The Department disallowed my Form 2106 employee business expenses and my Schedule C business expenses for lack of documentation -- can it do that, and do I get another chance to prove them?

Plain-English summary

A taxpayer filed Virginia resident returns for 2019 and 2020 that carried over two sets of federal deductions: employee business expenses claimed on a federal Form 2106 for 2019, and Schedule C business expenses for an adult rehabilitation business he ran in 2020. The Department audited both years, disallowed both sets of expenses, and assessed additional tax. The taxpayer appealed, arguing the Department lacked authority to disallow expenses that were already reflected on his federal return.

The Department disagreed. Virginia generally starts its income tax computation from federal adjusted gross income and normally relies on the accuracy of a taxpayer's federal return -- but it keeps independent authority under Virginia Code § 58.1-219 to adjust that starting figure where there's clear evidence the federal or Virginia numbers don't actually match what the Internal Revenue Code allows, and it has exercised that authority in several prior published rulings going back to 2010. Here, that clear evidence existed on both fronts. For 2019, an adjustment to income via Form 2106 was only available to a narrow list of taxpayers -- Armed Forces reservists, qualified performing artists, and certain fee-based government officials -- and the taxpayer never showed he fit any of those categories, nor did he document the expense amount. For 2020, the Department had specifically asked him to substantiate his Schedule C business expenses during the audit; he never provided anything, either then or with his appeal.

Because an assessment is presumed correct under Virginia law and the burden falls on the taxpayer to prove otherwise, both assessments were upheld. The Department did give him one more opportunity: 30 days to send real documentation to the RAP Unit auditor, with the assessments to be adjusted if the paperwork supports it, or treated as final if nothing more arrives.

What this means for you

Employees or business owners whose federal deductions get flagged in a Virginia audit

Just because an expense appears on your federal return doesn't mean Virginia has to accept it without question. The Department can independently verify that a claimed deduction actually satisfies the underlying federal rule -- here, that a Form 2106 adjustment was only available to specific categories of employees in 2019 -- and it can ask for documentation even though you've already filed a matching federal return.

Anyone claiming Form 2106 employee business expenses for a pre-2026 taxable year

Since the 2018 tax law changes, the "adjustment to income" version of Form 2106 (as opposed to the older miscellaneous itemized deduction, which was suspended) has only been available to a short list of taxpayers -- Armed Forces reservists, qualified performing artists, and fee-based state or local officials. If you don't fall into one of those categories, expect this kind of deduction to be disallowed on audit.

Schedule C filers who get an audit document request

Respond to it. This taxpayer lost his Schedule C deduction not because the business wasn't real, but because he never sent the Department (or later, the appeals office) anything to substantiate the expenses once asked. An assessment is presumed correct, and the burden of proving it wrong sits with you.

Common questions

Q: If an expense is already on my federal return, can Virginia still disallow it?
A: Yes. Virginia generally relies on federal figures, but it keeps authority under Va. Code § 58.1-219 to adjust FAGI or a deduction where there's clear evidence it doesn't actually match what the Internal Revenue Code allows -- and that authority is independent of anything the IRS itself has done.

Q: Who could still use Form 2106 to adjust income for the 2019 tax year?
A: A narrow group -- Armed Forces reservists, qualified performing artists, and certain fee-based state or local officials. If you don't fit one of those categories, the deduction is likely to be disallowed absent documentation showing otherwise.

Q: What happens if I never respond to an audit request for documentation?
A: The deduction gets disallowed and the assessment is presumed correct. The burden is then on you, not the Department, to prove the assessment wrong -- including on appeal.

Q: Do I get a second chance to submit documentation after losing an appeal like this?
A: Sometimes -- here the Department gave the taxpayer one final 30-day window to send documentation before treating the assessments as final. That's a courtesy the Department extended in this letter, not a guaranteed right.

Citations and references

• Va. Code § 58.1-301 (Virginia's income tax terminology generally follows the IRC unless the Code of Virginia says otherwise)
• Va. Code § 58.1-219 (Department's authority to adjust FAGI/deductions on clear evidence of an IRC inconsistency, independent of any IRS action)
• P.D. 10-126 (7/7/2010); P.D. 12-141 (8/29/2012); P.D. 14-155 (8/28/2014); P.D. 16-53 (4/11/2016); P.D. 19-104 (9/18/2019); P.D. 21-67 (5/25/2021) (prior rulings applying that independent-adjustment authority)
• IRC § 162 and Treas. Reg. § 1.162-1 (ordinary and necessary trade/business expense deduction)
• Treas. Reg. § 1.6001-1(a) (recordkeeping sufficient to establish correct tax liability)
• Va. Code § 58.1-310 (Department may require production of federal returns and supporting schedules)
• Va. Code § 58.1-205 (assessments presumed correct; burden on the taxpayer to disprove)
• Va. Code § 58.1-1826 (no court relief where an erroneous assessment stems from the taxpayer's willful failure to provide required information)

Subject

Deduction: Itemized - Employee Business Expenses; Expenses Reportable on Schedule C

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 22-94

Original ruling text

May 11, 2022

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 assessments issued to * (the “Taxpayer”) for the taxable years ended December 31, 2019, and 2020.

FACTS

The Taxpayer filed resident Virginia income tax returns for the 2019 and 2020 taxable years. He claimed employee business expenses on a federal Form 2106 and business expenses on a federal Schedule C on his 2019 and 2020 federal income tax returns, respectively. Under audit, the Department disallowed the expenses and issued assessments. The Taxpayer appealed, contending that the Department lacked the authority to disallow the expenses.

DETERMINATION

Virginia Code § 58.1-301 provides, with certain exceptions, 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. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia . For individual income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income properly 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 Chapter 3 of Title 58.1 of the Code of Virginia .

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. However, the Department retains the authority to adjust the FAGI and itemized deductions where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Virginia Code § 58.1-219. The Department has consistently exercised this authority in conducting its audit programs. See Public Document (P.D.) 10-126 (7/7/2010), P.D. 12-141 (8/29/2012), P.D. 14-155 (8/28/2014), P.D. 16-53 (4/11/2016), P.D. 19-104 (9/18/2019), and P.D. 21-67 (5/25/2021). In addition, the adjustments in these cases have been made independently from any actions taken by the IRS.

Form 2106 Deduction

The Taxpayer claimed an adjustment to federal gross income in 2019 for employee business expenses reported on federal Form 2106. For the 2019 taxable year, an adjustment to income could be claimed on federal Form 2106 only by certain individuals, including Armed Forces reservists, qualified performing artists, and fee-based state or local officials. The Taxpayer has not shown that he was one of the listed individuals who could claim business expenses on a Form 2106, nor did he provide any documentation to support the claimed expenses.

Schedule C Expenses

Under IRC § 162, taxpayers are permitted to deduct all of the ordinary and necessary business expenses paid or incurred during the taxable year in carrying on any trade or business. Such expenses must be directly connected with or pertaining to the taxpayer’s trade or business. See Treas. Reg. § 1.162-1.

Schedule C is used to report income or loss from a business, including a sole proprietorship. Income from the business is offset by expenses. This income or loss is reported on a taxpayer’s federal income tax return and thus is reflected in FAGI reported on the Virginia return.

The Taxpayer claimed ordinary and necessary business expenses for his adult rehabilitation business on his 2020 federal Schedule C. The Department requested that the Taxpayer provide documentation to substantiate his business expenses. When the documentation was not received, the deduction for the expenses was disallowed. The Taxpayer has provided no further documentation with his appeal to substantiate the claimed expenses.

CONCLUSION

Taxpayers must maintain records sufficient to allow the IRS to determine their correct tax liability. See Treas. Reg. § 1.6001-1(a). Similarly, Virginia Code § 58.1-310 provides:

Whenever in the opinion of the Department it is necessary to examine the federal income returns or any copy thereof of any individual, estate, trust, partnership or corporation in order properly to audit such returns, the Department or the commissioner of the revenue shall have the right to require such taxpayer to provide such return or a copy thereof and all statements, inventories, and schedules in support thereof.

Under the provisions of Virginia Code § 58.1-205, in any proceeding relating to the interpretation of the tax laws of Virginia, an “assessment of a tax by the Department shall be deemed prima facie correct.” As such, the burden of proof is on the Taxpayer to show that the assessment was erroneous. Further, Virginia Code § 58.1-1826 precludes a court from granting relief to taxpayers seeking correction of erroneous state tax assessments in cases in which the erroneous assessment is attributable to the taxpayer’s willful failure or refusal to provide the Department with necessary information as required by law.

I will, however, allow the Taxpayer one final opportunity to provide adequate documentation to substantiate the deductions that were disallowed. The documentation must be sent to the Virginia Department of Taxation, RAP Unit, Office of Compliance, Desk Audit, RAP, P.O. Box 5610, Richmond, Virginia 23220-0610, to the attention of the auditor, *, within 30 days of the date of this letter. Based on the documentation provided, the assessments will be adjusted as warranted. If the documentation is not received within the allotted time, the assessments will be considered to be correct.

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 . If you have any questions regarding the documentation you must provide or the audit process generally, you may contact at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3999.B

Related Documents

10-126

12-141

14-155

16-53

19-104

21-67