10-274 | Virginia Tax

Tax Type

Individual Income Tax

Description

Individual income taxpayers are not permitted to claim a foreign source income subtraction.

Topic

Federal Conformity

Pass-Through Entities

Subtractions and Exclusions

Date Issued

12-16-2010

December 16, 2010

Re: § 58.1-1824 Application: Individual Income Tax

Dear *****:

This will reply to your letter in which you seek correction of the individual income tax assessment issued to ***** (the "Taxpayer") for the taxable year ended December
31, 2007.

FACTS

During 2007, the Taxpayer was a shareholder in a Virginia S Corporation (VSC). VSC wholly owned a C corporation (VDISC) that operated as a domestic international sales corporation (DISC) for federal income tax purposes. VDISC was subject to Virginia income tax on all of its Virginia taxable income for the 2007 taxable year. On its Virginia income tax return, VSC subtracted all of the dividends received from VDISC. The subtraction was passed through to the Taxpayer, who subtracted the VDISC dividends in determining her Virginia taxable income.

The Department denied the subtraction, reduced the amount the overpayment claimed on the Taxpayer's 2007 individual income tax return, and issued the reduced amount as a refund. The subtraction was denied because individual income taxpayers are no longer permitted to claim a foreign source income subtraction.

The Taxpayer appeals the assessment, contending that disallowing the subtraction amounts to double taxation of VDISC's income. The Taxpayer further argues that Va. Code § 58.1-390.2 provides that owners are only liable for tax on their separate individual capacities on income passed through to them. She reasons that, because the VDISC dividend subtraction is reflective of the income passed through to the shareholder, the Taxpayer is entitled to the subtraction. In addition, the Taxpayer asserts that Va. Code § 58.1-391 does not limit modifications to those permitted under 58.1-322.

DETERMINATION

Under Internal Revenue Code (IRC) § 991, DISCs are exempt from the federal income tax. Virginia law, however, provides no similar exemption. As such, a DISC is subject to Virginia tax if it is a domestic corporation or doing business in Virginia. See Title 23 of the Virginia Administrative Code (VAC) § 10-120-102 C 1.

Virginia Code § 58.1-402 C 3 provides that to the extent included in and not otherwise subtracted from federal taxable income, dividends from a DISC can be subtracted from federal taxable income if 50% or more of the DISC's income for the preceding year, or the last year the DISC had income, was assessable by Virginia. Pursuant to this statute, if the return for the prior taxable year, or the last taxable year the DISC had gross income, shows that either all income was taxable in Virginia or that 50% or more of the net income was allocated and apportioned to Virginia, then the deemed dividends from the DISC in the current year can be subtracted from federal taxable income.

Virginia Code § 58.1-401 exempts "electing small business corporations" from Virginia corporation income tax. As a result, S corporations are not subject to tax in Virginia. Instead, the income of such corporations is taxed to the shareholders upon distribution. All pass-through entities, including S corporations, are required to file an annual information return with the Department setting forth their income and a list of their owners. Specifically, Va. Code § 58.1-391 A provides:

- In determining Virginia taxable income of an owner, any modification described in § 58.1-322 that relates to an item of pass-through entity income, gain, loss or deduction shall be made in accordance with the owner's distributive share, for federal income tax purposes, of the item to which the modification relates. [Emphasis added.]

Under this statute, any subtraction available under Va. Code § 58.1-322 will flow through from a pass-through entity to an individual taxpayer, who in turn can take the subtraction on his or her Virginia individual income tax return. The statute, however, limits the type of subtraction modifications passed through from S corporations to those permitted under Va. Code § 58.1-322. VSC, therefore, incorrectly reported the DISC dividend subtraction on its Virginia pass-through entity return and the schedule (Form VK-1) that reported the Taxpayer's portion of the subtraction.

Under Va. Code § 58.1-390.2, owners of pass-through entities are generally liable for income tax "only in their separate or individual capacities on income passed through to the owners of pass-through entities." The Taxpayer contends that, by disallowing the subtraction, the Department is attempting to impose a tax beyond her individual capacity as an owner of VSC.

The statutory language used in Va. Code § 58.1-390.2 is substantially similar to the language used in IRC § 701 concerning a partner's liability for income tax for income passed through from a partnership. Treas. Reg. § 1.701 clarifies that partners are individually liable for the income tax on income passed through from a partnership and partnerships, as such, are not subject to the income tax. Similarly, the Virginia statute clarifies the owners' responsibility for the income tax liability of a pass-through entity. Virginia Code § 58.1-390.2 does not limit the amount of income for which an owner may be subject to tax.

Finally, the Taxpayer asserts that disallowing the DISC dividend subtraction essentially subjects the income of VDISC to double taxation. The courts have long recognized that the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event. It is also a long established principle that the risk of double taxation does not violate a taxpayer's constitutional rights. In Guaranty Trust Co. of New York v. Commonwealth of Virginia, 305 U.S. 19 (1938), the United States Supreme Court held that the imposition of an income tax under Virginia laws on income received as beneficiary of a trust established in New York did not violate the Due (Process Clause of the Constitution, notwithstanding that the trust was also subject to tax in New York. Nor did such treatment deny equal protection under the United States Constitution.

Because Va. Code § 58.1-322 does not include a subtraction for DISC dividend income for individual income taxpayers, the Department correctly disallowed the Taxpayer's subtraction that flowed through from VSC. Accordingly, the adjustment to the Taxpayer's individual income tax return resulting in a reduction to the refund due the Taxpayers for the 2007 taxable year is correct.

The Code of Virginia sections and regulations 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 ***** in the Office of Tax Policy, Appeals and Rulings, at *****.

- - - - Sincerely,

- - - - Linda D. Foster
        Deputy Tax Commissioner

AR/1-4550123596.o

Rulings of the Tax Commissioner