June 27, 2016
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, 2012.
FACTS
The Taxpayers filed a Virginia resident individual income tax return claiming a tax credit for income tax paid to Maryland. Under review, the Department disallowed the credit because a reciprocal agreement prohibits Maryland from imposing income tax on certain income received by Virginia residents. The Department issued an assessment for additional tax and interest. The Taxpayers appeal the assessment, contending that the existence of the border state credit is not consistent with the reciprocal agreement with Maryland.
DETERMINATION
Reciprocity
Virginia Code § 58.1-342 B grants the Department the authority to enter into reciprocal agreements with other states to exempt nonresidents from the Virginia income tax when they earn salaries and wages from working in Virginia if such other states similarly exempt Virginia residents. In addition, employers are not required to withhold Virginia income tax from residents of these states. Virginia currently has this type of agreement with Maryland, West Virginia and Pennsylvania.
Virginia's reciprocity agreement with Maryland permits Virginia residents commuting daily to Maryland to have taxes withheld and paid to Virginia only. If a Virginia resident has Maryland income tax withheld from wages earned while commuting to work in Maryland, he should file an income tax return with that state in order to receive a refund.
In this case, the Taxpayers filed a return as if they were full year residents of Virginia during 2012, and their only income from Maryland was wages. Based on the manner in which they filed the return, the Taxpayers were considered to be nonresidents of Maryland during 2012 and exempt from income taxation by Maryland under the reciprocal agreement.
Out-of-State Tax Credit
Virginia Code § 58.1-332 A allows Virginia residents a credit on their Virginia individual income tax return for income taxes paid to another state provided the income is either earned or business income or gain on 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 Public Document (P.D.) 97-301 (7/7/1997).
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. Because the Taxpayers filed a resident Virginia income tax return, the Department concluded they were not subject to income tax in Maryland and were not eligible for an out-of-state tax credit on their 2012 Virginia return.
The Taxpayers argue that the Department's return instructions are confusing because they indicate that Virginia's border state credit applies to wages but wages earned by Virginia residents are exempt from Maryland tax because of a reciprocal agreement. The Department has previously addressed the issue of tax form instructions in P.D. 13-149 (7/31/2013). Tax form instructions merely paraphrase the statute and generally make no reference to the requirements for reporting amounts on a particular line of a return. See also P.D. 15-148 (7/2/2015).
Further, the border state credit was originally enacted to address changes to income tax laws of North Carolina, a state with which Virginia does not have a reciprocal agreement. After North Carolina changed its method of computing income tax, Virginia residents who worked in North Carolina in many cases received reduced credits for taxes paid to that state. The border state credit was designed to make sure such Virginia residents continued to receive a full credit for income tax paid to North Carolina, up to but not exceeding the full amount of their Virginia income tax liability. See P.D. 14-67 (5/20/2014).
Although the border state credit was designed to address changes to North Carolina law that affected certain Virginia residents, the General Assembly chose to apply the border state credit more generally to states “contiguous” to Virginia. See Va. Code § 58.1-332 A. The border state credit is irrelevant for Virginia residents who are not liable for Maryland income tax because of the reciprocal agreement. There are other circumstances, however, when a Virginia resident earning income in Maryland could properly claim the border state credit, such as if he had business income sourced to Maryland that was reportable on Schedule C or earned wages in Maryland in such a manner that the reciprocal agreement did not apply.
Interest
The Taxpayers request that interest on the assessment be waived because of the confusion surrounding the border state credit and the amount of time it took the Department to issue the assessment. The application of interest to tax underpayments is mandatory under Va. Code § 58.1-1812, and it cannot be waived unless the associated tax is adjusted. Interest is not assessed as a penalty, but represents a fee for the use of money that was properly due the Commonwealth.
In addition, like the federal tax regime, Virginia's taxing system is based largely on the theory of self-assessment. A taxpayer computes his own income tax, fills out his own return, and pays the tax indicated. Virginia has implemented a self-assessment system based on the federal system because it is less intrusive upon taxpayers, simpler, and less costly to administer.
Virginia receives approximately 3.5 million individual income tax returns per year. Only a small portion of the individual taxpayers can be audited or reviewed annually. In this case, the Department adjusted the return and issued the assessment within the three year period prescribed by Va. Code § 58.1-1812 A.
CONCLUSION
In this case, the Taxpayers filed their Virginia income tax return as full-year residents who earned wages in Maryland. As such, it appears that the reciprocal income tax agreement between Maryland and Virginia applied to the Taxpayers. Under that agreement, Virginia residents who earn wages by commuting to work in Maryland are not liable for Maryland income tax. Because the Taxpayers were not liable for Maryland income tax, they were not eligible to claim a credit for income tax paid to Maryland on their Virginia income tax returns. In addition, interest was assessed on the assessment as required by Va. Code § 58.1-1812 and cannot be waived unless the associated tax is adjusted.
Accordingly, the assessment is upheld. An updated bill will be issued shortly. The Taxpayers should remit payment for the outstanding balance within 30 days of the bill date to avoid any collections actions. If the Taxpayers paid income tax to Maryland, they should request a refund from that state.
The Code of Virginia sections 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/1-6303453902.M