June 25, 2015
Re: § 58.1-1821 Application: Fiduciary Income Tax
Dear *****:
This will reply to your letter in which you seek correction of the fiduciary income tax assessments issued to the ***** (the "Taxpayer") for the taxable years ended December 31, 2011 and 2012. In addition, you seek a refund of fiduciary income taxes paid for the taxable year ended December 31, 2013.
FACTS
For the 2011 through 2013 taxable years, the Taxpayer, a nonresident trust, filed Virginia fiduciary income tax returns and claimed credits for income tax paid to California. Under review, the Department concluded that the tax reported on the California returns was not an income tax, denied the credits, issued assessments for 2011 and 2012 and reduced the refund claimed on the 2013 return. The Taxpayer appealed, contending that the tax was the income tax applicable to the portion of an Electing Small Business Trust (ESBT) that consisted of shares of an S corporation.
DETERMINATION
Eligibility to Claim the Credit
ESBTs
Virginia Code § 58.1-360 provides that Virginia income tax is annually imposed on Virginia taxable income for each taxable year of every estate and trust. Virginia taxes a nonresident trust on its gross income from sources within Virginia less expenses
attributable to the income from Virginia sources reduced by the amount of income from Virginia sources distributed to beneficiaries. See Va. Code §§ 58.1-362 and 58.1-363.
Virginia Code § 58.1-332, which pertains to credits for taxes paid to other states by individuals, also applies to trusts and estates. See Va. Code § 58.1-371. Under Va. Code § 58.1-332 B, a nonresident is permitted to claim a credit against tax on income from Virginia sources when their state of residency provides a substantially similar credit to Virginia residents or imposes a tax on income derived from Virginia sources upon residents but does not tax income earned by Virginia residents. Because it is dependent on another state granting a similar or reciprocal credit, it may be limited by the credit permitted by the other state. Currently, only residents of Arizona, California, Oregon, and the District of Columbia may qualify for this credit.
Generally, trusts are not permitted to own shares in an S corporation. See IRC § 1361(b)(1)(B). Exceptions are made, however, for trusts qualifying as either ESBTs under IRC § 1361(e) or Qualified Subchapter S Trusts (QSSTs) under IRC § 1361(d). A trust that elects to be treated as an ESBT for federal income tax purposes is automatically treated as an ESBT on its California return. See Cal. Rev. & Tax. Code § 23800.5(d). Federal law requires the portion of an ESBT that consists of the S corporation shares to be treated as a separate trust subject to special rules in computing its tax liability. See IRC 641(c). This treatment also applies for purposes of computing an ESBT's California income tax. See Cal. Rev. & Tax. Code § 17731.
In this case, the Taxpayer asserts it was eligible for the credit for tax reported as "other taxes" on its California returns. This raises a question as to whether the tax was the type of broad-based net income tax for which Virginia allows the credit. See Public Document (P.D.) 89-348 (12/20/1989).
California's fiduciary income tax applies to the entire taxable income of a trust, if its fiduciary or beneficiary is a resident. See Cal. Rev. & Tax. Code § 17742(a). In addition, Cal. Rev. & Tax. Code § 17734 requires nonresident beneficiaries who derive income from sources within California to file and pay the income tax. California's fiduciary income tax is the type of broad-based net income tax for which Virginia allows the credit.
In P.D. 95-175 (6/28/1995), the Department ruled California's franchise tax imposed on S corporations under Cal. Rev. & Tax Code § 23802 does not qualify for the out-of-state tax credit. However, tax is imposed on the separate income of an ESBT using the highest rate of fiduciary income tax applicable in accordance with Cal. Rev. & Tax Code § 17041.
A review of the California returns and their instructions indicates that the "other taxes" line was where an ESBT had to report the tax attributable to that portion of the trust which consisted of the S corporation shares. The Taxpayer was still subject to tax on its net income. It was required, however, to separately compute that part of the tax because of the special computational rules for ESBTs described above. As such, the tax reported as "other taxes" was eligible for the credit as fiduciary income tax.
Mental Health Services Tax
In addition, questions have arisen as to whether the California Mental Health Services Tax was also eligible for the credit. This tax was separately reported on the Taxpayer's California returns and levied at the rate of 1% on taxable income in excess of one million dollars. See Cal. Rev. & Tax. Code § 17403. Although it was earmarked for certain state mental health services, it was nevertheless a broad-based net income tax that applied to the entire income of the Taxpayer over the threshold without regard to the type or source of the income. As such, this tax also qualified for the credit.
Computation of Credit
Under California law, a trust is considered a resident of the state that taxes the income of the trust irrespective of whether the income is derived from sources within that state. See Cal. Rev. & Tax. Code § 18003. California taxes all trust income sourced to that state, but it also requires non-California source income to be apportioned based on the ratio of residents trustees and beneficiaries to the total number of trustees and beneficiaries, respectively. See Cal. Rev. & Tax. Code §§ 17743 and 17744. Therefore, the Taxpayer would be considered a California resident trust to the extent that California taxed the Taxpayer's non-California income using its apportionment formula.
Under Va. Code § 58.1-332 B, the credit for nonresidents is computed by multiplying the tax payable to the resident state by a ratio, the numerator of which is the income which is subject to tax in Virginia and the denominator of which is the entire income upon which the tax payable to the other state is imposed. Because of California's apportionment rules, however, only a portion of the Taxpayer's Virginia taxable income was taxable in California. Therefore, the numerator must be adjusted by applying a separate fraction, the numerator of which is the non-California source income subject to California income tax, and the denominator of which is the total amount of non-California source income. The product of the adjusted formula is the amount of tax imposed by California on the portion of the Taxpayer's Virginia taxable income that was also taxable in California after that state's apportionment rules were applied. The credit that could be claimed on the Virginia return, however, was limited to the amount of Virginia income tax actually imposed on the same proportion of Virginia taxable income. See Title 23 of the Virginia Administrative Code (VAC) 10-110-222 C, Example 2.
The Department has computed the credits using the methodology described above and found that the amounts reported by the Taxpayer are correct. The computations are shown on the enclosed schedule.
CONCLUSION
In accordance with the enclosed schedule, the Department will abate the assessments for the 2011 and 2012 taxable years and issue the appropriate refunds for the taxable years at issue.
The Code of Virginia sections, regulation and public document 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 *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/1-5897434738.M