Did Virginia properly shift all income from a nonresident owner's LLC to Virginia because its only client was his Virginia S corporation?

Plain-English summary

Virginia reversed the auditor's full related-party income shift but still found that the out-of-state LLC conducted business in Virginia. The assessment had to be revised rather than eliminated.

The nonresident husband owned most of an out-of-state LLC and a Virginia S corporation. The S corporation, the LLC's only client, paid the LLC to provide investment and asset-management services. The couple reported the S corporation's pass-through loss to Virginia but reported all LLC income and the husband's LLC salary to their home state.

Related-party adjustment overturned

Va. Code § 58.1-446 allowed equitable adjustments when controlled entities arranged transactions that improperly reflected Virginia income. The LLC had one full-time and one part-time employee besides the husband, office space, salaries and benefits, licenses, and ordinary business expenses. Its fees were comparable to those charged by an unrelated service provider used by the Virginia S corporation.

Virginia therefore found economic substance and arm's-length pricing. The related-party arrangement did not improperly reduce the S corporation's Virginia income, so the auditor's adjustment shifting all LLC income was overturned.

Virginia nexus and income sourcing remained

Pass-through items retained their character under Va. Code § 58.1-391(B) and IRC § 702(b). The Department extended Public Law 86-272's solicitation principles to services as policy, but asset-management work performed in Virginia exceeded solicitation.

The husband spent 135 days in Virginia and claimed 74 were solely for the S corporation, with no LLC work. Virginia found that unlikely because the LLC had only one client, few employees, paid most compensation to him, and assigned him extensive investment-management responsibilities. The Department attributed 74 Virginia workdays to the LLC.

Under Va. Code § 58.1-325, the husband's salary was apportioned using Virginia workdays over total workdays. The ruling generally used 260 days for a full-time employee unless a different number was documented; hours could be more appropriate for part-time workers or consultants.

The taxpayers were told to keep detailed logs, calendars, or schedules showing the entity served, location, hours, and work performed.

What this means for you

• Related entities need real operations and market support for intercompany pricing.
• Economic substance can defeat a full income reallocation without eliminating state nexus.
• An owner's time can create service-business nexus and source both pass-through income and salary.
• Keep entity-specific daily records when one owner serves related businesses in multiple states.

Common questions

Q: Did Virginia accept the LLC's fee arrangement?
A: Yes. The fees were supported by a comparable unrelated provider and the LLC had real operations.

Q: Did that eliminate Virginia tax?
A: No. Virginia found that the LLC and owner performed asset-management work in Virginia.

Q: How many Virginia workdays did Virginia use?
A: Seventy-four for the revised assessment.

Citations and references

• Va. Code §§ 58.1-325, 58.1-391(B), and 58.1-446.
• IRC § 702(b); 15 U.S.C. §§ 381-384.
• Commonwealth v. General Electric Company, 236 Va. 54 (1988).
• Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992).
• P.D. 85-134 and P.D. 94-219.

Subject

LLC provided financial and retirement services; Pass through losses; Residency

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 12-219

Original ruling text

December 21, 2012

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, 2009.

FACTS

The Taxpayers, a husband and wife, were residents of * (State A). The husband was the majority owner of (ALLC), a limited liability corporation located in State A. The husband also held the majority interest in ** (VSC), a Virginia S Corporation. VSC provided financial and retirement services. VSC, ALLC's only client, paid ALLC fees to provide investment and asset management services on behalf of its clients. In 2009, the Taxpayers attributed the loss passed through from VSC to Virginia and income passed through from ALLC entirely to State A on their nonresident Virginia income tax return. The Taxpayers attributed all of the husband's salary from ALLC to State A on their income tax returns for the taxable years at issue.

Under audit, the Department determined that the transactions occurring between VSC and ALLC were not at an arm's length rate. As a result, the auditor attributed all of the husband's share of ALLC's income to Virginia and issued an assessment. The Taxpayer paid the assessments and filed an appeal, contending the fees paid to ALLC by VSC were made pursuant to an arm's length arrangement.

DETERMINATION

Improper Reflection of Income

Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers, Va. Code § 58.1-446 provides, in pertinent part:

When any corporation liable to taxation under this chapter by agreement or otherwise conducts the business of such corporation in such manner as either directly or indirectly to benefit the members or stockholders of the corporation . . . by either buying or selling its products or the goods or commodities in which it deals at more or less than a fair price which might be obtained therefore, or when such a corporation . . . acquires and disposes of the products, goods or commodities of another corporation in such manner as to create a loss or improper taxable income, and such other corporation . . . is controlled by the corporation liable to taxation under this chapter, the Department . . . may for the purpose determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year.

In case it appears to the Department that any arrangements exist in such a manner as improperly to reflect the business done or the Virginia taxable income earned from business done in this Commonwealth, the Department may, in such manner as it may determine, equitably adjust the tax. [Emphasis added.]

The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company , 236 Va. 54 (1988) upheld the Department's authority to equitably adjust the tax of a corporation pursuant to Va. Code § 58.1-446 (or its predecessor) where two commonly owned corporations structure an arrangement in such a manner as to reflect improperly, inaccurately, or incorrectly the business done in Virginia or the Virginia taxable income. Generally, the Department will exercise its authority if it finds that a transaction, or a party to a transaction, lacks economic substance.

Because Va. Code § 58.1-446 specifically addresses transactions between corporations, the Department has limited equitable adjustments to corporate income tax returns. Such adjustments have included adjusting the transaction amount to fair market value, disallowing deductions, and consolidating incomes of corporations involved in such arrangements.

In the instant case, ALLC had one full-time and one part-time employee. ALLC originally operated in the Taxpayers' State A residence, but subsequently acquired its own office space. It compensated its employees with salary and a benefits package and incurred normal business expenses, including license fees and typical office expenses. Based on the evidence, the operating costs appear to be reasonable in light of ALLC's business activities. Accordingly, the Department concludes that ALLC had economic substance for the 2009 taxable year.

ALLC also provided documentation concerning the rates of its fees. In addition to ALLC, VSC has a contract with an unrelated third party to provide investment and asset management services. The documentation provided indicates the fees charged by ALLC for its services are comparable to the unrelated third party provider. Accordingly, the transactions between ALLC and VSC do not create an improper reflection of VSC's Virginia income.

Pass-through Entity Income

The husband did not attribute any of ALLC's income to Virginia for the taxable year at issue contending that he only performed services on behalf of ALLC in State A.

Internal Revenue Code (IRC) § 702(b) states, "The character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share . . . shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership." Each item of pass-through entity income, gain, loss or deduction has the same character for an owner for Virginia income tax purposes as for federal income tax purposes. See Va. Code § 58.1-391 B. This would include a limited liability company that elects to be treated as a partnership for federal income tax purposes.

Public Law (P.L.) 86-272, as codified at 15 U.S.C. §§ 381-384, prohibits a state from imposing a net income tax where the only contacts with a state are a narrowly defined set of activities constituting solicitation of orders for sales of tangible personal property. The Department limits the scope of P.L. 86-272 to only those activities that constitute solicitation, are ancillary to solicitation, or are de minimis in nature. 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.

Accordingly, if the husband performed any asset management services on behalf of ALLC while he was in Virginia, such activities would exceed the protections afforded under P.L. 86-272, and the Commonwealth would have the authority to impose tax on ALLC's income from Virginia sources.

In 2009, the husband spent 135 days in Virginia. He states that he worked 74 of those days for VSC and performed no work for ALLC while in Virginia. Because of the nature of the relationship between the husband, VSC, and ALLC, the Department finds it doubtful that the husband performed no services on behalf of ALLC while he was in Virginia.

The investment management agreement between VSC and ALLC lists many responsibilities for ALLC including, but not limited to, providing historical performance information, fixed income marketing materials, consultation and commentary with clients, the purchase and sale of securities, and trade reconciliation. VSC was ALLC's only client. ALLC's only employees were the husband and two other individuals, one of whom was part-time. Because the vast majority of ALLC's compensation expenses were paid to the husband, he was making significant contributions to the day-to-day operations of ALLC. The Department, therefore, considers it likely that the husband performed these asset management services for ALLC while he was in Virginia, as well as State A. Accordingly, ALLC would have nexus with Virginia and its income would be subject to Virginia income tax.

Nonresident Salaries

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."

Typically, the factor that most equitably determines the apportionment of salaries and wages is the ratio of the number of days services were performed in Virginia to the number of days services were performed elsewhere. See Public Document (P.D.) 94­219 (7/13/1994). The Department has previously ruled that a nonresident who works in Virginia may apportion his or her salary to Virginia using a ratio of (1) the number of days or portion thereof spent in Virginia performing duties for his or her employer, divided by (2) the number of days or portion thereof spent anywhere performing duties for his or her employer. See P.D. 85-134 (6/18/1985).

As a general rule, the Department uses 260 days in the denominator of the ratio for determining wages attributable to Virginia for full-time employees. Taxpayers who claim to have worked more than 260 days during a given taxable year must document that claim. Likewise, taxpayers who worked less than 260 days are limited to using days actually worked in the denominator of the ratio. For part-time employees, semi-retired individuals, and consultants, a ratio of hours worked in Virginia divided by hours worked anywhere may be a better indicator of income from Virginia sources.

As stated above, the husband performed work in Virginia on behalf of ALLC. As such, a portion of his salary from ALLC would be attributed to Virginia.

CONCLUSION

Based on the evidence provided, the arrangement between ALLC and VSC was not conducted in such a manner as to reflect improperly, inaccurately, or incorrectly, the business done or the Virginia taxable income earned from business done in Virginia. Accordingly, the auditor's adjustments are overturned.

The evidence indicates, however, that ALLC conducted operations and the husband worked for ALLC in Virginia during 2009. Based on the available information, the Department will attribute 74 days as the number of days in which the husband performed work on behalf in ALLC in Virginia.

In accordance with this determination, the case will be returned to the audit staff and the assessment will be adjusted. After the auditor makes the appropriate adjustments, a revised bill will be issued to the Taxpayer. The Taxpayer should remit payment for the outstanding balance due within 30 days from the date of the bill to avoid the accrual of additional interest.

For future taxable years, the husband should document the time he worked in Virginia and elsewhere on behalf of ALLC. Such documentation should be in the form of a log, calendar, or schedule providing sufficient details to determine which days the husband worked, the number of hours worked each day, and the number of days worked in Virginia. Lack of substantiation could result in the Department reducing the number of days or hours worked, resulting in a higher nonresident apportionment percentage.

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/1-4666957190.B