When must an out-of-state investment pass-through entity file in Virginia and withhold for nonresident owners?

Subject

Virginia-source activity controlled pass-through filing and withholding

Plain-English summary

Virginia reached different results for the two out-of-state investment entities because only one had Virginia-source activity. PTE1 invested in an out-of-state LLC that did no Virginia business and held other stocks and notes. Its investment manager worked in Virginia but was not on PTE1's payroll. That connection alone did not create Virginia nexus or source income, so PTE1 did not file or withhold.

PTE2 invested in a lower-tier LLC that did business in Virginia. The lower-tier LLC's income, property, payroll, sales, and other attributes flowed through to PTE2. PTE2 therefore had to file a Virginia pass-through return and withhold 5% for nonresident owners, but only on income derived from or connected with Virginia sources.

What this means for you

• A Virginia-based investment manager does not automatically create entity nexus when the manager is not on the entity's payroll.
• A lower-tier pass-through's Virginia business activity can flow up to its owner.
• Filing and nonresident withholding track Virginia-source income, not the entity's total investment income.
• Preserve tiered-entity apportionment data for Virginia property, payroll, and sales.

Citations and references

• Va. Code §§ 58.1-302, 58.1-391, 58.1-392, 58.1-408 through 58.1-421, and 58.1-486.2.
• Public Law 86-272, 15 U.S.C. §§ 381-384.
• Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992).
• Virginia Tax Bulletin 05-6 and Public Documents 88-165, 91-33, 93-75, 97-343, and 07-150.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 15-91

Original ruling text

April 28, 2015

Re: Ruling Request: Pass-Through Entity Income Tax

Dear *:

This will reply to your letter in which you request a ruling concerning income tax and withholding requirements for a pass-through entity. I apologize for the delay in responding to your request.

FACTS

A ruling is requested as whether a pass-through entity formed to invest in intangible property would be required to file a Virginia pass-through entity return and withhold Virginia income tax. Two scenarios have been set forth, which will be addressed separately below.

RULING

Scenario One

PTE1 is located outside of Virginia. It has no employees or real or intangible property. PTE1 invests in a foreign limited liability company (FLLC) that is located in another state and does not do business in Virginia. It also invests in other stocks and notes. PTE1's investment manager does operate in Virginia and files a Virginia income tax return.

You ask if PTE1 would be required to file a Virginia pass-through entity tax return and withhold income tax on behalf of the owners.

Public Law (P.L.) 86-272, 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. 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 sale of other than tangible personal property. See Public Document (P.D.) 91-33 (3/18/1991) and P.D. 93­-75 (3/17/1993). 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). The Department has a long-established policy of narrowly interpreting the provisions of P. L. 86-272.

Under Va. Code § 58.1-392, pass-through entities (including S corporations, partnerships and limited liability companies) doing business in Virginia or having income from Virginia sources are required to file a return with the Department. Pursuant to Va. Code § 58.1-302, an entity has income from Virginia sources if it has any items of income, gain, loss and deduction attributable to ownership in real or tangible personal property in Virginia or resulting from a business, trade, profession or occupation carried on in Virginia.

Generally, a pass-through entity will have income from Virginia sources if there is sufficient business activity within Virginia to make any one or more of the applicable apportionment factors positive. Pass-through entities that have income from activity both within and without Virginia are required to compute their Virginia source income in accordance with the corporate statutory formula set forth in Va. Code §§ 58.1-408 through 58.1-421. As such, pass-through entities must allocate dividends to the state of commercial domicile and apportion all other income. Income is apportioned using a three-factor formula based on the property, payroll and sales within Virginia. See Public Document (P.D.) 88-165 (6/29/1988) and P.D. 07-150 (9/21/2007).

Neither PTE1 nor FLLC engage in business in Virginia. So long as the manager is not on PTE1's payroll, the fact that he is located in Virginia would not create nexus and Virginia source income for PTE1. This would be the case whether the manager is one of the owners of the investment pass-through entity or an unrelated party. See Tax Bulletin (VTB) 05-6 (5/6/2005). Based on the facts as presented, PTE1 would not have nexus with Virginia or any Virginia source income. As such, it would not be required to file a pass-through entity return.

Only those pass-through entities doing business in Virginia or having income from Virginia sources are required to file a withholding return. See Virginia Code § 58.1-486.2 D. Accordingly, PTE1 would not be required to pay a withholding tax equal to 5% of their nonresident owners' shares of income from Virginia sources.

Scenario Two

PTE2 is located outside of Virginia. It has no employees or real or intangible property. PTE2 invests in a Virginia limited liability company (VALLC) that is located in another state and does business in Virginia. It also invests in other stocks and notes. PTE2's investment manager does operate in Virginia and files a Virginia income tax return.

You ask if PTE2 would be required to file a Virginia pass-through entity tax return and withhold income tax on behalf of the owners.

Virginia Code § 58.1-391 B provides:

Each item of pass-through entity income, gain, loss or deduction shall have the same character for an owner under this chapter as for federal income tax purposes. Where an item is not characterized for federal income tax purposes, it shall have the same character for an owner as if realized directly from the source from which realized by the pass-through entity or incurred in the same manner by the pass-through entity.

For federal income tax purposes, attributes and activities of VALLC will flow through to PTE2. Further, the Department considers a taxpayer to be the owner of a share of the pass-through entity's assets and liabilities. See P.D. 97-343 (8/28/1997). In this case, the characteristics of VALLC will flow through to PTE2. Therefore, PTE2 will include income or loss of VALLC in determining Virginia taxable income and the appropriate amount of VALLC's property, payroll and sales in determining income apportioned to Virginia.

Virginia Code § 58.1-486.2 A provides that "a pass-through entity that has taxable income for the taxable year derived from or connected with Virginia sources, any portion of which is allocable to a nonresident owner" must pay withholding tax. The amount of tax that must be withheld is equal to 5% of the nonresident owner's share of income from Virginia sources of all nonresident owners that may lawfully taxed by Virginia and which is allocable to a nonresident owner. See Va. Code § 58.1-486.2 B 1.

In accordance with Va. Code § 58.1-486.2 A, a pass-through entity is required to file a return and remit withholding tax on only that income "derived or connected with Virginia sources." As such, only PTE2's Virginia source income would be subject to Virginia withholding tax.

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

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

Sincerely,

Craig M. Burns
Tax Commissioner

AR/1-5640431780.B