Rulings of the Tax Commissioner

May 10, 2017

Re:      §  58.1-1821 Application: Individual Income Tax

Dear *****:

This will reply to your letter in which you seek a refund of individual income tax paid by ***** (the “Taxpayers”) for the taxable year ended December 31, 2012.

FACTS

The Taxpayers, a husband and wife, are former residents of New Jersey.  The husband was employed by a locality in New Jersey from 1979 until he retired in 2011. During his employment, the husband made contributions to the New Jersey pension fund.  The contributions were included in federal adjusted gross income (FAGI).  Upon retirement, the husband began receiving pension payments from the pension fund, in the form of an annuity payable in monthly installments.  The Taxpayers subtracted the husband's 2011 pension distribution on their 2011 New Jersey income tax return.

The Taxpayers moved to Virginia in 2012.  They claimed a subtraction on their 2012 Virginia income tax return for the full amount of the husband's taxable contributions, less the distribution subtracted on their 2011 New Jersey return.

Under review, the Department disallowed the subtraction and issued an assessment.  The Taxpayers paid the assessment and appealed, contending that they should be permitted to subtract the entire amount of the payments because they paid both federal and New Jersey income tax on the contributions to the pension fund.

DETERMINATION

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required.  For individual income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI).  Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322.

Virginia Code § 58.1-322 C 19 provides a subtraction for any income received during the taxable year derived from a qualified pension, profit-sharing, or stock bonus plan as described by IRC § 401, an individual retirement account or annuity established under IRC § 408, a deferred compensation plan as defined by IRC § 457, or any federal government retirement program, the contributions to which were deductible from the taxpayer's federal adjusted gross income, but only to the extent the contributions to such plan or program were subject to taxation under the income tax in another state.  Before taxpayers are permitted to subtract any portion of their retirement income, contributions to the retirement plan must satisfy a two-part test: (1) they must have been deductible for federal income tax purposes; and (2) they must still have been subject to income tax in another state.

N.J. Rev. Stat. § 54A:6-10 provides that contributions made by an employee to a retirement benefits plan, including a public or private plan, are taxable at the time the contributions are made.  As such, the contributions to the New Jersey state retirement system were included in the husband's income, and he would be eligible to subtract the distributions from the pension plan to the extent contributions were subject to tax in New Jersey.  While the contributions made to retirement plan are eligible for the subtraction under Va. Code § 58.1-322 C 19, income generated by those contributions are not.

The complexity of calculating the portion of a retirement plan distribution attributable to previously taxed income was recognized by the Department and communicated to the General Assembly when it enacted House Bill 875 (Chapter 624, Acts of Assembly) in 1996.  In its Fiscal Impact Statement (FIS), the Department explained that it is generally difficult, if not impossible, to determine what portion of a distribution would be a return of a contribution or income generated from the investments because deferred compensation plan accounts can include multiple investment vehicles in which income is usually reinvested to and from funds that can be moved depending on the objectives of the owner of the account.  Also, it is possible that an individual may have lived in several different states, and made retirement plan contributions under both conformity and nonconformity rules.

By reason of their character as legislative grants, 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).  As such, it is incumbent upon the taxpayer to prove they are entitled to a subtraction reported on a Virginia return.

In Public Document (P.D.) 10-214 (9/15/2010), the Department established a pro-rata approach that accurately reflects the nature of a distribution from a retirement plan.  Because of Virginia's conformity to the IRC, the Department will look to the IRS treatment of like or similar items of income.  Accordingly, a taxpayer who receives a distribution from a retirement plan as described in Va. Code § 58.1-322 C 19 and whose contributions to such plan were subject to income taxation in another state would determine the portion of the annual distribution(s) eligible for the subtraction by multiplying the total amount of the annual distribution(s) by a ratio equal to the total balance of previously taxed contributions divided by the sum of the value of the retirement account at the end of the taxable year plus the total amount of the annual distribution(s).

Because a year end value of the husband's individual pension fund is not available from the state of New Jersey, the pro-rata formula provided in P.D. 10-214 cannot be used.  Instead the pension fund is held on behalf of current and former state and local employees.  As such, a different methodology must be considered.

Under IRC § 72(d)(1)(B), a simplified method for determining the tax-free portion of pension payments has been established.  Under the simplified method, the investment in the contract as of the annuity starting date (the total contributions previously taxed) is divided by a designated number of anticipated monthly payments to determine a monthly non-taxable payment.  Assuming annuity payments are made monthly, the non-taxable payment is multiplied by the number of months an annuitant receives payments during the taxable year to determine excludable retirement income.

If the annuity is payable over the life of a single individual, the number of anticipated monthly payments is determined by the following schedule: 

A different table is used if annuity benefits are based on the life of more than one annuitant.  In such cases, the number of anticipated monthly payments is determined as follows:

As with the situation in P.D. 10-214, the Department has looked to the IRC for guidance to find an appropriate method to reasonably compute the subtraction.  In light of Virginia conformity to the IRC and the lack of a method prescribed by law for determining the portion of retirement income eligible for the subtraction, the Department will adopt the simplified method for determining the tax-free portion of pension income under IRC § 72.

The husband appears to be the sole annuitant.  The Taxpayers, however, chose a retirement option that allows for survivor benefits to the wife.  Under these circumstances, the number of payments under the simplified method would be determined based on the life of both the husband and the wife.  At the time of the husband's retirement was 60 and his wife was 59 for a total 119.  As such, the number of anticipated monthly payments would be 360.  The total previous taxed contributions would be divided by 360.  This amount would be multiplied by 12 to determine the Taxpayers' annual subtraction as allowed in Va. Code § 58.1-322 C 19.

New Jersey allows two methods that may be used to calculate the nontaxable portion of retirement distributions or withdrawals.  If an individual will be able recover their contributions within three years of receiving the first payment from the IRA, annuity or pension, such individual may use a three-year rule method to determine their taxable New Jersey pension income.  If an individual does not qualify for the three-year rule method, they must determine the nontaxable portion of the retirement income proportionally in manner similar to Virginia's method established in P.D. 10-214.

Based on the 2011 New Jersey return provided, the Taxpayers opted to use the three-year rule method to determine their taxable New Jersey pension income. It appears they assumed the Virginia subtraction followed the same rules and subtracted the remainder of the investment in the husband's pension plan on their 2012 Virginia return.  As indicated above, however, Virginia does not follow the same rules as New Jersey.

Because the Taxpayers have already subtracted a significant portion of their investment under the rules of another state, the Department will consider those contributions to have already been recovered in determining the remaining balance of previously taxed contributions.  The subtraction will be adjusted in accordance with the enclosed schedule and a refund issued with appropriate interest for the 2012 taxable year. In addition, the Taxpayers may file amended returns to claim the appropriate subtraction for subsequent years.

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/747.B