Can an S corporation shareholder claim a Virginia subtraction for the business-expense deduction the company had to give up to take the federal tip credit?

Plain-English summary

The taxpayers were shareholders of an S corporation (a pass-through business). The corporation claimed the federal tip credit (IRC § 45B) for the Social Security tax it paid on employee tips. Federal law makes you give up the business-expense deduction for that same amount if you take the credit. On their Virginia return, the shareholders tried to subtract their share of that lost deduction. The Department disallowed the subtraction and assessed tax.

The Department upheld the assessment: Virginia has no subtraction for a deduction you gave up to claim a federal credit.

Why the deduction was "lost" — and why Virginia won't restore it

The federal tip credit (IRC § 45B) rewards employers for Social Security tax paid on tips above the minimum-wage level. But IRC § 45B(d) says you can't also deduct the amount used to figure the credit — no double benefit. For a pass-through S corporation, that reduced deduction means more income flows through to the shareholders, raising their federal adjusted gross income (FAGI). Because Virginia starts from FAGI, that higher income landed on their Virginia return — but Virginia has no equivalent to the federal credit to offset it.

The shareholders argued a Virginia subtraction should make them whole for the deduction they had to forgo. The Department said no, for three connected reasons:

• Virginia only allows the subtractions its statutes list. Subtractions and deductions in computing Virginia taxable income are set out in Va. Code §§ 58.1-322.02–322.04, and none covers a deduction reduced by the federal § 45B credit (citing P.D. 91-59, P.D. 16-34, P.D. 17-192).
• Deductions are strictly construed against the taxpayer. As legislative "grants," subtractions and credits are read narrowly in the taxing authority's favor (Howell's Motor Freight v. Virginia Dep't of Taxation).
• Other states' rules don't bind Virginia. Even if states where the corporation does business allow such a deduction, Virginia follows Virginia law.

Because no Virginia statute authorizes the subtraction, the assessment was correct. The taxpayers will get an updated bill with interest.

What this means for you

• The federal tip credit can quietly raise your Virginia tax. Giving up the federal deduction increases pass-through income and FAGI, and Virginia offers no matching credit or subtraction to offset it.
• Virginia subtractions are a closed list. If a subtraction isn't expressly in the statute, you can't claim it — the "it's only fair" argument doesn't work.
• Deductions are read against you. When a deduction or credit is ambiguous, expect the Department to resolve it in the Commonwealth's favor.
• Don't rely on another state's treatment. A subtraction or deduction allowed elsewhere gives you no right to it in Virginia.

Common questions

Q: My S corporation took the federal tip credit. Can I subtract the deduction it lost on my Virginia return?

A: No. Virginia has no subtraction for a business-expense deduction reduced by claiming the federal IRC § 45B credit, so the extra pass-through income remains taxable in Virginia.

Q: Isn't it double taxation to lose the deduction with no Virginia credit?

A: The Department treats it as the result of Virginia conforming to federal income but not offering the federal credit. Virginia subtractions are limited to those the statute lists, and this isn't one of them.

Q: Another state lets me deduct it. Why not Virginia?

A: Virginia is bound only by Virginia law. What other states allow doesn't create a Virginia subtraction.

Citations and references

• Va. Code § 58.1-301 — Virginia conforms to Internal Revenue Code terminology
• Va. Code §§ 58.1-322.02 through 58.1-322.04 — subtractions/deductions allowed in computing Virginia taxable income
• Va. Code § 58.1-402 — corporate Virginia taxable income starts from federal taxable income
• IRC § 45B and § 45B(d) — employer tip credit; no deduction for amounts used to figure the credit
• Howell's Motor Freight, Inc. v. Virginia Dep't of Taxation, Law No. 82-0846 (Roanoke Cir. Ct. 10/27/1983) — deductions strictly construed against the taxpayer
• Related Virginia rulings cited: P.D. 91-59, P.D. 16-34, P.D. 17-192

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 19-94

Original ruling text

August 23, 2019

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 * and *** (the “Taxpayers”) for the taxable year ended December 31, 2016.

FACTS

The Taxpayers were shareholders of a subchapter S corporation (the “Corporation”). On its 2016 federal income tax return, the Corporation claimed a credit pursuant to Internal Revenue Code (IRC) § 45B for Social Security taxes it paid on employee tips. On their 2016 Virginia individual income tax return, the Taxpayers claimed a subtraction for their proportional amount of the business expense deduction the Corporation could not claim on its federal return because it was not permitted to claim the tax as a business expense while also claiming a credit for it. The Department denied the subtraction and issued an assessment. The Taxpayers appealed, contending they were justified in claiming the subtraction because Virginia does not have a comparable credit and the subtraction properly reflects the amount of the business expense deduction they had to forego at the federal level to claim the credit.

DETERMINATION

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 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.

For individual income tax purposes, any income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Virginia Code § 58.1-322.01 through Virginia Code § 58.1-322.04. Virginia Code § 58.1-402 provides that a corporation’s Virginia taxable income (VTI) for any given taxable year is the FTI and any other income taxable to the corporation under federal law for such year, adjusted and modified by certain specified additions, subtractions, and exemptions.

IRC § 45B provides a credit against federal income tax to employers who pay Social Security taxes on employee tips that exceed the amount of federal minimum wage employees must be paid. Employers who claim the credit, however, may not also claim a deduction for any amount taken into account in determining the credit. See IRC § 45B (d). This has the effect of lowering their payroll expense deductions that would otherwise be allowable as business expense deductions for federal income tax purposes. Because the Taxpayers were shareholders in a pass-through entity, the reduced payroll expense deduction resulted in the Taxpayers’ receiving a greater amount of income in their distributive shares of pass-through entity income. The correspondingly higher amount of FAGI flowed through on their Virginia return to result in a higher amount of VTI, without a corresponding credit like they received on their federal return.

By reason of their character as legislative grants, 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 Dep’t of Taxation, Circuit Court of the City of Roanoke , Law No. 82-0846 (10/27/1983).

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 Public Document (P.D.) 91-59 (3/29/1991) and P.D. 16-34 (3/23/2016). Subtractions and deductions allowable in the computation of VTI are expressly set forth in Virginia Code § 58.1-322.02 through Virginia Code § 58.1-322.04 for individual income tax purposes. Virginia statutes do not allow taxpayers to claim a subtraction for the amount of business expense deductions that may be reduced by claiming the federal credit under IRC § 45B. See P.D. 17-192 (11/16/2007). Accordingly, the Department’s assessment was correct.

The Taxpayers argue that other states in which the Corporation does business allow the deduction. Even if that is the case, the Department is bound by Virginia law as to the subtractions or deductions that are allowed for Virginia income tax purposes. Accordingly, the assessment is correct.

The Taxpayers will receive an updated bill which will include accrued interest to date. The Taxpayers should remit payment within 30 days of the bill date to avoid the accrual of additional interest and possible collections actions.

The Code of Virginia sections 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/2023.M

Related Documents

91-59

16-34

17-192