Did a California shareholder owe Virginia nonresident tax on pass-through income from an S corporation with a Virginia office?

Subject

California shareholder had to report Virginia-source S-corporation income

Plain-English summary

Virginia required a California resident to file a nonresident return for his share of an S corporation's Virginia-source income. The corporation maintained a Virginia office and produced income attributable to Virginia. That source character passed through to shareholders even though this shareholder performed no services in Virginia.

The shareholder's liability depended on his pro rata ownership share and the corporation's Virginia apportionment, not solely on income generated by the California office or his personal work location. Because he had never filed a Virginia return, the Department could assess omitted tax without the ordinary three-year limit.

Virginia recommended filing Form 763 so the Department could correct the estimate using actual ownership, apportionment, deductions, and exemptions. The ruling also said the shareholder could claim the reciprocal nonresident credit allowed for qualifying California tax on the same Virginia-source income, and noted that the S corporation could seek permission for a unified nonresident filing.

What this means for you

• Pass-through income can retain Virginia source based on the entity's activity.
• A nonresident owner's personal work location does not by itself remove entity-level Virginia sourcing.
• Filing no return can leave the assessment period open.
• Use actual ownership and apportionment data, and evaluate home-state or reciprocal credits.

Common questions

Did the shareholder have to work in Virginia?

No. His share of the S corporation's apportioned Virginia income was enough.

Could Virginia assess after three years?

Yes, because no Virginia return had been filed.

Was a credit for California tax available?

The ruling said he could claim the reciprocal nonresident credit, subject to the other state's permitted credit.

Citations and references

• Va. Code §§ 58.1-325, 58.1-341, 58.1-312(A)(1), 58.1-301, 58.1-401, 58.1-405 through 58.1-421, 58.1-332(B), and 58.1-395.
• 23 VAC 10-120-90(E) and 10-110-180(B).
• P.D. 88-165.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-11

Original ruling text

February 4, 2009

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 is a shareholder in a Subchapter S corporation (Corporation A) based in * (State A) that operates an office in Virginia. For the 2003 taxable year, Corporation A properly filed corporate income tax returns as a Subchapter S Corporation with both the Internal Revenue Service and the Department. Corporation A subsequently filed an amended Virginia S corporation return reporting no distributions to its shareholders and filed a Virginia corporate income tax return as a taxable corporation.

The Taxpayer, a resident of California, did not file a Virginia nonresident individual income tax return for the 2003 taxable year. Under audit, the Department issued a tax assessment based on income passed through from Corporation A.

The Taxpayer contests the assessment, asserting that Virginia failed to make its assessment within the statute of limitations period. He also contends that Virginia cannot tax the distributions received from Corporation A. The Taxpayer further avers that his income was solely based on the amount he earned in California. Finally, the Taxpayer argues that even if he were subject to Virginia income tax, the assessment was computed incorrectly because it did not reflect his percentage of corporate ownership.

DETERMINATION

Nonresident Individuals

Individuals who are neither domiciliary nor actual residents of Virginia and have income from Virginia sources are taxed as nonresidents. The Virginia taxable income of a nonresident is defined under Va. Code § 58.1-325 as "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."

The Taxpayer lives and works in California. He did not perform any services in Virginia during 2003. Accordingly, he asserts that he did not receive any Virginia source income for the 2003 taxable year.

Virginia Code § 58.1-341 requires every nonresident individual having Virginia taxable income to file an income tax return. Virginia Code § 58.1-325 B provides statutory guidance for the treatment of a nonresident shareholder of an S corporation with Virginia activity. It has been the Department's longstanding policy that income received by a Subchapter S corporation, which is determined to be income from Virginia sources, will remain Virginia source income in the hands of the shareholders. See Public Document (P.D.) 88-165 (6/29/1988).

The evidence indicates that Corporation A had a location in Virginia and produced Virginia source income. Therefore, Corporation A had income subject to Virginia tax, which was passed through to its shareholders, including the Taxpayer. Accordingly, the Taxpayer is subject to Virginia income tax on the distribution of income from Corporation A.

Statute of Limitations

The Taxpayer contends that the Department did not issue its assessment for the 2003 taxable year within the limitations period. Virginia Code § 58.1-312 A 1 provides that the Department may assess omitted income taxes at anytime if a Taxpayer fails to file a return. In the instant case, the Taxpayer did not file any Virginia income tax returns for the taxable years at issue. As such, the Department was not precluded from issuing an assessment by the three-year limitations period cited by the Taxpayer.

S Corporation Income

Virginia's conformity to federal income tax 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 meaning as used in the Internal Revenue Code (IRC). For Virginia, federal taxable income (FTI) and federal adjusted gross income (FAGI), the starting points for determining income taxable in Virginia for corporations and individuals, respectively, are identical to that as defined by the IRC.

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 has 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 FAGI. See Title 23 of the Virginia Administrative Code (VAC) 10-120-90 E.

Corporation A elected to be a Subchapter S corporation for federal income tax purposes; therefore, it is treated as a Subchapter S corporation for Virginia income tax purposes. For the 2003 taxable year, it was required to file a Virginia S corporation income tax return and report its shareholders' proportionate share of income.

Virginia Source Income

The Taxpayer contends that he had no Virginia source income because his income was based solely on the income generated by the California office of Corporation A under Corporation A's profit sharing agreement, and that the income earned from the Virginia office comprised only a limited portion of Corporation A's total income.

Under Title 23 VAC 10-110-180 B, income of a nonresident attributable to a business, trade, profession or occupation carried on in Virginia includes income passed through from an S Corporation. Pursuant to P.D. 88-165, 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 a nonresident's Virginia source income from the S Corporation. As such, the Taxpayer's income was based on his share of the apportioned income produced by Corporation A in Virginia, not on the amount of work that he personally performed in Virginia.

The assessment for the 2003 taxable year was made based on information available to the Department. The Taxpayer may have additional information ( i.e. , apportionment information, itemized deductions and exemptions) that would accurately reflect the correct tax for the 2003 taxable year. Therefore, it is recommended that the Taxpayer file a nonresident individual income tax return for the 2003 taxable year.

State of Residence Credit

In addition to the issues raised in your appeal, the Department must address the fact that the Taxpayer is a resident of California. Generally, California allows an out-of­state tax credit on the nonresident income tax return rather than the resident return.

Virginia Code § 58.1-332 B provides a credit to nonresidents on income from Virginia sources when their home state provides a substantially similar credit to Virginia residents or imposes a tax upon the income derived from Virginia sources that is exempt from taxation by Virginia. This credit does not contain the same limitations as the credit under Va. Code § 58.1-332 A. Accordingly, the credit available to nonresidents is not limited to earned or business income. However, because it is dependent on another state granting a similar credit, it may be limited by the credit permitted by the other state.

Because California is one of the states that practices reciprocity with Virginia for purposes of claiming the individual income tax credit on nonresident individual income tax returns under Va. Code § 58.1-332 B, the Taxpayer would be permitted to claim an individual income tax credit for taxes paid to California on income from Virginia sources.

CONCLUSION

Based on this determination, the Taxpayer is subject to Virginia income tax and must file a nonresident individual income tax return (Form 763) for the 2003 taxable year. Upon receipt of the Taxpayer's 2003 return, the Department will make the appropriate adjustments to the assessment. The 2003 nonresident income tax return must be filed within 30 days of the date of this letter. If the Taxpayer fails to file a return, the current outstanding assessment will be upheld and become due and payable. Please send the requested return or payment of the assessment to: Virginia Department of Taxation, Office of Tax Policy, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203, Attn: *.

Virginia law does provide a mechanism for a pass-through entity, such as an S Corporation, to file and pay Virginia income tax on behalf of its owners (shareholders).

Virginia Code § 58.1-395 provides that the Tax Commissioner may grant permission to pass-through entities to file a statement of combined pass-through entity income attributable to nonresident owners. If the shareholders of Corporation A are interested in filing a unified nonresident individual income tax return on behalf of its nonresident shareholders, it may send a request to Tax Commissioner, Virginia Department of Taxation, P.O. Box 2475, Richmond, VA 23218-2475.

The Code of Virginia sections, regulations and public document cited, as well as forms and 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

AR/2416189752.B