Can a Virginia taxpayer subtract research expenses disallowed federally because of the R&D credit even if the research was done outside Virginia, and must it file an amended Virginia return?

Plain-English summary

An S corporation that files a Virginia pass-through return (Form 502) asked the Department two questions after it amended a prior federal return to claim the federal research and development (R&D) credit:

1. May it take a Virginia subtraction for the business-expense reduction caused by the federal credit -- even though the research was not conducted in Virginia?
2. Must it file an amended Virginia return?

The Department ruled: yes to the subtraction, and yes it must amend.

• Why federal income went up. Under IRC § 41 a taxpayer gets a credit for research expenses, but IRC § 280C(c) then disallows a federal deduction equal to that credit -- increasing federal income.
• Virginia allows this particular subtraction by statute. Virginia generally does not allow a subtraction for expenses offset by a federal credit unless a statute says so. Here Va. Code § 58.1-402 C 14 expressly lets corporations subtract qualified research and basic research expenses. So the taxpayer may subtract the expense reduction attributable to the federal R&D credit.
• Out-of-state research still qualifies. This subtraction is separate from the Virginia research credit under Va. Code § 58.1-439.12:08 (which requires research in Virginia). The § 58.1-402 C 14 subtraction applies even if the research occurred outside Virginia.
• An amended Virginia return is required. Because the federal amendment increases ordinary business income, Va. Code § 58.1-311 requires reporting the change within one year of the final federal determination by filing an amended Virginia return. If the taxpayer doesn't, the Department may assess additional tax at any time under § 58.1-312 (the IRS shares federal-income data under IRC § 6103(d)), and filing the amended return avoids a later assessment.

What this means for you

Claiming the federal R&D credit can raise your Virginia income -- but Virginia gives some of it back. Because § 280C(c) increases federal income, watch for the offsetting Virginia subtraction under § 58.1-402 C 14 for research expenses.

Two different Virginia benefits, two different rules. The § 58.1-402 C 14 subtraction does not require Virginia-based research; the § 58.1-439.12:08 Virginia research credit does. Don't confuse them.

A federal change means a Virginia amended return. When a federal amendment raises your income, report it within one year via an amended Virginia return -- otherwise the assessment window stays open indefinitely.

Common questions

Q: My research wasn't in Virginia -- can I still take the subtraction?

A: Yes. The § 58.1-402 C 14 subtraction for research expenses disallowed federally by the R&D credit applies regardless of where the research occurred. Only the separate Virginia research credit (§ 58.1-439.12:08) requires Virginia research.

Q: Do I have to file an amended Virginia return if the subtraction offsets the income increase?

A: Yes. Because ordinary business income increased on the federal amendment, § 58.1-311 requires reporting it within one year by amended Virginia return.

Q: What if I don't report the federal change?

A: The Department may assess additional tax at any time under § 58.1-312, using federal data it receives under IRC § 6103(d). Filing the amended return avoids that.

Citations and references

• Va. Code § 58.1-402 C 14 -- corporate subtraction for qualified research and basic research expenses
• Va. Code § 58.1-301 -- Virginia conformity to the Internal Revenue Code (FTI/FAGI starting points)
• Va. Code § 58.1-401 -- S corporations are not subject to Virginia income tax at the entity level
• Va. Code § 58.1-392 / § 58.1-302 -- pass-through entities with Virginia-source income must file
• Va. Code § 58.1-439.12:08 -- the separate Virginia research and development credit (requires Virginia research)
• Va. Code § 58.1-311 / § 58.1-312 -- report a federal change within one year, or the Department may assess at any time
• IRC § 41; IRC § 280C(c); IRC § 6103(d) -- federal research credit, matching deduction disallowance, and IRS data sharing

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 18-201

Original ruling text

December 7, 2018

Re: Ruling Request: Corporate Income Tax

Dear *:

This will reply to your letter in which you request a ruling regarding whether a taxpayer can claim a subtraction for the expense reduction attributable to the federal research and development credit and whether claiming such a subtraction effects the method of apportioning income. I apologize for the delay in responding to your request.

FACTS

An S corporation (the “Taxpayer”) files a Virginia Form 502 because it operates in a number of states including Virginia. The Taxpayer is amending a prior year federal return in order to claim a credit for increasing research activities and to reflect the resulting increase in ordinary business income. Because the research was not conducted in the Commonwealth, the Taxpayer did not claim a Virginia research and development tax credit under Virginia Code § 58.1-439.12:08. The Taxpayer asks whether Virginia allows a subtraction for the expense reduction attributable to the federal research and development credit and whether it would need to file an amended Virginia return if it claims the credit.

RULING

Virginia’s conformity to federal income tax law is set forth in Virginia Code § 58.1-301, which provides that the terms used in the Virginia income tax statutes will have the same meaning as used in the Internal Revenue Code (IRC). Further conformity does not extend to terms, concepts, or principles specifically provided for in Title 58.1 of the Code of Virginia. For Virginia, federal taxable income (FTI) and federal adjusted gross income (FAGI), the starting points for determining income taxable in Virginia for corporations and individuals, respectively, are identical to that as defined by the IRC.

In following federal tax policy with respect to S corporations, Virginia Code § 58.1-401 provides that such corporations are not subject to income tax in Virginia. Thus, Virginia has elected to treat S corporations in substantially the same manner as has the Internal Revenue Service (IRS), i.e., the corporate entity itself is not subject to taxation, but the shareholders will be taxed as individuals on their pro rata share of S corporation income to the extent includable in FAGI. See Title 23 of the Virginia Administrative Code (VAC) 10-120-90 E, Public Document (P.D.) 88-165 (6/29/1988) and P.D. 07-99 (6/27/2007). As such, the Taxpayer’s items of income, gain, loss, deduction and credit flow through to its shareholders.

Under Virginia 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 Virginia 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.

Under IRC § 41, a credit is permitted for a percentage of certain research expenses that include “qualified research expenses” and “basic research expenses”. Pursuant to IRC § 280C(c), however, a taxpayer cannot then claim deduction for the those certain research expenses equal to the credit claimed under IRC § 41(a).

Virginia does not allow a taxpayer to claim a subtraction for expenses offset by a credit at the federal level unless allowed by statute. See P.D. 91-59 (3/29/1991), P.D. 94-164 (5/25/1994) and P.D. 16-34 (3/23/2016). Pursuant to Virginia Code § 58.1-402 C 14, corporations are allowed to subtract the amount of qualified research expenses and basic research expenses. Under Virginia’s statute, taxpayers may claim a subtraction for the reduction of business expenses attributable to research not deductible for federal income tax purposes as a result of the credit limitations under IRC § 280C(c). Even if the research was not conducted in Virginia, the Taxpayer would be eligible to claim a subtraction for expense reduction attributable to the federal research and development credit.

The Taxpayer reasons that income subject to apportionment would be essentially the same because the subtraction would offset the increase to FTI. Under these circumstances, the Taxpayer asks whether it would be necessary to file an amended return. Because ordinary business income would increase as a result of claiming the credit on the federal return, Virginia Code § 58.1-311 would require the Taxpayer to report the change or correction in federal taxable income within one year of a final determination of such change by filing an amended return with the Department.

Further, under IRC § 6103(d), the IRS provides the Department with information concerning a taxpayer’s FAGI or FTI. When a Virginia amended return is not filed or the changes to federal taxable income are not otherwise reported, the Department is authorized to make an assessment of additional tax based on the federal adjustments at any time pursuant to Virginia Code § 58.1-312. Because the information received from the IRS may not clearly identify why the income has been changed, it can be difficult for the Department to precisely adjust a taxpayer’s Virginia liability. By filing an amended return documenting the IRS changes and any resulting adjustments to their Virginia return, a taxpayer can avoid the possibility of receiving an assessment from the Department.

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

Sincerely,

Craig M. Burns

Tax Commissioner

AR/742.B