After moving away, would sellers owe Virginia tax on contingent payments from an S-corporation sale and installments from their Virginia home?

Subject

Tax liability on contingent payments and installment payments

Plain-English summary

Virginia said the answer depended on whether the business transaction was a stock sale or an asset sale and how federal law characterized each payment. The couple planned to sell their Virginia S corporation and home, move away, and receive later contingent or installment payments.

For a true stock sale, gain and installment-note interest from an intangible asset not used in a Virginia trade or business generally would not be Virginia-source income after the sellers became nonresidents. But an asset sale—or a federal §338(h)(10) election treating stock as assets—could produce gain from assets employed in a Virginia business. Those contingent payments could remain taxable to nonresidents.

For the Virginia home, the federal principal-residence exclusion flowed through to Virginia. If gain stayed within the exclusion, no Virginia gain would be recognized. Gain above the exclusion, or gain tied to business use, could be Virginia-source as later installments were received.

Interest on the home-sale note was income from an intangible asset and generally followed the nonresident's domicile rather than Virginia. The ruling required the sellers to determine the federal character of every payment before deciding Virginia treatment.

What this means for you

• Transaction form can change later Virginia-source income after a move.
• A §338(h)(10) election can turn an apparent stock sale into an asset sale for Virginia as well as federal purposes.
• Separate principal gain, taxable excess gain, business-use gain, and interest on each installment.
• Confirm domicile and federal reporting before filing nonresident returns.

Common questions

Were all contingent stock-sale payments exempt after the move?

Only to the extent they were gain or interest from stock as an intangible not employed in a Virginia business. The ruling lacked enough facts for a single unconditional answer.

Was home-note interest Virginia-source?

Generally no for a nonresident; the ruling treated it as intangible income attributable to domicile.

Citations and references

• Va. Code §§ 58.1-301, 58.1-322, 58.1-302, 58.1-321, and 58.1-325.
• IRC §§ 121, 338(h)(10), 453, 461, and 483.
• Treas. Reg. §§ 1.1060-1 and 1.1275-5.
• P.D. 97-381, P.D. 91-317, and P.D. 94-274.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 11-48

Original ruling text

March 31, 2011

Re: Request for Ruling: Individual Income Tax

Dear *:

This will reply to your letter in which you seek a ruling regarding the treatment by a Virginia nonresident of contingent payments resulting from the sale of a Virginia business and an installment sale of a personal residence located in the Commonwealth. I apologize for the delay in responding to your letter.

FACTS

A married couple (the "Taxpayers") currently residing in Virginia own all of the shares of a Virginia S corporation (VSC). The Taxpayers intend to sell VSC and their Virginia home and change their domiciliary residence to another state. The Taxpayers are considering a proposal that require a buyer to make an initial payment at closing and contingent payments based on the S corporation's revenue in future years.

The Taxpayers request a ruling as to their Virginia income tax liability on the contingent payments. In addition, the Taxpayers seek guidance concerning any potential Virginia tax liability resulting from installment payments of principal and interest from the sale of their Virginia personal residence after they move out of Virginia.

RULING

Sale of VSC

The Taxpayers indicate that the sale of VSC would occur before they leave Virginia, but that the contingent payments would be received after they move to another state.

The Internal Revenue Code (IRC) includes a number of rules concerning contingent payments. The treatment of the contingent payments could be different depending on whether they result from a contingent payment sale under IRC § 453, a contingent payment under IRC § 483, or a contingent payment debt instrument under Treas. Reg. § 1.1275-5. Contingent payments can also be subject to the economic performance test under IRC § 461 or the residual method of allocating costs to assets under Treas. Reg. § 1.1060-1.

Sufficient information as to the character of the contingent payments pursuant to the IRC has not been provided. The Department has previously ruled, however, that interest income from an installment note from the sale of the stock of a corporation is considered to be income from an intangible asset not employed in a trade or business carried out in Virginia. Under such circumstances, nonresidents would not be subject to tax on this interest income. See Public Document (P.D.) 97-381 (9/23/1997). Similarly, to the extent contingent payments result from the gain or sale of an intangible asset ( i.e. , stock in VSC) not employed in a trade or business carried out in Virginia, such payments would not be subject to Virginia income tax when received by a nonresident of Virginia.

If the Taxpayers sell the assets of VSC, or an election is made under IRC § 338(h)(10) to treat a stock sale as an asset sale for federal income tax purposes, the results could be different. Virginia's conformity to federal law is set forth in Va. Code § 58.1-301. This section states that, except as otherwise provided, the terms used in the Virginia income tax statutes will have the same meanings as used in the IRC. Therefore, federal adjusted gross income (FAGI) is identical to that as defined by the IRC. As such, Virginia's treatment of the IRC § 338(h)(10) election will mirror federal treatment as closely as possible, while ensuring that any Virginia tax accurately reflects the business activity in Virginia.

In all cases, if the seller, target, purchaser or any combination thereof are Virginia taxpayers, the IRC § 338(h)(10) election actually made on a federal return will be recognized exactly as it is for federal purposes. See P.D. 91-317 (12/30/1991). To the extent that any gain or loss is deemed to be recognized for federal purposes by any party, it will be similarly recognized by the applicable entity for Virginia purposes.

Under Treas. Reg. § 1.1060-1(a)(1), for the purpose of allocating certain contingent payments, a group of assets may be considered to be a business if their character is such that goodwill or going concern value could attach to the assets, or if the use of such assets would be treated as an active trade or business. Such treatment would be the same for both the seller and buyer. Thus, to the extent a contingent payment is treated as a capital gain on the sale of the assets, it would be considered income from assets employed in a trade or business carried out in Virginia. Such contingent payments, therefore, would be Virginia source income subject to tax even when received by nonresidents of Virginia.

Pursuant to Va. Code § 58.1-325, a nonresident individual who has income from carrying on a business, trade, profession, or occupation within Virginia is required to file a Virginia individual income tax return, unless the individual meets the filing exception described in Va. Code § 58.1-321. The Virginia taxable income of a nonresident is computed by multiplying his Virginia taxable income (computed as if he were a resident) by the ratio of his net income, gain, loss, and deductions from Virginia sources to his net income, gain, loss, and deduction from all sources. Under Va. Code § 58.1-302, "income and deductions from Virginia sources" includes income from "a business, trade, profession or occupation carried on in Virginia." Thus, it is incumbent upon the Taxpayers to determine how the contingent payments would be treated for federal income tax purposes in order to determine whether they would be subject to Virginia income tax on the payments after they moved out of Virginia.

Sale of Personal Residence

In general, taxpayers are required to recognize gain or loss at the time they sell property. Taxpayers that sell property using the installment method of reporting gain, pursuant to IRC § 453, recognize gain in proportion to the installment payments received. The installment method is usually required for reporting a gain on a sale where at least one payment is due after the taxable year in which the sale occurs.

Under Va. Code § 58.1-302, income and deductions from Virginia sources includes items of income gain, loss and deductions attributable to the ownership of property in Virginia. Thus, a nonresident that recognizes a gain on the sale of property in Virginia would be required to file a Virginia income tax return and compute their liability as prescribed under Va. Code § 58.1-325.

In the case of a personal residence, however, IRC § 121 provides an exclusion for a gain from the sale or exchange of a principal residence. Because Virginia begins it computation of Virginia taxable income with FAGI pursuant to Va. Code § 58.1-322, Virginia's conformity to federal law, as is set forth in Va. Code § 58.1-301 permits an exclusion on the gain from the sale of a principal residence to the extent allowed for federal income tax purposes. As such, if the Taxpayers gain from the sale of their Virginia home does not exceed the amount of the exclusion, no gain would recognized for Virginia income tax purpose.

The Department has previously addressed a similar issue in which a taxpayer did not realize a gain on the sale of a principal residence. In P.D. 94-274 (9/13/1994), the Department concluded that interest income derived from a mortgage note secured by real property located in Virginia is considered to be income derived from an intangible asset. Thus, a nonresident note holder would not be subject to tax on mortgage interest from the installment sale.

If, however, the gain on the principal residence exceeds the amount of the exclusion or a portion of the Virginia home was used for business purposes, a portion of the gain could be included in the Taxpayer's FAGI in future taxable years. Such a gain would be Virginia source income under Va. Code § 58.1-302. Under this scenario, the Taxpayers, as nonresidents, would be subject to tax on the capital gain portion of the installment payments only. Any interest income included in the installment payments would be considered to be income received from an intangible asset attributable to the Taxpayers' state of domicile.

This ruling is based on the facts presented as summarized above. Any change in the introduction of new facts may lead to a different result.

The Code of Virginia sections 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 ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

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