through from a pass-through entity to an individual taxpayer, who in turn can take the subtraction on his or her Virginia individual income tax return. The statute, however, limits the type of subtraction modifications passed through from S corporations to those permitted under Va. Code § 58.1-322. The "S Corporation, therefore, incorrectly reported the foreign source income subtraction on its Virginia pass-through entity return and the schedule (Form VK-1) that reported the Taxpayer's portion of the subtraction.

Because the Code of Virginia no longer includes a subtraction for foreign source income for individual income taxpayers, the Department correctly disallowed the Taxpayers' subtraction that flowed through from the S Corporation. Accordingly, the adjustment to the Taxpayer's' individual income tax return resulting in a reduction to the refund due the Taxpayers for the 2005 taxable year is correct.

The Code of Virginia sections cited are available on-line at www.tax.virgiriia.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 Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-2188571958.B