Did Maryland partnership income reported on Schedule E qualify a Virginia couple for the full border-state tax credit?

Subject

Schedule E partnership income did not qualify for border-state credit

Plain-English summary

Virginia denied the special full border-state credit because the Maryland partnership income was reported on Schedule E. The ordinary credit for another state's tax was still available, but it was limited to the lesser of Maryland tax actually paid or Virginia tax imposed on the Maryland income.

The border-state exception could disregard that Virginia-tax limitation when all out-of-state income from one adjoining state was qualifying earned income or Schedule C business income. The husband argued that his partnership share was federal self-employment and earned income, but Virginia did not use the federal earned-income-tax-credit definition for this state credit.

Under Virginia's regulation, Schedule E income from the professional partnership was not earned income, and it was not Schedule C sole-proprietor business income.

Result: the Department's limited credit and assessment were upheld.

What this means for you

• Identify the federal schedule on which adjoining-state income is reported.
• Partnership Schedule E income does not meet this ruling's border-state exception.
• Compute the ordinary credit using the Virginia limitation when the exception fails.
• Do not import the federal EITC definition automatically into Virginia credit rules.

Common questions

Q: Was all credit for Maryland tax denied?

A: No. Virginia allowed the ordinary credit but limited it to Virginia tax on the Maryland income.

Q: Did self-employment treatment make Schedule E income earned income?

A: No for this Virginia border-state-credit analysis.

Citations and references

• Va. Code §§ 58.1-332(A) and 58.1-301.
• 23 VAC 10-110-221.
• IRC §§ 32 and 1402.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 15-141

Original ruling text

June 30, 2015

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, 2011. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayers, a husband and wife, were Virginia residents. The husband was a general partner in a partnership (the "Partnership") that operated in Maryland. The Taxpayers reported the husband's income from the Partnership on federal Schedule E. On their Virginia individual income tax return for the 2011 taxable year, the Taxpayers claimed a credit for taxes paid to another state for the entire amount of income tax paid to Maryland. Under review, the Department adjusted the credit to the amount of Virginia income tax actually imposed on the Maryland taxable income and issued an assessment. The Taxpayers appealed, contending that the Department should have allowed the credit for the entire amount of tax paid to Maryland because the husband's Maryland income was earned income.

DETERMINATION

It is well established that a state may tax all the income of its residents, even income earned outside the taxing jurisdiction. In New York ex. rel. Cohn v. Graves , 300 U.S. 308, 57 S.Ct. 466 (1937), the United States Supreme Court explained "[t]hat the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event is universally recognized." Thus, a state may tax all of the income of a resident regardless of whether such income is subject to tax in another state.

As a matter of fairness and equity, most states, including Virginia, provide a mechanism to relieve residents from being taxed by both their state of residence and the state in which the income was derived. Virginia's method of limiting taxation of income by more than one state has been to permit a credit for taxes paid to other states pursuant to Va. Code § 58.1-332. By reason of their character as legislative grants, however, statutes relating to deductions and subtractions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell's Motor Freight, Inc., et al. v. Virginia Department of Taxation , Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983).

Virginia Code § 58.1-332 A allows Virginia residents a credit on their Virginia return for income taxes paid to another state provided the income is either earned or business income or gain from the sale of a capital asset. Virginia law does not necessarily allow a taxpayer to claim a credit for the total amount of tax paid to another state. Rather, the credit is limited to the lesser of the amount of tax actually paid to the other state or the amount of Virginia income tax actually imposed on the taxpayer on the income earned or derived in the other state. See Public Document (P.D.) 97-301 (7/7/1997). The limitation is computed by multiplying the individual's Virginia tax liability by a fraction, the numerator of which is the income upon which the other state's tax is imposed, and the denominator of which is Virginia taxable income.

If certain criteria are met, the limitation that restricts the credit to the amount of Virginia income tax actually imposed on the taxpayer on the income derived in the other state is disregarded. The special rule (commonly referred to as the border state credit) will apply if the income subject to tax in a single state contiguous to Virginia is less than Virginia taxable income and all of the income from sources outside Virginia is earned income or business income reported on federal form Schedule C from that single contiguous state. In such instances, the Virginia resident will be entitled to a credit equal to the lesser of: (1) the amount of income tax actually paid to the contiguous state; or (2) 100% of their Virginia income tax liability. See Va. Code § 58.1-332 A.

The Taxpayers contend that credit for the full amount of income tax paid to Maryland should have been allowed because the husband's distributive share of Partnership income was considered earned income under federal law. The Taxpayers assert that, because Virginia does not define "earned income" differently than federal law, the federal definition applies.

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. The Taxpayers assert that the husband's distributive share of partnership income is considered net earnings from self-employment within the meaning of IRC § 1402(a) and, as such, is also considered earned income under IRC § 32(c)(2)(A)(ii). The federal definition cited by the Taxpayers pertains to the federal earned income tax credit (EITC). The starting point for computing Virginia income tax and subsequently any out-of-state tax credit is FAGI. The IRC does not define "earned income" for purposes of inclusion in FAGI. As such, the definition of earned income for purposes of Virginia's credit for taxes paid to other states is not confined to the definition under IRC § 1402 and IRC § 32.

Title 23 of the Virginia Administrative Code (VAC) 10-110-221 defines the term earned income as "wages, salaries, or professional fees and other amounts received as compensation for professional services actually rendered . . . ." In P.D. 04-125 (9/16/2004), the Department held that income reported on Schedule E that the taxpayer received as a member of a professional limited liability company was not earned income as defined by the regulation. In this case, the Taxpayer received income reported on Schedule E from a partnership engaged in professional practice. While the form of the pass-through entity in P.D. 04-125 was different, the Taxpayer's income from the partnership does not meet the definition of earned income under Title 23 VAC 10-111-221.

Further, the border state credit clearly limits the type of business income that would qualify to that received from a sole proprietorship that filed a Schedule C. Because the partnership income was reported on a Schedule E, it would not qualify for the border state credit.

Accordingly, the assessment is upheld. The Taxpayers will receive an updated bill with accrued interest to date. The Taxpayers should remit payment within 30 days of the bill date 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 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/1-5907345756.M