How did Virginia tax S-corporation income after a couple moved away, merged the Virginia company, and performed no later Virginia work?

Subject

2004 S-corporation income required allocation, but later Virginia income was not proven

Plain-English summary

Virginia abated the couple's 2005 and 2006 assessments but required a corrected nonresident calculation for 2004. They moved from Virginia to State A in April 2004. The husband was sole shareholder and employee of a Virginia S corporation that wrote and edited textbooks, then merged into a State A S corporation in September.

The Virginia company had nexus for the entire 2004 taxable year because it operated in Virginia before the move and remained in existence until the merger. Its income first had to be divided between the couple's resident and nonresident periods based on days of operation, then the company's Virginia apportionment factor applied to the nonresident portion.

For 2005 and 2006, documentation showed the husband performed no services for the State A successor while in Virginia. The successor also lacked Virginia nexus. Virginia therefore found no Virginia wages or successor pass-through income for those years and abated the assessments.

What this means for you

• Moving an owner did not end an entity's nexus retroactively for the taxable year.
• Part-year pass-through income required both time allocation and source apportionment.
• S-corporation Virginia-source income retained that character for a nonresident shareholder.
• Documentation of where services were performed defeated assumptions based only on time spent at a Virginia residence.

Common questions

Why did the Virginia company have nexus for all of 2004?

It operated in Virginia during the year and did not cease to exist until the September merger.

Why were 2005 and 2006 abated?

The husband proved he performed no successor-company services in Virginia, and the successor had no Virginia nexus.

Citations and references

• Va. Code § 58.1-325(B) and §§ 58.1-405 through 58.1-421.
• 23 VAC 10-110-180(F).
• 15 U.S.C. §§ 381-384.
• Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992).
• P.D. 95-184, 06-99, and 08-32.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-77

Original ruling text

May 26, 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 assessments issued to * (the "Taxpayers") for the taxable years ended December 31, 2004 through 2006.

FACTS

The Taxpayers, a husband and wife, changed their domicile from Virginia to * (State A) in April 2004. The Taxpayers filed a part-year Virginia individual income tax return for 2004 that reported their change in residence to State A as of May of that year. They did not file returns for the 2005 or 2006 taxable years.

The husband is the sole shareholder and sole employee of * (VSC), a Virginia S Corporation. The husband writes and edits textbooks on behalf of VSC. The edited manuscripts are sent electronically to a publisher that prints and sells the textbooks. VSC's income consists of the fees and royalties from the sale of the textbooks. The husband earns a salary from VSC and its income flows through to the Taxpayers' income tax return.

In September 2004, VSC was merged into a State A S corporation (ASC). VSC filed a pass-through entity return for 2004. The husband reported his salary and flowthrough income from VSC as a Virginia resident through April 2004 on the Taxpayers' individual return. VSC did not file pass-through returns for the 2005 and 2006 taxable years.

Under audit, the Department assessed additional tax and interest against the Taxpayers for the 2004 through 2006 taxable years. The auditor found that the Taxpayers spent a considerable amount of time in Virginia after they moved to State A and concluded that the husband performed services as an employee of VSC and ASC in Virginia. The Taxpayers contest the assessments, asserting that VSC lacked nexus with Virginia after the Taxpayers moved to State A, ASC has neither nexus nor income from Virginia sources, and the husband did not earn any of his salary in Virginia after April 2004.

DETERMINATION

Nexus

Public Law (P.L.) 86-272, as codified at 15 U.S.C. §§ 381-384, prohibits a state from imposing an income tax on businesses when the only contacts with the state are a narrowly defined set of activities. P.L. 86-272 protection has been extended by the U.S. Supreme Court to include activities that are ancillary to direct sales solicitation, as well as de minimis activities. See Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992). Although P.L. 86-272 applies to tangible property, the Department's policy has been to extend the "solicitation test" of P.L. 86­-272 to situations involving the sales of services. Further, the Department has a long­established policy of narrowly interpreting the provisions of P.L. 86-272.

The Taxpayers contend that when VSC moved to State A, it ceased having nexus with Virginia and was no longer subject to Virginia income tax. Title 15 U.S.C. § 381 a., however, clearly applies the minimum standards for creating nexus to those business activities conducted within a state by or on behalf of such person during a taxable year. Thus, once a business establishes nexus in a state, it is subject to

income tax for its entire taxable year.

VSC operated in Virginia through April 2004 and did not cease operations until it was merged into ASC in September of that year. There can be no doubt that VSC had nexus with Virginia for the 2004 taxable year.

Nonresident income for 2004 taxable year

Virginia Code § 58.1 325 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 nonresident's 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 husband reported his salary and flow-through income from VSC as Virginia income through April 2004.

In such cases, 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 he is a nonresident as provided in Public Document (P.D.) 06-99 (9/29/2006). Also see P.D. 95-184 (7/14/95).

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. See P.D. 08-32 (4/2/08).

In this case, the portion of VSC's income attributable to the time the Taxpayers were nonresidents would be VSC's total taxable income multiplied by the number of days VSC operated in State A and divided by the total number of days VSC operated in 2004. Next, VSC's income attributable to the Taxpayer's as nonresidents is multiplied by VSC's apportionment factor to determine the amount of VSC's income to include in the numerator of the Taxpayer's nonresident apportionment factor.

Nonresident income for 2005 and 2006 taxable years

After moving to State A, the husband claims that he did no work for ASC while in Virginia. The Department's auditors, however, concluded that the husband must have worked for ASC in Virginia. This assertion was based solely on the facts that the Taxpayers continued to maintain a residence in Virginia and spent considerable time at the Virginia residence.

The husband has provided sufficient documentation to indicate that he performed no services as an employee of ASC after he moved to State A. Based on these facts, the husband earned no wages from Virginia sources for the 2005 and 2006 taxable years. Further, ASC did not have nexus with Virginia and was not subject to Virginia income tax for the taxable years at issue.

CONCLUSION

Based on the foregoing, the assessments of individual income tax for the 2005 and 2006 taxable years have been abated. In addition, in order to appropriately adjust the assessment for the 2004 taxable year, the Taxpayers should file a nonresident return in accordance with this determination. The return should be sent to: Virginia Department of Taxation, Appeals and Rulings, Post Office Box 27203, Richmond, Virginia 23261-7203, Attn: *. The return must be filed within 30 days of the date of this letter or the 2004 assessment will be adjusted based on the information available, and collection action will resume.

The Code of Virginia sections, regulation and public document cited 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 * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-2416189912.B