My company filed amended corporate returns before an audit was finished, and disputes how the auditor handled loss characterization and overpayment credits across affiliates -- what does Virginia require?

Plain-English summary

A corporation filed combined Virginia corporate income tax returns with its subsidiaries for two taxable years, then filed amended returns for the same years. The Department later audited the group and made a number of adjustments, and the taxpayer appealed several of them.

Starting point for the audit. The taxpayer argued the audit should have started from its amended return figures, not the original return figures, since the amendments were filed before the audit concluded. The Department held that its practice is correct: until an amended return is actually processed and recorded in the Department's own accounting system, the audit's proper starting point is the taxpayer's ORIGINAL return -- even if the amendment was received earlier. That said, the Department found the auditor's own worksheets didn't clearly show how the amended-return changes were folded into the audit, and directed that going forward, amended-return adjustments must be separately labeled and clearly explained in the audit report.

A subtraction that was disallowed by oversight. One affiliate's 2010 subtraction was disallowed with no stated reason; the Department agreed this looked like an auditor oversight and reinstated it.

Ordinary vs. capital loss characterization. The taxpayer had reported certain losses (on the sale of mortgages, by its own original characterization) as ordinary losses offsetting ordinary income, for two different affiliates -- one a leasing company (arguing the losses were from ordinary-course lease sales) and one a broker-dealer (arguing the loss was from a securities sale, also ordinary for a dealer). The auditor reclassified these as capital losses. The Department found the taxpayer's explanation alone wasn't enough -- once a taxpayer's own return figures are questioned by an audit, the taxpayer bears the burden of providing clear and cogent documentary evidence supporting the originally-claimed characterization, and none had been supplied here.

Overpayment credits. The taxpayer argued the auditor didn't apply all available 2008 overpayment credits (including credits tied to an affiliate that merged into the group that year) to 2009, and didn't apply 2009 overpayments to 2010. The Department explained the underlying rule: estimated tax payments can only be applied to the tax year for which they were made; only after a return is filed showing a refund can any excess be refunded or carried forward as an estimated payment for the NEXT year -- they cannot be applied retroactively to an earlier year's underpayment. For an affiliated group filing combined returns (including a group that gains a new member through a mid-year merger), the group's combined overpayment credits are what carry forward, computed on that combined basis. Because payments had been made under multiple affiliates' separate accounts in 2008, reconciling this took a detailed worksheet, which the Department applied.

Outcome: the case was remanded to the auditor, who will reinstate the one wrongly-disallowed subtraction, apply overpayment credits per the Department's worksheet, clearly document how the amended-return figures were incorporated, and give the taxpayer a real opportunity to submit documentation on the loss-characterization issue before a new 90-day appeal window on the revised audit report.

What this means for you

Corporations that amend a combined/consolidated Virginia return during an active audit

Filing an amended return doesn't automatically reset the auditor's starting point -- until the Department actually processes your amendment into its system, the audit will start from your ORIGINAL return figures. If your amendment is later incorporated as an audit adjustment, insist that the audit report clearly separates and labels those adjustments so you can verify they were applied correctly.

Businesses that reclassify a loss as ordinary rather than capital (or vice versa) under audit

Simply asserting the correct characterization (e.g., "this was a lease sale in the ordinary course" or "this was a securities sale by a dealer") isn't enough once the return figure is questioned. You need documentary evidence -- contracts, transaction records, entity classification support -- to substantiate the claim; an unsupported explanation, even a plausible one, will be treated as insufficient.

Affiliated groups managing estimated tax payments and overpayment credits across entities

Estimated payments belong to the tax year for which they're made and can't be shifted backward to cover a prior year's underpayment -- only forward, as an estimated payment for the following year, once a return is filed. If your group gains a new member mid-year (through a merger), that member's own overpayment history becomes part of the combined group's credit reconciliation going forward, which can get complicated if payments were made under separate legacy accounts -- keep clear records tying each payment to its originating entity and year.

Common questions

Q: If I amend my Virginia corporate return mid-audit, does the auditor have to use my amended figures as the starting point?
A: Not automatically. Until the Department processes and records the amended return in its own accounting system, the audit properly starts from your original return figures, even if the amendment was filed and received before the audit concluded.

Q: Can I apply a later year's overpayment credit backward to cover an earlier year's underpayment?
A: No. Estimated tax payments and overpayment credits can only be applied to the tax year for which they were made, or carried forward as an estimated payment toward the NEXT taxable year once a return is filed showing a refund -- not applied retroactively to a prior year.

Q: What do I need to prove a loss should be characterized as ordinary rather than capital under audit?
A: More than an explanation. You need clear, cogent documentary evidence -- such as records showing the assets were sold in the ordinary course of a leasing business, or that the seller is a securities dealer -- because amounts questioned on audit are not presumed correct just because you say so; the burden is on you to substantiate the originally-claimed characterization.

Citations and references

• P.D. 99-99 (5/6/1999) and P.D. 03-43 (4/24/2003) (Department policy that overpayment credits carried to a later year become estimated payments for that year and cannot be applied retroactively to an earlier underpayment)

Subject

Subtractions : Income - Ordinary Income, Capital Gains; Administration : Returns - Amended Returns, Overpayment Credits

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 21-137

Original ruling text

October 26, 2021

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek a refund of corporate income tax paid by * (the “Taxpayer”) for the taxable years ended December 31, 2009 and 2010. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer filed combined Virginia corporate income tax returns with its subsidiaries for the taxable years at issue. Subsequently, the Taxpayer filed amended returns. The Department audited the Taxpayer and numerous adjustments were made. The Taxpayer filed an appeal contesting several of the adjustments. Each of the adjustments will be addressed separately below.

DETERMINATION

Amended Returns

Because it had filed amended returns for the taxable years at issue, the Taxpayer believes the Department’s audit computations incorrectly started with the amounts reported on the Taxpayer’s original returns. Under audit, the Department will begin with the most current balances recorded in its accounting system. Until an amended return is processed and recorded in the Department’s accounts, the proper starting point for an audit is a taxpayer’s original return. While the amended returns in this case were received prior to the conclusion of the audit, they were not processed until the audit report was issued. As such, the auditor’s worksheets properly used the Taxpayer’s original return figures as the computational starting point.

The auditor did acknowledge that the amended return changes were incorporated into the audit. In such situations, the audit report and worksheets should clearly set forth how such changes were incorporated into the audit. When audit staff includes amended return as audit adjustments, they should be recorded in the appropriate section of the audit report and identified as taxpayer amendments. Adjustments to taxpayer amendments should be recorded as a separate adjustment and labeled as such in the audit report. A review of the audit report does not clearly show how the Taxpayer’s amendments were included.

Taxable Income Increase

The auditor disallowed a subtraction claimed by Taxpayer affiliate * (Corporation A) for the 2010 taxable year. The Taxpayer claims the auditor provided no explanation for the adjustment. It appears the adjustment was an oversight by the auditor.

Characterization of Loss

Virginia Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia have the same meaning as provided in the Internal Revenue Code (IRC), unless a different meaning is clearly required. As such, Virginia’s conformity to federal law is limited to the actual use of a specific term in a Virginia statute. Further, conformity does not extend to terms, concepts, or principles specifically provided for in Title 58.1 of the Code of Virginia . For corporate income tax purposes, Virginia generally “conforms” to federal law in that it starts the computation of Virginia taxable income with federal taxable income (FTI).

Virginia Code § 58.1-402 provides that a corporation’s Virginia taxable income 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. For purposes of this statute, the term “federal taxable income” means all income from whatever source derived and however named on which a federal tax is imposed. See Title 23 VAC 10-120-100 A.

The Taxpayer explains that it mistakenly characterized certain losses incurred by * (Corporation B), (Corporation C), and ** (Corporation D) as losses on mortgages on its 2009 federal income tax return. It used these losses to offset ordinary income. Under audit, the Department determined that losses on the sale of mortgages should be classified as capital losses and disallowed the offset of ordinary income. The Taxpayer contends that because Corporation A and Corporation B were leasing companies, losses from the sale of leases occurred from sales transacted in the normal course of business and were thus ordinary losses. The Taxpayer also asserts that Corporation C was a broker-dealer and the loss was from the sale of securities which is an ordinary loss.

The Department requested documentation to substantiate the nature of the sales transactions in question. Although the Taxpayer provided an explanation as to the discrepancy, no further documentation has been provided.

Amounts reported by a taxpayer on its return are considered to be accurate unless an inquiry, review or audit finds otherwise. When items are mischaracterized on a return, it is incumbent for the taxpayer to provide clear and cogent evidence of the error when requested to do so.

Overpayment Credits

The Taxpayer contends that the auditor did not apply all available overpayment credits from the 2008 taxable year to the 2009 taxable year, including overpayment credits derived from a corporation and its affiliates that merged with the Taxpayer in 2008. The Taxpayer also asserts that no overpayment credits from the 2009 taxable year were applied to its liability for the 2010 taxable year.

Title 23 of the Virginia Administrative Code (VAC) 10-120-420 requires every corporation that expects its income tax to exceed $1,000 for a taxable year to file a declaration of estimated tax and to pay the tax in installments during the taxable year. Title 23 VAC 10-120-440, further provides:

All payments of estimated tax shall be applied toward the income tax liability of the taxpayer for the taxable year ... [p]ayments of estimated tax may not be applied toward any other tax or taxable year unless and until an income tax return is filed showing a refund.

It has been the Department’s policy that estimated taxes may be applied only toward the income taxes due for that taxable year. Once a return has been filed for that taxable year, any excess estimated payments may be returned to the taxpayer as a refund or applied to estimated payments toward the next tax year. Overpayments credited to a subsequent taxable year become estimated payments for that taxable year and may not be applied retroactively to a prior year’s underpayment. See Public Document (P.D.) 99-99 (5/6/1999) and P.D. 03-43 (4/24/2003).

Virginia Code § 58.1-442 B 2 provides for a combined return for an affiliated group of corporations that computes its Virginia taxable income or loss separately for each corporation. This income or loss is then combined and reported on a single return.

Pursuant to Title 23 VAC 10-120-420 E, affiliated groups of corporations which file on a consolidated or combined basis must also pay estimated tax on a consolidated or combined basis. Members of affiliated groups which become subject to Virginia income tax must use the method of reporting previously elected by the groups. See Title 23 VAC 10-120-320 B. As such, the combined overpayments of corporate taxpayers and their affiliates, including those that merged into an affiliated group during the prior taxable year, may be credited as an estimated payment for the combined groups the following taxable year.

A reconciliation of the Taxpayer’s overpayment credits was complicated by the fact payments were made under a number of affiliates’ accounts in 2008. Based on the Department’s analysis (worksheet attached), it appears that the Taxpayer has ultimately carried forward a greater amount of overpayment credit than the Department can account.

CONCLUSION

The subtraction claimed by Corporation A will be reinstated. The Taxpayer, however, has not provided sufficient documentation to show that the losses sustained by Corporation B and Corporation C were losses from the sale of leases, nor has it shown that the loss reported by Corporation D was from the sale of securities. As such, the Department cannot determine whether the losses were properly classified as ordinary. In addition, the Taxpayer’s overpayment credits from the 2008 taxable year have been applied in accordance with the attached schedule.

The case will be remanded back to the auditor and the Taxpayer will be granted an opportunity to provide the documentation regarding the classification of the losses. The Taxpayer should contact the auditor to determine what documentation is required. Upon receipt, the documentation will be reviewed and the audit adjusted accordingly. The auditor is instructed to provide a clear explanation to the Taxpayer as to how the amended returns were reflected in the audit report. Once the adjusted audit report is issued, the Taxpayer will have 90 days from the date it is issued to appeal of it disagrees with the conclusions. In addition, the audit staff is instructed to provide the Taxpayer with additional explanations concerning how the amended return figures were incorporated into the audit, if requested by the Taxpayer.

The Code of Virginia sections, regulations 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/539.B

Related Documents

99-99

03-43