Did clarified facts overturn Virginia's treatment of an S-corporation lump-sum payment received after the shareholder moved out of Virginia?

Subject

Lump sum payment creates an inaccurate statement of Taxpayer's Virginia income

Plain-English summary

Virginia denied reconsideration and kept its adjustment of a lump-sum S-corporation payment that had been attributed entirely outside Virginia. The taxpayer supplied useful factual clarifications, but they did not change the conclusion that the payment inaccurately reduced Virginia income.

The taxpayer moved from Virginia to another state on December 1, 2003 and received the lump sum from Corporation A that month. She treated Corporation A's pass-through income and the lump sum as entirely outside Virginia. The earlier determination consolidated the taxpayer, her partner, and Corporation A under Va. Code § 58.1-445.

On reconsideration, Virginia acknowledged that it had misstated Corporation A's ownership interest in the Virginia LLC and clarified other descriptions. The taxpayer also said the payment covered future services for Corporation A after the move. But Corporation A's activity declined sharply in 2004, including a sales decline of more than 90%, so the Department could not accept the future-services explanation. It viewed the distribution as earnings from Virginia sources.

Virginia also rejected the argument that federal related-party rules controlled the state adjustment. State conformity gave federal meanings to terms actually used in Virginia statutes; it did not import every federal concept. Sections 58.1-445 and 58.1-446 separately authorized correction when Virginia-source income was inaccurately stated.

For a multistate pass-through entity, the Department first divided income between the resident and nonresident periods. It then applied the entity's apportionment factor to the nonresident-period income to determine the Virginia-source portion. Income in the resident period remained taxable by Virginia, subject to the available credit for qualifying tax paid to another state.

What this means for you

• Moving before a related-party payment does not automatically move the underlying income outside Virginia.
• Part-year pass-through income can require both time allocation and entity-level apportionment.
• A payment labeled as compensation for future services needs evidence consistent with the company's later activity.
• Correcting factual details on reconsideration does not produce relief unless those details affect the operative tax analysis.

Common questions

Did Virginia admit errors in the earlier ruling? Yes. It corrected several factual descriptions but said they did not affect the result.

Why was the future-services explanation rejected? Corporation A's activity fell significantly in 2004, including a sales decline of more than 90%.

Did federal § 482 prevent Virginia from consolidating the accounts? No. The Department relied on Virginia's own statutes for inaccurately stated Virginia-source income.

Citations and references

• Va. Code §§ 58.1-301, 58.1-445, 58.1-446, and 58.1-332.
• 23 VAC 10-120-350; Treas. Reg. § 1.482; I.R.C. § 482.
• New York ex rel. Cohn v. Graves, 300 U.S. 308 (1937).
• P.D. 07-100 (June 27, 2007) and P.D. 06-99 (September 29, 2006).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 08-32

Original ruling text

April 2, 2008

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter seeking reconsideration of the Department's determination letter, published as Public Document (P.D.) 07-100 (6/27/2007), issued to your client, * (the "Taxpayer").

FACTS

The Taxpayer, a Virginia resident, was a 50% shareholder in a Subchapter S Corporation (Corporation A). Corporation A, in turn owned a one-third interest in a limited liability corporation (VLLC) that is commercially domiciled and operating in Virginia. The Taxpayer also owned an interest in another S corporation (Corporation B)

As of December 1, 2003, the Taxpayer and her partner changed their residence to * (State A). In December 2003, the Taxpayer received a lump sum payment from Corporation A. The Taxpayer filed a Virginia part-year individual income tax return claiming she ceased residing in Virginia by September 30, 2003. The Taxpayer sourced all salary received from VLLC and an unrelated employer in 2003 to Virginia. On her 2003 individual income tax return, all pass-through income received from Corporation A and the lump sum payment from Corporation A was sourced to State A.

In P.D. 07-100, the Department concluded that the lump sum payment was not made at arm's length and it grossly misstated the Taxpayer's income. As such, the Department consolidated the accounts of the Taxpayer, the partner and Corporation A pursuant to Va. Code § 58.1-445.

The Taxpayer requests a redetermination, contending that the Department materially misstated the facts and incorrectly interpreted Virginia's policy. The Taxpayer states additional evidence has been provided to support her request.

DETERMINATION

Misstatement of Facts

Ownership of VLLC

The Taxpayer has presented evidence that Corporation A owned a one-third interest in VLLC and that the remaining two-thirds interest was owned by an unrelated party. The return information obtained during the course of the audit and appeal did not clearly indicate this fact. The Department acknowledges that it incorrectly stated in P.D. 07-100 that Corporation A was the sole owner of VLLC. This factual difference, however, has no impact on whether the transaction between Corporation A and the Taxpayer was at fair market value and, therefore, would not change the determination in P.D. 07-100.

Income Apportionment

The Taxpayer disagrees with the Department's statement in P.D. 07-100 that the income for Corporation A and Corporation B were apportioned entirely to State A because they appropriately apportioned income within and without Virginia on their corporate income tax returns. The issue, however, was not how the corporations apportioned income, but to which state the Taxpayer attributed the income on the nonresident apportionment schedule on her 2003 nonresident individual income tax return. This return clearly shows that she completely disregarded Corporation A and Corporation B's apportionment information and attributed all of the income outside Virginia.

Taxpayer Services

The Taxpayer avers that the Department incorrectly stated that the lump-sum payment was compensation for future services performed on behalf of VLLC. The Taxpayer contends that the Taxpayer was to perform services on behalf of Corporation A, not VLLC. The Taxpayer argues that this payment was for future services performed on behalf of Corporation A while a resident in State A. A review of the information provided reveals a significant decrease in Corporation A's activities in 2004, including a decline of more than 90% in sales. Under these circumstances, the Department cannot conclude that the lump-sum payment was for future services. Rather, the lump-sum distribution appears to be a payment of earnings resulting from Virginia sources.

Pass-Through Entity Interest

The Taxpayer contends that the Department erred when it stated that Corporation A will be considered the owner of all VLLC's assets and liabilities. The Taxpayer argues that Corporation A will actually be considered an owner of a partnership interest in VLLC. This statement resulted from the information available that did not show that Corporation A only owned one-half of VLLC. Again, this statement has no impact on the primary issue of the inaccurate statement of income resulting from the lump sum payment to the Taxpayer.

Interpretation of Statute

The Taxpayer contends that because Virginia conforms to the Internal Revenue Code (IRC), Treas. Reg. § 1.482 is applicable when determining whether a taxpayer is engaged in an arms-length transaction with a related entity.

Virginia's conformity to federal law is set forth in Va. Code § 58.1-301, which provides that the terms used in the Virginia income tax statutes will have the same meanings as used in the IRC. As such, Virginia's conformity to federal law is limited to the actual use of a specific term in a Virginia statute. Conformity does not extend to terms, concepts, or principles not specifically provided in Title 58.1 of the Code of Virginia . Virginia Code § 58.1-445 and Title 23 of the Virginia Administrative Code (VAC) 10-120-350 provide 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.

Virginia Code § 58.1-446 provides guidance as to whether Virginia taxable income is considered to be inaccurately stated. As such, the Department is not limited to the requirements of IRC § 482 in determining whether a transaction inaccurately states Virginia income. To that end, P.D. 07-100 clearly sets forth the Department's reasoning for holding that the treatment of the lump sum payment by the Taxpayer inaccurately stated her Virginia income for 2003.

New Evidence

The only new evidence provided by the Taxpayer are the clarifications to the facts addressed above. As indicated above, these new facts do not change the Department's position that the lump sum payment to the Taxpayer creates an inaccurate statement of Virginia income under Va. Code § 58.1-445.

Part Year Income

The Taxpayer argues that the Department ignored Corporation A for purposes of apportioning ordinary income in P.D. 07-100 by imposing the method used in P.D. 06-99 (9/29/2006). Income from a multistate pass-through entity, such as an S corporation, that passes through to a part-year resident of Virginia must go through a multi-step process in order to be appropriately reported on a part-year return and a nonresident return. The income must first be apportioned between the time an individual is a resident and the time she is a nonresident as provided in P.D. 06-99. In this case, the Department appropriately applied P.D. 06-99 in order to determine what portion of Corporation A's income should have been reported on the Taxpayer's 2003 part-year return and the portion to be reported on the Taxpayer's 2003 nonresident return.

Once this is done, the issue of how much of the multistate pass-through entity's income is subject of Virginia tax must be determined. For the nonresident return, the pass-through entity's apportionment factor is applied to the income that flows through to the nonresident return to determine how much income should be reported in the numerator of the nonresident apportionment factor. In the Taxpayer's case, the Department applied Corporation A's apportionment formula to the accounts consolidated under Va. Code § 58.1-445 included on the 2003 nonresident return in order to determine the income from Virginia sources for purposes of the nonresident apportionment formula.

As for the Taxpayer's part-year return, it is well-established that a state may tax all the income of its residents, even income earned outside the taxing jurisdiction. In New York ex rel. Cohn v. Graves , 300 U.S. 308, (1937), the United States Supreme Court explained, ". . . the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event is universally recognized."

As a matter of fairness and equity, most states, including Virginia, provide a mechanism to relieve residents from being taxed by both their state of residence and the state in which the income was derived. For most residents, Virginia allows a credit on their Virginia individual income tax return for certain income taxes paid to another state. See Va. Code § 58.1-332. The Department took this provision into account when it adjusted the Taxpayer's part-year return for the 2003 taxable year pursuant to P. D. 07-100.

CONCLUSION

Accordingly, the Taxpayer's request for abatement of tax assessed for the 2003 taxable year is denied. A schedule showing the current balance due is enclosed. The Taxpayer should remit payment within 30 days of the date of this letter to: Virginia Department of Taxation, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203, Attn: *. If payment is not received within the allotted time, additional interest will accrue on the outstanding balance.

The Code of Virginia sections, regulations and public documents cited, as well as other reference documents, are available on-line 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 * at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

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