Could Virginia attribute another LLC's sales to the taxpayers' business and treat financed piano inventory as personal withdrawals?

Subject

Separate LLC sales and financed piano inventory were restored

Plain-English summary

Virginia reversed the audit's attribution of another LLC's sales and restored financed pianos to inventory and cost of goods sold. The two LLCs shared a manager but were separate legal entities, and third-party financing did not show personal withdrawal of inventory.

The taxpayers supplied a management agreement, affidavit, and the other LLC's articles of organization. Virginia found no evidence that the entities were the same or even related, so the other LLC's Virginia sales could not be added to the taxpayers' business receipts.

The piano business used finance companies to pay manufacturers and wholesalers, recorded the pianos as inventory and loan payables, and paid the loans when items sold. Virginia called this normal financing for expensive retail goods and rejected the audit's personal-withdrawal theory.

Remaining expense issue

The taxpayers still needed to substantiate advertising, commissions, contract labor, insurance, interest, office, utility, and other deductions. Virginia returned the case to audit and gave them 30 days to provide those records before revised bills.

Citations and references

• Va. Code §§ 58.1-301 and 58.1-219; 23 VAC 10-20-490; IRC § 162; Treas. Reg. § 1.162-1.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 14-166

Original ruling text

September 9, 2014

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you request correction of the individual income tax assessments issued to * (the "Taxpayers") for the taxable years ended December 31, 2008 through December 31, 2010. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayers, a husband and a wife, reported income from * (VALLC), a single member limited liability company, on Schedule C of their federal income tax returns for the taxable years at issue. VALLC, solely owned by the husband, hired an individual to manage its operations. The manager also owned and operated (SALLC) located in ** (State A).

Under audit, the Department discovered that SALLC was making sales in Virginia without collecting Virginia sales and use tax. Because the entities were managed by the same individual, the auditor attributed SALLC's Virginia sales to VALLC. In addition, the auditor concluded some products were withdrawn from inventory instead of being sold and reduced VALLC's cost of goods sold. This resulted in an increase in Schedule C income. The auditor also made adjustments to business deductions reported on Schedule C. As a result, the Taxpayers' federal adjusted gross income (FAGI) was increased and assessments were issued.

The Taxpayers appeal the assessments, contending VALLC was a separate legal entity from SALLC. In addition, the Taxpayers assert that the owner of the SALLC was contracted to act as an agent on behalf of the VALLC. The Taxpayers also claim they have documentation to support their business deductions.

DETERMINATION

Virginia Code § 58.1 301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia conforms to federal law, in that it starts the computation of Virginia taxable income with the FAGI.

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. However, the Department retains the authority to adjust FAGI where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Va. Code § 58.1- 219.

Receipts

Because VALLC and SALLC were both managed by the same individual, the auditor was unable to determine if they were separate entities and combined SALLC's Virginia sales with the receipts of VALLC. The Taxpayers assert that the auditor's adjustments are unfounded because VALLC and SALLC are separate entities.

During the appeals process, the Department found no evidence to suggest that VALLC and SALLC were the same or even related entities. The agreement between VALLC and the manager required him to oversee the operations, sales, and services of VALLC. In addition, the Taxpayer provided an affidavit attesting that VALLC and SALLC were separate entities. The manager provided a copy of SALLC's Articles of Organization to support this claim.

Inventory Withdrawals

The auditor reclassified inventory purchased through third party financing from cost of goods sold to withdrawals from inventory. VALLC used several finance companies to finance the purchase of its pianos. Under the arrangement, VALLC ordered inventory from a manufacturer or wholesaler and the finance company remitted payment for the purchase. VALLC recorded the purchases in the inventory and loan payable accounts. When the item of inventory was sold, VALLC paid the loan. The Taxpayers contend that the reduction in the cost of goods sold resulted in a gross profit percentage well outside the normal range expected in the industry.

Under Virginia Title 23 of the Administrative Code § 10-20-490, a person who withdraws an item of tangible personal property for his own use from an inventory of property on which no tax has been paid, must pay the sales tax on the cost price of the property withdrawn for purposes of that for sale.

The arrangement used by VALLC to purchase its inventory is not unusual among retailers of large or expensive consumer goods. Accordingly, the Department concludes the use of financing to purchase inventory is not an indication of personal use and the inventory purchased by VALLC with assistance from a finance company was properly classified as inventory on the Schedule C for the taxable years at issue.

Business Expenses

Under IRC § 162, taxpayers are permitted to deduct all of the ordinary and necessary business expenses paid or incurred during the taxable year in carrying on any trade or business. Such expenses must be directly connected with or pertaining to the taxpayer's trade or business. See Treas. Reg. § 1.162-1.

The auditor examined VALLC's bank statements and adjusted VALLC's deductions for advertising, commissions, contract labor, insurance, interest, office expense, utilities, and other expenses. The Taxpayers contend they have additional documentation to support all of the deductions claimed for the taxable years at issue; however, such information was not presented with the appeal.

CONCLUSION

The evidence indicates VALLC and SALLC were separate legal entities. As such, the adjustments to attribute SALLC's sales to VALLC cannot be sustained. Further, the documentation shows that pianos were not withdrawn from inventory. Accordingly, the adjustments to reduce cost of goods sold for the taxable years at issue are hereby reversed.

In light of this determination, the case will be returned to the auditor for adjustments in accordance with this determination. In addition, the Department will allow VALLC an opportunity to provide the documentation to support the business deductions. The information should be mailed to: *, Senior Auditor, Virginia Department of Taxation, PMB 251, 10302 Southern Maryland Boulevard, Dunkirk, Maryland 20754. If the information is not received within 30 days from the date of this letter, the assessment will be adjusted according to this determination and revised bills will be issued.

The Code of Virginia sections and regulations cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions 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/1-5144585057.D