October 10, 2018
Re: Appeal of Final Local Determination
Taxpayer: *****
Locality: *****
Business, Professional and Occupational License (BPOL) tax
Dear *****:
This final state determination is issued upon the application for correction filed by you on behalf of ***** (the “Taxpayer”), with the Department of Taxation. You request a refund of Business, Professional and Occupational License (BPOL) taxes paid by the Taxpayer to the ***** (the “County”) for the 2015 through 2017 tax years.
The BPOL tax is imposed and administered by local officials. Virginia Code § 58.1-3703.1 authorizes the Department to issue determinations on taxpayer appeals of BPOL tax assessments. On appeal, a BPOL tax assessment is deemed prima facie correct, i.e., the local assessment will stand unless the taxpayer proves that it is incorrect.
The following determination is based on the facts presented to the Department summarized below. The Code of Virginia section, regulations and public documents cited are available online at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department’s web site.
FACTS
The Taxpayer, an S corporation, had a definite place of business in the County. It filed a request with the County for a refund of BPOL taxes paid contending that it failed to claim an out-of-state deduction for gross receipts attributable to business conducted in other states in which it filed tax returns.
The County reviewed the Taxpayer’s request and allowed the deduction for some states, but disallowed deductions for gross receipts from Arizona, California, the District of Columbia, Florida, Georgia, New York, Texas, Utah, and West Virginia. In its final determination, the County concluded these states did not impose an income tax or the Taxpayer was not liable for the states income tax. The Taxpayer filed an appeal with the Department, contending that the out-of-state deduction disallowed by the County was for gross receipts attributable to states in which income tax returns were filed.
ANALYSIS
Virginia Code § 58.1-3732 B 2 provides a deduction from gross receipts otherwise taxable for any receipts “attributable to business conducted in another state or foreign country in which the taxpayer (or its shareholders, partners, or members in lieu of the taxpayer)... is liable for an income or other tax based upon income.” Pursuant to Title 23 of the Virginia Administrative Code (VAC) 10-500-80 A 2, a taxpayer must file an income or income-like tax return in a state or foreign country even if there is no actual tax liability in a given year, in order to claim the deduction in that state or foreign country.
Public Document (P.D.) 97-490 (12/19/1997) further clarifies that a taxpayer must be required by the laws of another state or foreign country to file an income tax return or other return for a tax based upon income in order to be eligible to claim a deduction.
Tax Liability
The County disallowed the deduction of gross receipts attributable to Arizona, Florida, Utah and West Virginia. It found that although the Taxpayer filed returns, it was not liable for income tax in these states. The Taxpayer asserts that it filed returns in these states although no liability was reported and should be entitled to the deduction.
While the deduction is measured with reference to revenue derived from customers located outside Virginia, the statute limits the availability of the deduction to those businesses liable for an income or other tax based upon income. Thus, while Title 23 VAC 10-500-80 requires a business to file a return in the other state in order to be eligible for the deduction, gross receipts are not automatically attributable to business conducted in another state or foreign country simply because a return was filed in another state. In order to take the deduction, a business must be required by the laws of another state or foreign country to file an income tax return or other return for a tax based upon income. See P.D. 97-490.
For those states that impose an income tax or another type of tax based on income, Public Law (P.L.) 86-272, codified at 15 U.S.C. §§ 381-384, prohibits the imposition of a net income tax where the only contacts with a state are a narrowly defined set of activities constituting solicitation of orders for sales of tangible personal property. The scope of P.L. 86-272 is limited to only those activities that constitute solicitation, are ancillary to solicitation or are de minimis in nature. See Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214, 112 S.Ct. 2447 (1992). Although P.L. 86-272 provides a minimum standard, states differ in their interpretation of activities that are permitted without creating nexus.
In some cases, a business deriving revenue from customers outside Virginia may not be able to deduct such revenue or gross receipts from taxable gross receipts related to the exercise of the same privilege in Virginia. This would occur when the business is not required by the laws of another state or foreign country to file an income tax return or other return for a tax based upon income.
Further, Virginia’s regulation does not require a business to actually pay any tax to another state in order to be eligible to take the deduction. There are several reasons for this provision. Because the measurement of taxable income includes the deduction of most business expenses, the resulting computation may result in a net operating loss (NOL). In such cases, the business would have no income on which to compute a tax. In addition, if the state allows NOLs to be carried over, a business may compute a positive taxable income in subsequent years that is completely offset by an NOL carried forward from a previous period. Thus, an analysis of liability must go beyond the mere filing of a return reporting no tax due.
In addition, many states do not tax pass-through entities, included Subchapter S corporations, at the entity level. Instead, Virginia Code § 58.1-3732 B 2, considers a business to have been liable for an income tax if it was paid on behalf of a pass-through entity by its shareholders, partners or members. In such circumstances, it may be necessary for a business’s owners to show that they were required to file and pay income tax in the other state. An individual owner of a pass-through entity may be exempt from the other state’s tax because it lacks nexus or because the income attributable to that state does not meet the filling threshold. As such, merely filing a pass-through return reporting income subject to tax in another state may not be sufficient to show that the income was liable for tax in that state.
Arizona
In accordance with Ariz. Rev. Stat. Ann. § 43-1126, a small business corporation that has made a Subchapter S election under the Internal Revenue Code (IRC) is not subject to Arizona tax to the extent such corporations are not subject to federal income tax. In addition, Subchapter S corporations are also not subject to entity-level net worth or gross receipts tax or fees.
Such corporations, however, are required to file an annual return. On the return, the S corporation must report the name and address of each shareholder and their respective pro rata share of income or loss.
Both resident and nonresident shareholders are subject to tax on their entire distributive share of income from the S corporation. Under certain conditions, nonresident individual shareholders may have the S corporation file a composite return filed on their behalf in lieu of filing nonresident returns. See Ariz. Rev. Stat. Ann. § 43-1126(B) and Arizona Individual Income Tax Ruling No. 16-2 (9/13/2016).
The Taxpayer provided copies of S corporation returns it filed in Arizona. Based on these returns, the Taxpayer did not have any payroll or property in Arizona, but did attribute a portion of its sales there. Under Virginia’s interpretation of P.L. 86-272, an entity will almost always have property or payroll in Virginia before nexus can be established. The fact that the Taxpayer had no property or payroll in Arizona raises questions as to whether it was liable for Arizona income tax and no information has been provided to indicate whether the shareholder was required to file an individual return.
Florida
Florida law provides that S corporations are qualifying small business corporations that meet the requirements of IRC § 1361. Under Fla. Admin. Code Ann. § 12C-1.022(1)(b), S corporations are not subject to the tax unless they were liable for the federal tax. For a taxable S corporation, the amount of income subject to tax is limited to the amount subject to federal tax under IRC § 1374 (built-in gains or capital gains) or IRC § 1375 (passive investment income). See Fla. Admin. Code Ann. § 12C-1.013. Further, because Florida has no individual income tax, S corporation shareholders are not required to pay tax on their prorated portion of the income from the S corporation.
Because the amount subject to Florida tax is limited to the built-in gains or capital gains and passive investment income, Florida would be considered to have an income tax or another type of tax based on income. Virginia does not directly impose tax on S corporation income from built-in gains or capital gains and passive investments. The returns provided by the Taxpayer reported no income attributable to Florida.
Utah
Generally, S corporations are subject to Utah income tax in the same manner set forth IRC §1361 et seq. Thus, S corporations are exempt from the Utah corporate franchise and income taxes to the same extent they are exempt from the federal income tax. See Utah Code Ann. § 59-7-701. Pursuant to Utah Code Ann. § 59.7-505, S corporations are required to file an information return. However, they are only liable for tax in certain limited circumstances. See Utah Code Ann. § 59.7-701.
Pursuant to Utah Code Ann. § 59-10-1403.1(2), both resident and nonresident shareholders are required to include their distributive share of the S corporation's income, gain, loss or deduction in their computation of Utah taxable income. Nonresident shareholders, however, are only taxed on their share of the S corporation’s income apportioned and allocated under Utah’s apportionment formula.
According to the Taxpayer, it reported taxable income on the Utah S corporation return. On the return, the Taxpayer reported positive payroll and sales factors. Because it only filed one year in Utah and reported a positive payroll factor, it would appear the Taxpayer may have been engaged in activities that exceeded the protections afforded by P.L. 86-272. It is unclear whether the shareholder was required to file a Utah income tax return.
The County appears to have denied a deduction for gross receipts attributable to Utah because the Taxpayer paid withholding tax on the return. Utah imposes a withholding tax on all pass-through entity Utah business and nonbusiness income derived from Utah. See Utah Code Ann. § 59-10-1403.2(1)(a). Virginia imposes a similar withholding requirement on pass-through entities that have nonresident owners. While a withholding tax may not equate to an income tax, it is attributed to the pass-through entity owners in order to be claimed on their income tax returns. Thus, the fact that a pass-through entity pays a withholding tax does not mean a business was not liable for an income or income-like tax.
West Virginia
Under W. Va. Code § 11-24-5(d), corporations electing to be taxed as Subchapter S corporations under IRC §1361 et seq., are exempt from the corporate income tax. However, S corporations that engage in business in West Virginia or that derive income from property, activity or other sources in the state must file an information return.
Like Virginia, shareholders are required to pay West Virginia income tax individually on their proportionate share of the S corporation’s taxable income. See W. Va. Code § 11-21-17a. In addition, W. Va. Code § 11-21-71a requires S corporations to withhold West Virginia personal income tax from nonresident shareholders unless certain exceptions are met.
On the return provided, the Taxpayer reported taxable income attributable to West Virginia. The Taxpayer also reported positive payroll and sales factors. Because it only filed one year in West Virginia and reported a positive payroll factor, it would appear the Taxpayer may have been engaged in activities that exceeded the protections afforded by P.L. 86-272. No information has been provided to indicate whether the shareholder was required to file a West Virginia return.
Income Like Tax
The County disallowed a deduction for gross receipts attributable to California, the District of Columbia, Georgia, New York and Texas on the basis that such states did not impose income taxes. However, Virginia Code § 58.1-3732 B 2 allows a deduction for gross receipts for states in which a business was liable for a tax based upon income. This statutory construction contemplates a business would be eligible for the deduction based on the substance on which a tax is computed and not simply whether it is called an income tax.
Any analysis of the taxes imposed by other states must also be consistent with character of the state taxes at issue. By reason of their character as legislative grants, statutes relating to deductions allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See City of Lynchburg v. English Constr. Co., 277 Va. 574, 675 S.E.2d 197 (2009) and DKM Richmond Associates, L.P. v. City of Richmond, 249 Va. 401, 457 S.E.2d 76 (1995).
The Department has stated that Virginia’s statutes for administering other taxes are not generally applicable with regard to BPOL tax. See P.D. 97-490 and P.D. 04-46 (8/12/2004). By tying the subtraction for out-of-state receipts to an income tax liability, however, the legislature has infused income tax principles into a tax based on gross receipts. Thus, for purposes of determining whether a business is eligible for a subtraction, an income tax type analysis is required with regard to whether a business was subject to an income tax in another state.
Fortunately, Virginia’s income tax modification under Virginia Code § 58.1-402 B 4 includes language substantially similar to Virginia Code § 58.1-3732 B 2. The modification requires taxpayers to add amounts attributable to net income taxes and other taxes based on, measured by, or computed with reference to net income in computing Virginia taxable income. For purposes of this modification, taxes that are deducted in computing federal taxable income that are based on or utilize net income in their computation are required to be added to federal taxable income in computing Virginia taxable income. See P.D. 99-126 (5/28/1999). Under Title 23 VAC 10-120-101 D, the addition for income taxes would include any net income taxes and other taxes, including franchise and excise taxes which are based on, measured by, or computed with reference to net income, imposed by any other taxing jurisdiction were deducted in determining federal taxable income.
California
A corporation that elects to be taxed as an S corporation for federal tax purposes is also taxed as an S corporation for state tax purposes. See Cal. Rev. & Tax. Cd. § 23801(a). An S corporations must file annual return and pay either a tax based on a percentage of its net income under Cal. Rev. & Tax. Cd. § 23802(b)(1) or a minimum tax under Cal. Rev. & Tax. Cd. § 23153.
In addition, an S corporation’s income is taxed directly to its shareholders by allocating the corporation's items of income, loss, deduction, and credit to its shareholders. Both California residents and nonresidents are taxed on all their pro rata share of income (or loss) and may be eligible for a credit a credit for taxes paid to other states. See Cal. Rev. & Tax. Cd. §18001 and Cal. Rev. & Tax. Cd. § 17041(b), respectively. Nonresident shareholders may also elect to file a group (composite) return. See California FTB Informational Publication No. 1067 (12/1/2015).
The 2014 through 2016 returns provided by the Taxpayer indicate that the minimum franchise tax was paid each year. However, it appears the Taxpayer’s income would have been subject to a tax based on income on returns filed by its shareholder. As indicated above, however, a determination would have to be made as to whether the Taxpayer was actually subject to California tax under the limitations set forth under P.L. 86-272 and whether the shareholder was required to file.
District of Columbia
Under D.C. Code Ann. § 47-1801.04(10)(B), S corporations are included in the definition of the term “corporation.” All corporations, including subchapter S corporations, are subject to the corporation franchise tax, which is based on taxable income. See D.C. Code Ann. § 47-1807.02.
An examination of the District of Columbia’s returns and procedures indicate a computation similar to that used for federal income tax purposes. Gross revenues are reduced by cost of sales and other business related expenses (i.e., salaries and wages, office expenses, and depreciation). While the D.C. Court of Appeals held in Bishop v. District of Columbia, 401 A.2d 955 (D.C. 1979), aff’d en banc, 411 A.2d 997 (1980) that the D.C. corporate franchise tax was considered to be a tax for the privilege of doing business that is applied to income, the deduction for BPOL tax purposes contemplates a more substantive analysis. As such, while it is labeled as a franchise tax, the computation of the tax appears to be a tax based on income.
The Taxpayer filed franchise tax returns and paid the tax required by the District of Colombia. Evidence has not been provided showing a clear indication that the Taxpayer was legally subject to the franchise tax.
Georgia
Pursuant to Ga. Code Ann. § 48-13-72, a tax, in addition to other taxes, is imposed on the net worth of a corporations for the privilege of doing business or exercising a corporate franchise in Georgia. Ga. Code Ann. § 48-7-21 imposes income tax on corporations.
While Georgia does not impose an entity level income tax on S Corporations, the shareholders of the corporation include in their Georgia taxable income, their proportionate share of the corporation’s taxable income. See Ga. Code Ann. §48-7-21. An S corporation election is allowed only if all the stockholders are taxable in Georgia on their portion of corporate income or if all nonresident shareholders pay the Georgia income tax on their portion of corporate income. See Ga. Code Ann. § 48-7-21(b)(7). Failure to furnish a properly executed form for all nonresident stockholders negates Georgia’s recognition of the election requiring the S corporation to file and to pay the regular corporate tax.
The Taxpayer reported paying the net worth tax on the Georgia returns provided, but did not report any Georgia taxable income on the front of the return. Based on this presentation, the County likely concluded the Taxpayer was not subject to Georgia’s income tax. A closer review of the returns indicates that a computation was made resulting in total Georgia net income. Because Georgia’s computation of net income is similar to Virginia, it appears the Taxpayer would be entitled to a deduction of gross receipts attributable to Georgia. As with other states, the question would be whether the Taxpayer’s activities were protected under P.L. 86-272 or if the shareholder was required to file a Georgia income tax return.
New York
New York requires Taxpayers to file franchise tax returns. See N.Y. Tax Law § 658(c)(2). Pursuant to N.Y. Tax Law § 210, New York imposes a flat rate of tax based on a corporation’s adjusted receipts. See N.Y. Tax Law §210(1)(d).
Corporations that meet the requirements both under federal and New York law to be treated as S corporations are exempt from the general corporation franchise tax. Even if the S corporation is exempt from the general tax, New York imposes a fixed dollar minimum tax on S corporations based on gross receipts as set forth in N.Y. Tax Law § 210(1)(d).
Unless the shareholders elect New York S corporation status, the S corporation is not a conduit, or pass-through, entity for New York tax purposes. See N.Y. Tax Law § 660(a). If the election is made, shareholders must include their pro rata share of the S corporation’s items of income, loss, and deduction to the extent included in federal adjusted gross income for the tax year. See N.Y. Tax Law § 660.
Based on the returns provided, the Taxpayer filed its New York return as an electing S corporation and paid the fixed dollar minimum tax. Under these circumstances, the shareholder may have been required to include their prorated portion of the Taxpayer’s income on their New York income tax returns. As with other states that impose an income tax on shareholders of S corporations, the nature of the Taxpayer’s business activities raises questions as to whether it was actually liable for New York’s tax on income.
Texas
The Taxpayer filed franchise returns and paid the tax on the apportioned margins. In accordance with Tex. Tax Code Ann. § 171.001(a), a franchise tax is imposed on a taxable entity, including electing federal S corporations, if they do business in Texas or are organized in Texas. The franchise tax is based on an entity’s margin. Generally, an entity has four ways to compute taxable margin including (i) 70% of total revenue or subtracting (ii) cost of goods sold (COGS), (iii) compensation; or (iv) $1 million from total revenue. In addition, total revenue is equal to revenue amounts reported for federal income tax less certain statutory exclusions. On the returns filed by the Taxpayer, the franchise tax was based on 70% of total revenue.
When legislation creating the margin tax was passed, the legislature contemporaneously enacted a separate section that expressly stated that “[t]he franchise tax imposed by Chapter 171, Tax Code, as amended by this Act, is not an income tax.” See Act of May 2, 2006, ch. 1, § 21, 2006 Tex. Gen. Laws 1, 38.
Further, Tex. Admin. Code 34 § 3.586(e) specifically states that the franchise tax is not subject to the limitations provided under P.L. 86-272. Finally, in Graphic Packaging Corp. v. Hegar, 471 S.W.3d 138 (2015), the Third District Court of Appeals of Texas (court of appeals) concluded that the Texas franchise tax was not an income tax or a tax imposed on or measured by net income.
DETERMINATION
After extensive analysis, it is the Department’s opinion that Texas does not impose an income tax or an income-like tax. Further, even though Florida does impose income tax on corporations, the tax imposed on S corporations is limited to certain types of passive or built-in income and no income tax is imposed on shareholders. Thus, the Taxpayer would have no income tax liability in Florida. As such, the Taxpayer would not be eligible for an out-of-state deduction for gross receipts attributable to these states.
Conversely, the Department concludes the taxes imposed by California, the District of Columbia, Georgia, and New York are either an income tax or a tax based on income. As with Arizona, Utah and West Virginia, however, the Taxpayer has failed to provide sufficient evidence that it or its shareholder were liable for taxes in these states.
This case is being remanded back to the County with the instruction to work with the Taxpayer to determine what information may be required to show it was liable for an income or income-like tax in Arizona, California, the District of Columbia, Georgia, New York, Utah and West Virginia for the 2015 through 2017 tax years consistent with the analysis in this letter. The information should be provided within 30 days of the date the County determines what information is required.
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/1534.B