The IRS already adjusted my federal return for the same year Virginia is auditing -- doesn't that mean Virginia's assessment is wrong?

Plain-English summary

A husband and wife filed a joint Virginia resident individual income tax return for the 2020 taxable year. During a Department review, the Department asked them to substantiate business expense deductions claimed on their federal Schedule C. When no supporting documentation was received, the Department disallowed the deductions and issued an assessment. The Taxpayers disputed the assessment, arguing that the IRS had already adjusted their 2020 federal return — implying the matter was already resolved in their favor. When the Department asked for documentation of that IRS adjustment, the Taxpayers provided their IRS transcript for 2020, and the Department revised the assessment to match the federal adjusted gross income (FAGI) shown on that transcript. A balance still remained due, and the Taxpayers applied for full correction, continuing to rely on the fact that the IRS had already adjusted their return.

Why the IRS adjustment didn't help them. Virginia's individual income tax starts the computation of Virginia taxable income with FAGI (Va. Code § 58.1-301), and the Department generally relies on the accuracy of a taxpayer's federal return unless there's clear evidence the federal figures aren't consistent with the Internal Revenue Code (Va. Code § 58.1-219). Here, the Department actually reviewed the IRS transcript the Taxpayers submitted — and found that the IRS itself had disallowed the very same Schedule C business expense deductions the Department had disallowed. In other words, the IRS audit didn't contradict Virginia's assessment; it independently confirmed the same conclusion. Under IRC § 162 and Treas. Reg. § 1.162-1, deductible business expenses must be ordinary, necessary, and connected to the taxpayer's trade or business — and the Taxpayers never provided documentation substantiating that connection to either the IRS or the Department.

The assessment matched the corrected FAGI. Because any IRS adjustment to FAGI must flow through to the Virginia return (and Va. Code § 58.1-311 requires reporting such a federal change within a year via an amended return, with Va. Code § 58.1-312 A 3 letting the Department assess at any time if that isn't done), the Department confirmed its audit staff had already updated the assessment to match the FAGI shown on the federal transcript. With that confirmed, the assessment was upheld in full, with interest continuing to accrue until paid.

What this means for you

Anyone disputing a Virginia assessment by pointing to an IRS audit

Don't assume an IRS audit of the same year helps you — read your own IRS transcript closely first. If the IRS also disallowed the deduction or adjustment at issue, citing that audit will backfire; it corroborates the state's position rather than undermining it.

Business owners claiming Schedule C deductions

Keep documentation substantiating that each expense is ordinary, necessary, and connected to your trade or business. Virginia will ask for the same support the IRS would, and a real IRS adjustment disallowing a deduction carries over directly into your Virginia taxable income.

Anyone whose federal return is later adjusted by the IRS

File an amended Virginia return within one year of a final IRS adjustment. If you don't, the Department can assess the correct tax at any time — there's no ordinary statute-of-limitations protection for an unreported federal change.

Common questions

Q: If the IRS adjusts my federal return, does that automatically fix my Virginia return too?
A: No — you must report the change by filing an amended Virginia return within one year of the final federal determination. If you don't, the Department can assess the corrected amount at any time.

Q: I have an IRS transcript for the year in question — does that prove my Virginia assessment is wrong?
A: Only if the transcript actually shows the IRS reached a different conclusion than Virginia did. Read it carefully — as in this ruling, it may confirm the same disallowance rather than contradict it.

Q: What does the Department need to substantiate Schedule C business expense deductions?
A: Documentation showing the expenses were ordinary and necessary and directly connected to your trade or business, consistent with IRC § 162 and its regulations.

Citations and references

Statutes and regulations:

• Va. Code § 58.1-301 — Virginia tax terminology generally follows Internal Revenue Code meanings; Virginia taxable income computation starts with FAGI
• Va. Code § 58.1-219 — Department's authority to adjust FAGI/itemized deductions where inconsistent with the IRC
• Va. Code § 58.1-311 — duty to report a federal change/correction within one year by filing an amended Virginia return
• Va. Code § 58.1-312 A 3 — Department may assess at any time if a required amended return is not filed
• IRC § 162 — deduction for ordinary and necessary business expenses connected to a trade or business

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-139

Original ruling text

December 13, 2024

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will respond to your letter in which you seek correction of the individual income tax assessment issued to * (the “Taxpayers”) for the taxable year ended December 31, 2020.

FACTS

The Taxpayers, a husband and wife, filed a joint resident individual income tax return for the 2020 taxable year. Under review, the Department requested information to support the business expense deductions reported on the Taxpayers’ federal Schedule C. After no response was received, the Department denied the deductions and issued an assessment. The Taxpayers disputed the assessment on the basis that the Internal Revenue Service (IRS) had already adjusted their 2020 federal income tax return. Additional documentation was requested by the Department, and the Taxpayers provided a copy of their IRS transcript for the 2020 taxable year. The Department adjusted the assessment to match the federal adjusted gross income (FAGI) reported on the transcript, but a balance remained due. The Taxpayers applied for correction, contending that the IRS has already adjusted their return.

DETERMINATION

Virginia Code § 58.1-301 provides, with certain exceptions, that the 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 (VTI) with the 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).

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 Taxpayers claimed ordinary and necessary business expenses on Schedule Cs filed with their 2020 federal income tax return. The Department requested that the Taxpayers provide documentation to substantiate these business expenses. When the documentation was not received, the deduction for the expenses was disallowed. The Taxpayers have provided no further documentation with their application for correction to substantiate the claimed expenses.

The Taxpayers argue that the Department’s assessment is invalid because the IRS already audited their 2020 federal income tax return and made the necessary adjustments. A review of the IRS transcript provided by the Taxpayers indicates that the IRS also disallowed the Taxpayers’ claimed deductions for business expenses. The IRS audit, therefore, actually supports the findings of the Department’s audit.

As stated above, the income or loss from a business is reflected in the FAGI reported on the federal income tax return. FAGI, in turn, is used as the starting point for the computation of VTI on the Virginia return. Any adjustment made by the IRS to a taxpayer’s FAGI must also be reflected in the FAGI used to determine the taxpayer’s Virginia income tax liability. In fact, Virginia Code § 58.1-311 requires any individual to report a change or correction in federal taxable income within one year of the final determination of such change or correction by filing an amended return with the Department. If the taxpayer fails to file an amended return, Virginia Code § 58.1-312 A 3 permits the Department to assess the appropriate tax at any time.

In this case, the audit staff ensured that the FAGI reported on the federal transcript matched the FAGI used to compute the assessment at issue. Accordingly, the assessment is upheld. The Taxpayers will receive an updated bill with accrued interest to date. The bill should be paid within 30 days of the bill date to avoid the accrual of additional interest.

The Code of Virginia sections cited are available online at law.lis.virginia.gov. The public documents cited are available at tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy and Legal Affairs, Tax Adjudication and Resolution Division, at or **.

Sincerely,

James J. Alex

Tax Commissioner

Commonwealth of Virginia

AR/4649.Y

Related Documents

10-126

12-141

14-155

16-53

19-104

21-67

22-94