Document Number
10-116
Tax Type
Individual Income Tax
Description
Lack of substantiation could result in higher tax bills/S corporation
Topic
Records/Returns/Payments
Tangible Personal Property
Taxability of Persons and Transactions
Date Issued
07-01-2010


July 1, 2010




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, 2006 and 2007. I apologize for the delay in responding to your letter.

FACTS


The Taxpayer, a resident of ***** (State A), was the sole owner of ***** (ASC), an S corporation located in State A. The Taxpayer also held a substantial interest in ***** (VSC), a Virginia S Corporation. VSC engaged ASC to develop and run administrative software on behalf of VSC. The administrative software processes data for VSC and provides VSC customers with access to this data. The Taxpayer attributed all of his income from VSC to Virginia and attributed all of the income and wages from ASC to State A on his 2006 and 2007 Virginia nonresident returns.

Under audit, the Department determined that the transactions occurring between VSC and ASC were not at an arm's length rate. As a result, the auditor attributed ASC's income and the Taxpayer's ASC wages to Virginia based on VSC's apportionment percentage and issued an assessment. The Taxpayer paid the assessments, but filed an appeal contending that the fees paid to ASC by VSC were made pursuant to an arm's length arrangement.

DETERMINATION


Improper Reflection of Income

Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers, Va. Code § 58.1-446 provides, in pertinent part:
    • When any corporation liable to taxation under this chapter by agreement or otherwise conducts the business of such corporation in such manner as either directly or indirectly to benefit the members or stockholders of the corporation . . . by either buying or selling its products or the goods or commodities in which it deals at more or less than a fair price which might be obtained therefore, or when such a corporation . . . acquires and disposes of the products, goods or commodities of another corporation in such manner as to create a loss or improper taxable income, and such other corporation . . . is controlled by the corporation liable to taxation under this chapter, the Department . . . may for the purpose determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year.
    • In case it appears to the Department that any arrangements exist in such a manner as improperly to reflect the business done or the Virginia taxable income earned from business done in this Commonwealth, the Department may, in such manner as it may determine, equitably adjust the tax. [Emphasis added.]

The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54 (1988) has upheld the Department's authority to equitably adjust the tax of a corporation pursuant to Va. Code § 58.1-446 (or its predecessor) where two commonly owned corporations structure an arrangement in such a manner as to reflect improperly, inaccurately, or incorrectly the business done in Virginia or the Virginia taxable income. Generally, the Department will exercise its authority if it finds that a transaction, or a party to a transaction, lacks economic substance.

Because Va. Code § 58.1-446 specifically addresses transactions between corporations, the Department has limited equitable adjustments to corporate income tax returns. Such adjustments have included adjusting the transaction amount to fair market value, disallowing deductions, and consolidating incomes of corporations involved in such arrangements.

In the instant case, the Taxpayer is the sole owner and employee of ASC. The evidence clearly shows that ASC is an operating entity with sufficient economic substance. It compensated its employee with a substantial salary and benefits package and incurred normal business expenses including rent and license fees. Further, the documentation provided indicates the fees charged by ASC for its services are comparable to similar businesses. Accordingly, the transactions between ASC and VSC do not create an improper reflection of VSC's Virginia income.

S Corporation Income

The Taxpayer did not attribute any of ASC's income to Virginia for the taxable years at issue. During the course of the Department's review of this case, however, the Taxpayer provided information showing that he performed services in Virginia in his capacity as an employee of ASC.

Public Law (P.L.) 86-272, as codified at 15 U.S.C. §§ 381-384, prohibits a state from imposing 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 Department limits the scope of P.L. 86-272 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 (1992). Although P.L. 86-272 applies to tangible property, the Department's policy has been to extend the "solicitation test" of P.L. 86-272 to situations involving the sales of services.

Based on the information provided, ASC's activities in Virginia exceed the protections afforded under P.L. 86-272. As such, the Commonwealth has the authority to impose tax on ASC's income from Virginia sources. Nonresident shareholders in S corporations conducting business in Virginia are subject to Virginia income tax on their apportioned share of the S corporation's income. See Public Document (P.D.) 05-49 (4/7/2005).

Nonresident Salaries

On his income tax returns for the taxable years at issue, the Taxpayer attributed all of his salary for ASC to State A. While this appeal was under consideration, the Taxpayer acknowledged he worked on behalf of ASC in Virginia during the taxable years at issue.

Individuals who are neither domiciliary nor actual residents of Virginia and have income from Virginia sources are taxed as nonresidents. The Virginia taxable income of a nonresident is defined under Va. Code § 58.1-325 as "an amount bearing the same proportion to his Virginia taxable income, computed as though he were a resident, as the net amount of his income, gain, loss and deductions from Virginia sources bears to the net amount of his income, gain, loss and deductions from all sources."

Typically, the factor that most equitably determines the apportionment of salaries and wages is the ratio of the number of days services were performed in Virginia to the number of days services were performed elsewhere. See Public Document (P.D.) 94­219 (7/13/1994). The Department has previously ruled that a nonresident who works in Virginia may apportion his or her salary to Virginia using a ratio of (1) the number of days or portion thereof spent in Virginia performing duties for his or her employer, divided by (2) the number of days or portion thereof spent anywhere performing duties for his or her employer. See P.D. 85-134 (6/18/1985).

As a general rule, the Department uses 260 clays in the denominator of the ratio for determining wages attributable to Virginia for full-time employees. Taxpayers who claim to have worked more than 260 days during a given taxable year must document that claim. Likewise, taxpayers who worked less than 260 days are limited to using days actually worked in the denominator of the ratio. For part-time employees, semi-retired individuals, and consultants, a ratio of hours worked in Virginia divided by hours worked anywhere may be a better indicator of income from Virginia sources.

The Taxpayer has provided schedules showing the amount of time he worked in Virginia during the taxable years at issue. As such, the salary earned from ASC will be adjusted to reflect the amount of work that he performed in Virginia on behalf of ASC.

CONCLUSION


Based on the evidence provided, the arrangement between ASC and VSC did not primarily reflect "paper" intercompany transactions resulting in an arrangement conducted in such a manner as to reflect improperly, inaccurately, or incorrectly, the business done or the Virginia taxable income earned from business done in Virginia. Accordingly, the auditor's adjustments are overturned.

It is clear, however, that ASC conducted significant operations in Virginia that were not reflected on the Taxpayer's 2006 and 2007 income tax returns. As such, the assessments will be adjusted in accordance with this determination.

The enclosed schedules reflect the changes made to the audit assessments. Because the proper amount of tax for the 2006 taxable year is greater than the amount previously assessed and paid, the Department will issue a new assessment as provided in Title 23 of the Virginia Administrative Code (VAC) 10-20-160 D 6. For the 2007 taxable year, the Department will issue a refund for the amount of the overpayment of tax and interest, along with applicable refund interest.

For future taxable years, the Taxpayer should document the time he worked in Virginia and elsewhere. Such documentation should be in the form of a log, calendar, or schedule providing sufficient details to determine which days the Taxpayer worked, the number of hours worked each day, and the number of days worked in Virginia. Lack of substantiation could result in the Department reducing the number of days or hours worked, resulting in a higher nonresident apportionment percentage.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact ***** at *****.
                • Sincerely,


                • Linda Foster
                  Deputy Tax Commissioner



AR/1-3401661359.B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46