How did Virginia tax severance and dividends when a couple moved out of the state during 2007?

Subject

Severance remained taxable, while post-move dividends and a duplicate adjustment were removed

Plain-English summary

Virginia treated every periodic payment under the husband's separation agreement as taxable severance, but reduced the assessment for post-move dividends and an apparent duplicate income adjustment. The couple moved from Virginia to another state in May 2007.

The original agreement expressly described the payments as severance. A later amendment added noncompetition and nonsolicitation promises but assigned no consideration to them. Although compensation for a covenant not to compete could be non-Virginia-source income after the move, the couple supplied no substantive valuation evidence. Virginia rejected their proposed equal one-third allocation and treated all 2007 payments as severance from a Virginia employer.

The dividend issue depended on receipt dates. The couple received three distributions during 2007; one arrived while they were Virginia residents and two after they changed domicile. Their part-year return correctly included only the first dividend, so the auditor's day-based proration was not sustained.

Virginia also found that the audit schedule appeared to include the original Virginia adjusted gross income twice. The assessment was returned to the audit staff for all required adjustments and a revised bill.

What this means for you

• Contract wording matters when payments could represent severance or consideration for a noncompetition covenant.
• A later covenant does not create a tax allocation without evidence that the parties assigned it value.
• Under the part-year rule applied here, dividend receipt dates controlled which distributions entered Virginia taxable income.
• Audit arithmetic can be challenged separately from the underlying tax issue.

Common questions

Why was the proposed one-third noncompete allocation rejected?

The agreement called the payments severance, the amendment assigned no consideration to the covenant, and the taxpayers supplied no supported valuation.

How many dividends were included in Virginia income?

One. The other two were received after the couple changed domicile.

Did Virginia uphold the assessment as calculated?

No. It returned the assessment for correction of the dividend treatment and apparent double counting, while preserving the severance conclusion.

Citations and references

• Va. Code § 58.1-303.
• 23 VAC 10-110-40.
• Ansan Tool and Manufacturing Co. v. Commissioner, T.C. Memo. 1992-121.
• Better Beverages, Inc. v. United States, 619 F.2d 424 (5th Cir. 1980).
• Annabelle Candy Co. v. Commissioner, 314 F.2d 1 (1962).
• Wilson Athletic Goods Mfg. Co. v. Commissioner, 222 F.2d 355 (7th Cir. 1955).
• Virginia Public Documents 97-123, 02-151, and 95-117.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 10-37

Original ruling text

April 8, 2010

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 year ended December 31, 2007. I apologize for the delay in responding to your letter.

FACTS

The Taxpayers, a husband and wife, changed their domicile from Virginia to * (State A) in May 2007. In December 2006, the husband entered into a separation and general release agreement with his employer. This agreement called for the former employer to make periodic payments to the husband over the course of 2007. The employer made the payments in accordance with the agreement.

In April, 2007, the husband and his former employer amended the separation and general release agreement to include a noncompetition and nonsolicitation provision that prohibited the husband from competing with his former employer from August 2007 through July 2008. No consideration was specifically stated in the amendment.

The Taxpayers filed a 2007 Virginia part-year resident individual income tax return, claiming that the payments from the separation and general release agreement were received in State A. Under audit, the Department determined that the payments were taxable by Virginia as severance payments made by a Virginia employer to an employee who ended his employment. In addition, the Department prorated dividend income based on the number of days the Taxpayers resided in Virginia.

The Taxpayers concede that the portion of the payments made under the agreement at issue constituted severance pay taxable in Virginia. The Taxpayers, however, contend that a portion of the payments are attributable to the covenant not to compete included in the amendment to the agreement. They propose that it would be equitable to attribute one-third of the periodic payments to the noncompetition provision. The Taxpayers also assert that the prorated dividends were earned entirely while the Taxpayers resided in State A. Finally, the Taxpayers believe that the auditor made a mathematical error when adjusting the Taxpayers' Virginia adjusted gross income (VAGI).

DETERMINATION

Employment Separation Agreement

In Public Document (P.D.) 97-123 (3/10/1997), the Department determined that severance pay is considered Virginia source income to a nonresident individual when paid by a Virginia employer. On the other hand, income received by a nonresident of Virginia for a promise not: to compete is not considered income from Virginia sources and, therefore, is not taxable by Virginia. See P.D. 02-151 (12/10/2002).

Under these rulings, any payments made to the husband as severance pay are subject to Virginia income tax, while any payments made to the husband after he moved out of Virginia that were attributed to the noncompetition provision would not be subject to Virginia income tax. The husband's separation and general release agreement states the employer "agrees to pay [the husband], as severance, an aggregate amount equal to . . . in equal installments on the [employer's] regular pay dates . . . ". The noncompetition provision does not specifically attribute any payment to the husband for his agreement not to compete with the former employer.

While the Department recognizes that noncompetition agreements have value, the issue in this case is what, if any value should be attributed to the noncompetition provision in the husband's agreement with his former employer. The Taxpayers propose that it would be equitable to allot one-third of the payments under the agreement to each of the separation, general release, and noncompetition provisions, respectively.

Typically, courts look to the parties to provide substantive evidence as to the value of the covenant not to compete. In Ansan Tool and Manufacturing Company, Inc. v. Commissioner , T.C. Memo. 1992-121, the United States Tax Court held that the non­compete agreement must be essential and its valuation methods fully supported by evidence and logically reasoned. In Better Beverages, Inc, v. United States , 619 F.2d. 424 (1980), the Fifth Circuit Court of Appeals held that in order to provide a value to a non-compete agreement that was part of a lump-sum purchase, the buyer must prove that the parties mutually intended at the time of the agreement that a portion of the consideration be allocated to a covenant not to compete.

Further, even if the inclusion of a covenant not to compete were contemplated in a final sales contract, substantive evidence as to its value must be provided. See Annabelle Candy Co., v. Commissioner , 314 F.2d. 1 (1962). In Wilson Athletic Goods Mfg. Co. v. Commissioner , 222 F.2d. 355 (1955), the Seventh Circuit Court of Appeals held that even when the purchase contract of a business declared the value of a covenant not to compete, it was necessary to look; at other evidence as to whether the agreement had value, and to the amount of that value.

In the instant case, the Taxpayers have not provided any substantive evidence regarding the value of the noncompetition agreement. Rather, they maintain that their method of valuing the noncompetition provision is equitable.

In this case, the husband and his employer entered into a separation agreement ratified in December 2006. This agreement expressly designates that the employer agrees to pay a severance amount. Based on the clear wording of the contract, and absent evidence to the contrary, I must conclude that all of the payments made to the husband during 2007 were for severance pay and, therefore, are subject to income tax in Virginia.

Dividends

Virginia Code § 58.1-303 provides that a person who becomes a resident of Virginia is subject to taxation during the period of Virginia residency. Title 23 of the Virginia Administrative Code ("VAC") 10-110-40 provides that an individual who becomes a resident of Virginia during the taxable year is taxed as a resident only for that portion of the year that he resides in Virginia. Such a part-year resident is generally required to include income in his Virginia taxable income if the payments that resulted in the income were received when the taxpayer was a Virginia resident. See P.D. 95-117 (5/15/1995).

In this case, the auditor prorated the dividends based on the number of days the Taxpayers lived in Virginia during the 2007 taxable year. The evidence provided shows that the Taxpayers received three dividend payments through the course of 2007. Two of the dividend distributions were received by the Taxpayers after they changed their domicile to State A. As such, the Taxpayers appropriately included only one of the dividend payments in Virginia taxable income on their 2007 part-year return.

Mathematical Error

The Taxpayers contend that in addition to the aforementioned adjustments, the auditor erroneously included the VAGI reported on the original 2007 part-year return twice. A review of the records shows that the auditor listed the total amount of the audit adjustments for the dividends and severance pay in the audit closing letter. The total recorded in the letter, however, does not reconcile to the amount reported on the auditor's schedule of audit adjustments on which the assessments were based. The amount of the difference equals the amount of VAGI reported by the Taxpayers on their original 2007 part-year return. Accordingly, it appears that the auditor did erroneously count the Taxpayers' original VAGI twice in adjusting the 2007 part-year return.

CONCLUSION

The assessment will be returned to the audit staff to be adjusted in accordance with this determination. After the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill. The Taxpayer should remit its payment for the outstanding balance as shown on the revised bill within 30 days from the date of the bill to avoid the accrual of additional interest.

The Code of Virginia sections, regulation, and public documents 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

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