December 23, 2015
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 "Taxpayers") for the taxable year ended December 31, 2011.
FACTS
The Taxpayers, husband and wife, were Virginia residents. The husband was a general partner in a partnership (the "Partnership") that operated in Maryland. The Taxpayers reported the husband's income from the Partnership on federal Schedule E. On their Virginia individual income tax return for the 2011 taxable year, the Taxpayers claimed a credit for taxes paid to another state for the entire amount of income tax paid to Maryland. Under review, the Department adjusted the credit to the amount of Virginia income tax actually imposed on the Maryland taxable income and issued an assessment. The Taxpayers appealed, contending that the Department should have allowed the credit for the entire amount of tax paid to Maryland because the husband's Maryland income was earned income.
In Public Document (P.D.) 15-141 (6/30/2015), the Department upheld the assessment, concluding that the husband's income from the Partnership was not earned income. The Taxpayers paid the assessment and filed a protective claim for refund. The Taxpayers contend that the husband's income was earned income in the form of professional fees earned as compensation for professional services rendered.
DETERMINATION
Protective Claim
Virginia Code § 58.1-1824 permits any person who has paid an assessment of taxes administered by the Department of Taxation to file a protective claim for refund within three years of the date of an assessment. Pursuant to the authority granted the Department under Va. Code § 58.1-1824, a protective claim for refund can be held pending the outcome of another case before the courts or the claim may be decided based upon its merits pursuant to Va. Code § 58.1-1821. As permitted by statute, the Taxpayer's request has been treated as an appeal under Va. Code § 58.1-1821.
Strict Construction
As a matter of fairness and equity, most states, including Virginia, provide a mechanism to relieve residents from being taxed by both their state of residence and the state in which the income was derived. Virginia's method of limiting taxation of income by more than one state has been to permit a credit for taxes paid to other states pursuant to Va. Code § 58.1-332. By reason of their character as legislative grants, however, statutes relating to deductions and subtractions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell's Motor Freight, Inc., et al. v. Virginia Department of Taxation, Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983).
The Taxpayers contend that the Department cannot strictly interpret Va. Code § 58.1-332 A because no Virginia appellate court has confirmed the standard set forth in Howell's Motor Freight as to the interpretation of an income tax credit statute. The Taxpayers state they could only find instances in Virginia appellate case law of exemptions from other types of taxes being strictly construed.
The Virginia Supreme Court has consistently ruled that exemptions from taxation are the exception rather than the rule and as such, they must be strictly construed. If there is any doubt as to whether an exemption applies, it must be resolved in favor of the taxing authority, and the burden is on the taxpayer to show that it comes within the exemption. See Commonwealth v. Manzer, 207 Va. 996, 1000, 154 S.E.2d 185, 189 (1967). While it is true that this rule is most commonly applied in Virginia cases to interpret license and property tax exemptions, in the context of income taxes, exemptions, subtractions, deductions and credits represent similar legislative grants that reduce or eliminate a taxpayer's tax liability. As such, the Department believes it is appropriate to apply the standard as expressed in Howell's Motor Freight when interpreting an income tax credit statute. It is also consistent with the view of the United States Supreme Court that when interpreting provisions of the Internal Revenue Code (IRC), income tax deductions are strictly construed and allowed only as there is clear provision therefor. See INDOPCO, Inc. v. Comm'r, 503 U.S. 79, 84 (1992).
Credit for Taxes Paid to Another State
Virginia Code § 58.1-332 A allows Virginia residents a credit on their Virginia return for income taxes paid to another state provided the income is either earned or business income or gain from the sale of a capital asset. Virginia law does not necessarily allow a taxpayer to claim a credit for the total amount of tax paid to another state. Rather, the credit is limited to the lesser of the amount of tax actually paid to the other state or the amount of Virginia income tax actually imposed on the taxpayer on the income earned or derived in the other state. See P.D. 97-301 (7/7/1997). The limitation is computed by multiplying the individual's Virginia tax liability by a fraction, the numerator of which is the income upon which the other state's tax is imposed, and the denominator of which is Virginia taxable income.
If certain criteria are met, the limitation that restricts the credit to the amount of Virginia income tax actually imposed on the taxpayer on the income derived in the other state is disregarded. The special rule, commonly referred to as the border state credit, will apply if the income subject to tax in a single state contiguous to Virginia is less than Virginia taxable income and all of the income from sources outside Virginia is earned income or business income reported on federal form Schedule C from that single contiguous state. In such instances, the Virginia resident will be entitled to a credit equal to the lesser of: (1) the amount of income tax actually paid to the contiguous state; or (2) 100% of their Virginia income tax liability. See Va. Code § 58.1-332 A.
Legislative History
In 1989, North Carolina enacted legislation that restructured its tax to track federal taxable income instead of federal adjusted gross income (the base of Virginia tax). This change resulted in many Virginia residents who worked in North Carolina receiving reduced credits for taxes paid to that state and having to pay additional Virginia income tax at year end.
After the North Carolina law change, Virginia residents working in North Carolina generally received a credit equal to a percentage of their Virginia tax, resulting in a balance due at year end. In years prior to this legislation, Virginia residents generally received a credit for tax paid to North Carolina equal to 100% of their Virginia tax liability.
In 1992, House Bill (H.B.) 512 was introduced into the General Assembly in order to address this change in North Carolina law. The enacted bill was intended to grant special treatment to those individuals earning wages and salaries who commuted from Virginia to work in North Carolina on a daily basis. See P.D. 97-301.
Originally, taxpayers who were self-employed individuals or sole proprietors were excluded from the special border state computation, but Va. Code § 58.1-332 A was amended in 1998 to include sole proprietors who filed federal Schedule C. See the Fiscal Impact Statement (FIS) accompanying H.B. 33 (Chapter 291, Acts of Assembly). The FIS stated that H.B. 33 "would expand the current provision for the special 'border state' computation to include the business income of a sole proprietor in addition to earned income." The legislative history, therefore, indicates that the income of self-employed individuals and sole proprietors was not considered earned income. Rather, such income was classified as business income, and in enacting H.B. 33, the General Assembly chose to include only sole proprietors filing Schedule C in the special border state computation.
Earned Income
The Taxpayers contend that credit for the full amount of income tax paid to Maryland should have been allowed because the husband's distributive share of Partnership income consisted of professional fees earned as compensation for professional services rendered. Title 23 of the Virginia Administrative Code (VAC) 10-110-221 defines the term earned income as "wages, salaries, or professional fees and other amounts received as compensation for professional services actually rendered . . . ." In P.D. 04-125 (9/16/2004), the Department held that income reported on Schedule E that the taxpayer received as a member of a professional limited liability company (PLLC) was not earned income as defined by the regulation. In this case, the Taxpayer received income reported on Schedule E from a partnership engaged in professional practice. While the form of the pass-through entity in P.D. 04-125 was different, the Department held in P.D. 15-141 that the Taxpayer's income from the partnership did not meet the definition of earned income under Title 23 VAC 10-110-221.
Title 23 VAC 10-110-221 excludes from the definition of earned income "that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as a compensation for the personal services actually rendered." The Taxpayers argue that the Department's holding in P.D. 04-125 was justified because the professional limited liability company was a corporate entity and the income in that case was a distribution of corporate earnings. The Taxpayers assert that their case is different because the husband's business was a partnership and his income from it consisted of professional fees earned as compensation for professional services he rendered.
The Department did not treat the income in P.D. 04-125 as a distribution of corporate earnings or profits. In that case, the Department rejected the same argument the Taxpayers now make, namely that the income received from the PLLC represented compensation earned for professional services actually rendered. Instead, the Department treated such income as business income, and because it was not reported on Schedule C, the taxpayer did not qualify for the special border state computation.
In any event, Va. Code § 58.1-332 A provides that, in order for the special border state rule to apply, "all income derived from sources outside the Commonwealth and subject to taxation under this chapter [must be] earned income or business income reported on federal form Schedule C . . ." (emphasis supplied). In this case, the husband also received interest income from the Partnership which he reported as Maryland source income on his Maryland return. Because such income was neither earned income nor business income reported on Schedule C, the Taxpayers did not qualify for the border state computation.
CONCLUSION
In accordance with the Department's policy as set forth in P.D. 04-125, I find that the husband's income from the Partnership was not earned income for purposes of the border state credit, and thus the Taxpayers were not permitted to claim the border state credit on their Virginia return. In addition, even if some part of that income was earned income, the husband also received interest income from the Partnership that was sourced to Maryland. Such income was neither earned income nor business income reported on federal form Schedule C. Thus, the requirement under Va. Code § 58.1-332 A that all income derived from sources outside Virginia must be earned or business income reported on Schedule C was not met. While I recognize the Taxpayers' continuing disagreement with the validity of the assessment, the Taxpayers' request for a refund cannot be granted.
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/1-6102345318.M