Did a nonresident owe Virginia tax on S-corporation investment income when a lower-tier partnership owned undeveloped Virginia land?

Subject

A domiciliary resident of State A owns a 50% share of an S Corporation (S) incorporated in Virginia.

Plain-English summary

Virginia abated the nonresident shareholder's 2003 and 2004 assessments because the S corporation's investment income was apportioned entirely outside Virginia. The S corporation itself was not taxed; its shareholders included their shares of Virginia-source income.

The lower-tier partnership's undeveloped Virginia land flowed through as an ownership attribute, creating nexus and Virginia authority to tax an appropriate share. But the S corporation was a financial corporation whose investment income used cost-of-performance apportionment. No activity generating that income occurred in Virginia, and the partnership incurred no Virginia costs that passed through.

The result could change if the Virginia parcel were developed or sold, creating a positive apportionment factor and a future nonresident filing duty.

What this means for you

• Pass-through ownership can transmit the attributes of underlying Virginia real property.
• Nexus does not by itself establish Virginia-source income.
• Financial-corporation investment income depended on where income-producing costs occurred.
• Development or sale of Virginia property can change future apportionment and filing obligations.

Common questions

Q: Did the Virginia land create nexus?
A: Yes. The partnership's real-property attributes flowed through to the S corporation and shareholder.

Q: Why was no Virginia tax due for 2003-2004?
A: All activities and costs producing the investment income occurred outside Virginia.

Q: Could later years be different?
A: Yes. Development or sale of the Virginia parcel could create a positive apportionment factor.

Citations and references

• Va. Code §§ 58.1-401, 58.1-391 B, 58.1-418, and 58.1-405 through 58.1-421.
• 23 VAC 10-110-180 F and 10-120-250.
• Virginia Tax Bulletin 05-6 and P.D. 88-165.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 08-143

Original ruling text

July 30, 2008

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 assessments issued to your client, * (the "Taxpayer"), for the taxable years ended December 31, 2003 and 2004.

FACTS

The Taxpayer is a domiciliary resident of * (State A). She owns a 50% share of an S Corporation (S) that is incorporated in Virginia. S operates out of *** (State B) where its president resides. S holds cash, investment securities and a 25% interest in a State A limited partnership (LP). S has no real or tangible property within or without Virginia and has no payroll. All investment transactions are made through an investment advisor located in State A. The LP holds cash and one parcel of undeveloped real estate located in Virginia.

In 2003 and 2004, S filed Virginia returns and issued a K-1 to the Taxpayer. The Taxpayer did not file a Virginia individual income tax return for the taxable years at issue. The Department concluded that S's income was Virginia source income and issued tax assessments to the Taxpayer.

The Taxpayer contests the assessments and contends that S's income is not Virginia source income subject to tax to nonresidents. In the alternative, the Taxpayer avers that Virginia's statutory apportionment method is inapplicable to the Taxpayer's situation as it constitutes double taxation and taxes income earned outside of Virginia's borders.

DETERMINATION

In following federal tax policy with respect to S corporations, Va. Code § 58.1-401 provides that such corporations are not subject to income tax in Virginia. Thus, Virginia has elected to treat S corporations in substantially the same manner as the Internal Revenue Service, i.e. , the corporate entity itself is not subject to taxation but the shareholders will be taxed as individuals on their pro rata share of S corporation income, to the extent includable in federal adjusted gross income (FAGI). See Public Document (P.D.) 88-165 (6/29/1988).

Further, Va. Code § 58.1-32'.5 B, which governs the taxation of income from S corporations on nonresident individuals, states:

For a nonresident individual who is a shareholder in an electing small business corporation (S corporation), there shall be included in his Virginia taxable income his share of the taxable income of such corporation, and his share of any net operating loss of such corporation shall be deductible from his Virginia taxable income.

Title 23 of the Virginia Administrative Code (VAC) 10-110-180 F further states that the income or loss to be included is that amount attributable to a business, trade, profession or occupation carried on in Virginia. Accordingly, when nonresident individuals are shareholders of an S corporation that conducts business in Virginia, the Department applies the provisions of Va. Code §§ 58.1-405 through 58.1-421 in order to determine the portion of income from an S corporation that is attributed to Virginia for purposes of determining a nonresidents Virginia income tax liability. As such, Virginia source income received from an S corporation will remain income from Virginia sources in the hands of the shareholders whether they are residents of Virginia or not.

The Taxpayer contends that S has no employees or real or tangible property. It contends that the pass-through income, which consists of investments in intangible property generated by S, does not constitute Virginia source income for nonresident shareholders.

Tax Bulletin 05-6 (5/6/05) provides that pass-through entities that are established solely to invest in intangible personal property, such as stocks and bonds, and that have no employees, and no real or tangible property are not considered to be carrying on a trade or business. In the instant case, S has no employees or tangible assets. It does, however, own 25% of LP that in turn owns a parcel of real property located in Virginia.

The Taxpayer argues that S does not own the Virginia real property; rather, it owns a 25% limited partnership share of LP, which constitutes intangible property. Virginia Code § 58.1-391 B provides:

Each item of pass-through entity income, gain, loss or deduction shall have the same character for an owner under this chapter as for federal income tax purposes. Where an item is not characterized for federal income tax purposes, it shall have the same character for an owner as if realized directly from the source from which realized by the pass-through entity or incurred in the same manner by the pass-through entity.

The Department, therefore, considers a taxpayer to be the owner of a share of the pass-through entity's assets and liabilities. In this case, the attributes of the real property ownership flowed through to S and ultimately to the Taxpayer. As such, the Taxpayer would be considered to be an owner of a share of the real property owned by LP and passed through from S. Having real assets in Virginia creates nexus to S and establishes authority for the Commonwealth to tax an appropriate portion of the income passed through to the Taxpayer.

Because S derived all of its income from investment activities during the 2003 and 2004 taxable years, it was a "financial corporation" for Virginia income tax purposes. Virginia Code § 58.1-418 defines a financial corporation as one that derives more than 70 percent of its gross income from (1) fees for financial services, (2) gross profits from securities trading, (3) interest, and (4) dividends to the extent included in Virginia taxable income. Accordingly, S would be considered a financial corporation and it must apportion its income using the cost of performance.

Pursuant to Va. Code § 58.1 -418, financial corporations are required to apportion income based on "cost of performance." Title 23 VAC 10-120-250 defines the cost of performance as the cost of all activities directly performed by the taxpayer for the ultimate purpose of obtaining gains or profit, except activities directly performed by the taxpayer for the ultimate purpose of obtaining allocable dividends.

In this case, there is no evidence that any of the activities performed by S to generate the investment income occurred in Virginia. In addition, LP incurred no costs in Virginia that would have passed through to S. As such, the cost of performance occurred outside Virginia, and all of S's income would be apportioned outside Virginia. Accordingly, S had no income from Virginia sources during the taxable years at issue. Thus, the Taxpayer's ownership in S does not make her subject to Virginia income tax for the 2003 and 2004 taxable years.

CONCLUSION

Based on the foregoing, the 2003 and 2004 assessments will be abated. You should note, however, that the subsequent development or sale of the unimproved parcel in Virginia may create a positive apportionment factor in future taxable years. In that event, the Taxpayer will be required to file a Virginia nonresident individual income tax return and apportion income generated by S and LP.

The Code of Virginia sections, regulations, tax bulletin, and public document cited, are available online at www.tax.virginia.gov in the Tax Policy Library section of the Department's website. If you have any questions regarding this determination, please contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-1906028329.B