Could taxpayers offset a 2006 Virginia assessment with a late 2005 refund after the IRS shifted passive losses between years?

Plain-English summary

Virginia refused the late cross-year refund offset but reduced the 2006 assessment for Social Security benefits. The IRS moved passive activity losses from 2006 to 2005, increasing 2006 federal adjusted gross income and decreasing it for 2005. The taxpayers did not amend either Virginia return within one year after the September 29, 2008 final federal determination.

Virginia law allowed an assessment based on the federal change at any time when the required amended return was not filed. A refund claim tied to that change had its own deadline, and the Tax Commissioner said he could not waive it or apply the expired 2005 refund against the 2006 liability.

The audit had also increased Virginia taxable income by the entire federal adjustment. Part of that increase was Social Security benefits newly included in federal adjusted gross income. Va. Code § 58.1-322(C)(4) allowed those benefits to be subtracted, so the Department revised the 2006 assessment on that point while leaving the remaining balance due.

The ruling separately told the taxpayers that financial hardship could be considered through an offer in compromise based on doubtful collectibility; hardship did not erase the underlying tax determination.

What this means for you

• Report a final IRS change to Virginia within one year on amended returns for every affected year.
• Do not assume an expired refund year will automatically offset an assessment year.
• Trace each federal adjustment through Virginia-specific subtractions, including qualifying Social Security benefits.
• Financial hardship uses a separate collection-compromise process.

Citations and references

• IRC § 86.
• Va. Code §§ 58.1-311, 58.1-312, 58.1-322(C)(4), and 58.1-1823.
• P.D. 90-20 (Jan. 11, 1990) through P.D. 10-110 (June 22, 2010), as listed in the ruling.

Subject

Passive activity losses ; Failure to timely file.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 11-100

Original ruling text

June 9, 2011

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 "Taxpayers") for the taxable year ended December 31, 2006.

FACTS

The Taxpayers, a husband and wife, were audited by the Internal Revenue Service (IRS) for the 2005 and 2006 taxable years. The IRS shifted passive activity losses from 2006 to 2005, resulting in an increase in federal adjusted gross income (FAGI) in the 2006 taxable year and a decrease in the 2005 taxable year. As a result of the shift in income, the amount of Social Security benefits included in FAGI was also adjusted.

The Taxpayers failed to file amended Virginia income tax returns for either the 2005 or 2006 taxable years reflecting the federal adjustments as required under Virginia law. As a result, the Department issued an assessment for the 2006 taxable year.

The Taxpayers appeal the assessment, contending the IRS adjustment to the passive activity losses did not affect the net Virginia tax liability for the 2005 and 2006 taxable years. In addition, the Taxpayers assert that the Department included nontaxable Social Security benefits in computing their liability.

DETERMINATION

Limitations Period

Under Va. Code § 58.1-311, a taxpayer audited by the IRS is required to file an amended return and report the changes to the Department within one year of the final determination of the change. Further, under Va. Code § 58.1-1823, a taxpayer has three years from the last day prescribed by law for the timely filing of the return, or one year from the final determination of a federal change or correction to file an amended return to request a refund. If such amended returns are not filed, the Department may make an assessment of additional tax based on the federal adjustments at any time pursuant to Va. Code § 58.1-312.

The Taxpayers argue that the additional assessment for 2006 and the refund for 2005 that would result from the IRS adjustments would essentially offset each other, resulting in no net change in Virginia tax liability. The Department, however, has consistently denied refund offset requests in circumstances similar to the Taxpayers. See Public Document (P.D.) 90-20 (1/11/1990), P.D. 95-155 (6/13/1995), P. D. 96-137 (6/17/1996), P. D. 97-224 (5/16/1997), P. D. 00-140 (7/31 /2000), P.D. 06-37 (4/5/2006), P.D. 09-89 (5/28/2009), and P.D. 10-110 (6/22/2010).

The final IRS determination occurred September 29, 2008. Under Virginia law, the Taxpayers were required to file amended 2005 and 2006 Virginia income tax returns reporting the federal changes on or before September 29, 2009. The Taxpayers did not file amended returns for the 2005 and 2006 taxable years.

Social Security Subtraction

Under Va. Code § 58.1-322 C 4, the amount of any Social Security benefits received under Title II of the Social Security Act and any other benefits included in FAGI solely by virtue of lnternal Revenue Code (IRC) § 86 may be subtracted from FAGI in computing Virginia taxable income.

A review of the Department's audit shows that the Taxpayers' Virginia taxable income was adjusted by the total amount of the IRS adjustment to FAGI. A review of the IRS adjustments shows a reduction in the amount of Social Security benefits exempt from federal income tax. Thus, an additional portion of the Taxpayers' Social Security benefits were included in FAGI for 2006. This income is eligible for the subtraction under Va. Code § 58.1-322 C 4.

CONCLUSION

Based on the evidence provided, the 2006 assessment will be adjusted to allow a subtraction for the additional Social Security benefits included in FAGI. Accordingly, the assessment will be adjusted in accordance with the enclosed schedule.

With regard to the failure to file amended Virginia returns for the 2005 and 2006 taxable years based on the shifting of passive losses by the IRS I am bound by the clear requirements under the law. The Tax Commissioner is not empowered to waive the statute of limitations period in this situation. Accordingly, I must deny the Taxpayers' request for the abatement of the balance of the 2006 assessment. A revised bill will be sent to the Taxpayers. No additional interest will accrue provided the outstanding balance in paid within 30 days from the date of the revised bill.

The Taxpayers state that payment of the assessment would create a financial hardship. If the Taxpayers wish to pursue such an offer in compromise based on doubtful collectibility, please complete the enclosed form, Offer in Compromise - Individual Request for Settlement, and the accompanying Financial Information Statement. The completed form and statement will allow the Department to review and analyze the Taxpayers' financial situation. Upon completion of that review, a response will be issued to the Taxpayers.

The Code of Virginia sections 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 Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-4652242333.B