Document Number
19-16
Tax Type
Individual Income Tax
Description
Individual Net Operating Loss (NOL); NOL Deduction (NOLD) Carryback and Virginia NOL Modifications
Credit for Tax Paid to Another State - Maryland
Topic
Appeals
Out of State Tax Credits
Accounting Periods and Methods
Date Issued
03-21-2019

 

March 21, 2019

 

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 your clients, ***** (the “Taxpayers”), for the taxable year ended December 31, 2012. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayers, a husband and wife, incurred a net operating loss (NOL) in the 2014 taxable year for federal income tax purposes derived from losses sustained by the husband’s ownership in a Virginia S corporation. The Taxpayers carried back the 2014 net operating loss deduction (NOLD) to the 2012 taxable year on an amended Virginia income tax return. The entire amount of the NOLD was used in 2012.

Under audit, the Department reduced the refund requested by adjusting the Virginia return to match the amount of federal adjusted gross income (FAGI) reported on the federal return and disallowing an out-of-state credit claimed for income tax paid to Massachusetts and Maryland because the credit was not based on the FAGI. The Taxpayers appealed, contending that the Department’s adjustment did not use the correct amount of NOL and that the addition modification is unsupported. They also assert that they should be allowed to claim a credit for taxes paid to another state.

DETERMINATION

Net Operating Loss Computation
 
Virginia income tax laws do not address the computation or application of NOLDs. Nonetheless, Virginia Code § 58.1-301 provides, with certain exceptions, 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.  Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia.  For individual income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income with FAGI. Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, and income properly excluded from FAGI is not subject to taxation, unless it is specifically subject to a Virginia modification pursuant to Virginia Code § 58.1-322.01 through § 58.1-322.04.  

Because the starting point in computing Virginia taxable income is FAGI, Virginia allows a NOLD to the extent that it is allowable in computing FAGI.  See Title 23 of the Virginia Administrative Code (VAC) 10-110-84. Thus, before an individual may claim an NOLD, they must first determine if they have a NOL for Virginia income tax purposes. As explained in Public Document (P.D.) 18-115 (6/8/2018), the computation of an NOL has been complicated by exceptions to the IRC terminology and references enacted under Virginia Code § 58.1-301 B. 

For a given taxable year, an individual may have an NOL if FAGI is a negative amount after subtracting the standard deduction or itemized deductions. To determine if an individual has an NOL and the amount of such NOL, the negative amount must be adjusted to eliminate any deduction for personal exemptions, capital losses in excess of capital gains, IRC § 1202 exclusions of the gains from the sale or exchange of qualified small business stock, nonbusiness deductions in excess of nonbusiness income, any NOLD carry over from another taxable year, and any domestic production activities deduction. See Internal Revenue Service (IRS) Pub 536 for more information concerning computing an NOL for federal income tax purposes.

Further, because Virginia does not fully conform to the IRC, the NOL must be further adjusted to determine if the individual has a federal NOL for Virginia income tax purposes. In 2003, Virginia began conforming to the IRC as of a specific or fixed date. Since then the General Assembly has enacted legislation to move the fixed date forward each year. Effective for taxable years beginning on and after January 1, 2014, Virginia's fixed-date of conformity was advanced from January 3, 2013, to December 31, 2014, with limited exceptions. See Virginia Tax Bulletin (VTB) 15-1 (2/19/2015). For the 2014 taxable year, Virginia disallowed federal deductions: (1) for bonus depreciation allowed for certain assets under IRC §§ 168(k), 168(l), 168(m), 1400L, and 1400N; (2) related to applicable high yield discount obligations under IRC § 163(e)(5)(F); or (3) related to cancellation of debt income realized in connection with a reacquisition of business debt at a discount after December 31, 2008, and before January 1, 2011 pursuant IRC § 108(i) (individuals recognizing income during the 2014 through 2018 taxable years as a result of the federal deferral are permitted a fixed date conformity subtraction on their corresponding Virginia return). In addition, Virginia does not conform to the 5-year carry-back allowed under IRC § 172(b)(1)(H).

Fixed date conformity additions and subtractions are not considered to be Virginia modifications. Rather, these exceptions are added to or subtracted from FAGI as computed under the IRC in order to determine an individual taxpayer's FAGI for Virginia income tax purposes. In order to compute the federal NOL allowed for Virginia income tax purposes, an individual would need to make either negative or positive adjustments for the bonus depreciation, the original issue discount on high yield discount obligations, the deferral of income from the discharge of indebtedness, and domestic production deduction conformity modifications related to items included in the computation of the NOL on the federal return.  In addition, as with the computation of a federal NOL, any fixed date NOLD addition or subtraction carried over to the current taxable year would be excluded from the federal NOL (FNOL) computation for Virginia income tax purposes. An individual's Virginia federal NOL (VAFNOL) would be calculated by starting with the FNOL as reported on the federal income tax return, adding applicable fixed date conformity additions (AFDCA) and the subtracting applicable fixed date conformity subtractions (AFDCS). The formula for determining Virginia FAGI would then be as follows:

FNOL + AFDCA - AFDCS = VAFNOL

For Virginia income tax purposes, an individual taxpayer will have an NOL only if the formula results in a VAFNOL that is less than zero.  If AFDCA exceeds the total of a FNOL plus AFDCS, the individual taxpayer will not have a VAFNOL. Conversely, if AFDCS exceeds FNOL plus AFDCA, the taxpayer may have a VAFNOL for Virginia income tax purposes even if they do not report an NOL on their federal return.

Net Operating Loss Deduction 

Generally, IRC § 172(b)(1)(A), as in effect in the taxable years at issue, permits NOLs to be carried back two years and carried forward 20 years from the year of loss. Taxpayers may, however, elect to forego the NOL carryback pursuant to IRC § 172(b)(3). The resulting NOLD, to the extent it exceeds taxable income for the taxable year to which it is carried, is carried forward to the next earliest taxable year in chronological order until it is completely absorbed.

The Taxpayers contend that the NOL should be equal to the amount reported on their 2014 federal Schedule 1045. While the federal NOL starts with FAGI of the loss year, IRC § 172(d) requires certain modifications to FAGI. For federal income tax purposes, deductions for state income tax, casualty and theft losses, and employee business expenses, with certain limitations are considered to be business expenses for purposes of computing an NOL. These deductions are also usually reported as itemized deductions on a federal income tax return.

These itemized deductions are not lost, however, for purposes of carrying over an NOLD. Virginia Code § 58.1-322.03 1 a provides a deduction for federal itemized deductions less income tax imposed by Virginia or any other taxing jurisdiction and deducted on the federal return. These include both nonbusiness and business deductions. Because itemized deductions are permitted as a deduction separate from FAGI, they are treated as a modification in determining Virginia taxable income instead of an adjustment to the starting point for calculating Virginia income tax. Even though they likely included taxes and other expenses resulting from business activities, the Taxpayers treated all of the itemized deductions as nonbusiness expenses for purposes of computing their federal NOLD.

As indicated above, Virginia allows NOLDs to the extent that they are included in computing FAGI. Generally, an NOLD cannot exceed the amount of the FAGI for the taxable year to which it is carried. As such, the FAGI reported on a Virginia income tax return cannot be less than zero for a taxable year in which a taxpayer is claiming an NOLD. Further, because the computation is limited to amounts included in FAGI, itemized deductions included in the computation of the VAFNOL must be removed in order to report the correct portion of the VAFNOL in FAGI. Thus, the Department’s auditor was correct in removing the itemized deductions from the computation of the Taxpayers’ VAFNOL.

Virginia Modifications

Under Title 23 VAC 10-110-82, certain modifications must be made to any item that is a component of the federal NOLD. The net result of these modifications, which relates to the loss year, follows the federal NOL to the taxable year in which the loss is utilized. The Virginia NOLD modification applies in the same proportion as the amount of NOLD that is used. Title 23 VAC 10-110-83 contains examples of how to calculate the Virginia NOLD modification and includes model worksheets.

Positive modifications include the additions in enumerated in Virginia Code § 58.1-322.01 (formerly Virginia Code § 58.1-322 B) and the negative modifications for subtractions in Virginia Code § 58.1-322.02 (formerly Virginia Code § 58.1-322 C). See Title 23 VAC 10-110-82. In addition, the modifications include the federal itemized deductions specified in Virginia Code § 58.1-322.03 1 a (formerly Virginia Code § 58.1-322 D 1 a). See Title 23 VAC 10-110-80.  

The net amount of the Virginia NOLD modification to be applied to the carryback or carryforward year must be reported on the Virginia return corresponding to such carryback or carryforward year as a separate Virginia addition to, or subtraction from, FAGI, as the case may be. If the Virginia NOLD modification addition exceeds the amount of the NOLD, the modification addition would be reduced to equal the amount of the NOLD. The resulting effect of any carryover would result in no net change to the tax liability for the taxable year to which it is carried, but must be reported in order to correctly adjust the FAGI for that taxable year. Failure to report such a carryover could result in issues with subsequent federal adjustments or NOLDs from other taxable years.

The Taxpayers failed to account for additions, subtractions, and nonbusiness itemized deductions reported for 2014 when they amended their 2012 return. As required by Virginia’s regulation, the Department calculated the Virginia NOL modification by combining net additions and subtractions including itemized deductions. The computation, however, also inappropriately included fixed date conformity additions and subtractions reported for 2014.  

Reporting an NOLD

Because Virginia requires a number of additional computations in determining the amount of an NOLD, an individual cannot simply apply the amount of a federal NOLD to the FAGI in a carryover year. To determine the amount of the NOLD that can be deducted, the individual must determine the amount of income that could be offset on their federal return for the carryover year and then adjust that amount to account for Virginia fixed date conformity additions and subtractions. Only after making such adjustments to FAGI can an individual determine what portion of the NOLD may be used in the carryover year for Virginia income tax purposes.

As indicated above, an NOL can be carried back and forward in accordance with the rules established under IRC § 172, except for the five-year carryback allowed under IRC § 172(b)(1)(H). See Virginia Code § 58.1-301 B 2. Accordingly, a taxpayer must report the difference between the amount of the NOLD claimed on a federal income tax return and the amount usable for Virginia income tax purposes as a fixed date conformity subtraction. This amount would include fixed date additions and subtractions reported in the loss year.
 
In addition, because the Virginia NOLD modification must be applied with the NOLD, individuals must also report the applicable amount as an addition or subtraction. Although, individuals have reported the Virginia NOLD modification on Virginia Schedule ADJ (Form 760-ADJ), any portion of the Virginia NOLD modification resulting from the difference between federal and Virginia carry over computations would properly be reported as a fixed date conformity addition or subtraction.
 
A separate schedule should be attached to the Virginia return to reconcile the amount of the VAFNOLD used to the amount of the VAFNOL carried over. In addition, taxpayers should attach a worksheet to the return showing the computation used to calculate the Virginia NOLD modification amount. The schedule should provide sufficient detail in order to show what amounts are reported as a reduction to FAGI as reported for federal income tax purposes, amounts reported as fixed date conformity adjustments, and the amount of the Virginia NOL modification.

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).  

The Department disallowed the out-of-state credit for income tax paid to other states because the incorrect amount of NOL was carried back from the 2014 taxable year. While the Department was correct in asserting that the NOL carryback was not properly reported by the Taxpayers, they were entitled to claim an out-of-state credit for income tax paid to other states.

The Taxpayers claimed a border state credit for taxes paid to Maryland using the border method because it is contiguous to Virginia. If a border state credit is claimed, 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 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 Virginia Code § 58.1-332 A.  

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 Virginia Code § 58.1-332 A. Virginia residents earning income in a border state could properly claim the border state credit if they had earned income or business income sourced to the border state that was reportable on Schedule C. In this case, the Taxpayers had business income sourced from the border state that was reported on Schedule E. As such, the Taxpayers would qualify for the border credit only if the husband’s income derived from the Virginia S corporation was earned income.  

Title 23 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 because it represented income received as a member of a professional limited liability company.  Thus, it was business income, not earned income.  In this case, the Taxpayer received income reported on Schedule E from a Virginia S corporation. As such, this would be business income rather than earned income.  Taxpayers with business income from a contiguous state should only qualify for the border credit if this income was reported on a Schedule C. Because this income was reported on a Schedule E, it would not qualify for the border credit.  

The Taxpayers would still be able to claim the out-of-state credit for the income attributed to both Maryland and Massachusetts pursuant to Virginia Code § 58.1-332 A, but it would be 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. 

CONCLUSION

A schedule calculating the carryback of the NOL from the 2014 to the 2012 taxable year and the out-of-state credit for income tax paid to another state is enclosed. These schedules were based on information available to the Department. The Taxpayers, however, may have information that better represents their amended Virginia income tax liability for the 2012 taxable year.  As such, they should file another amended 2012 Virginia income tax return in accordance with this determination. The return should be submitted within 30 days from the date of this letter to: Virginia Department of Taxation, Office of Tax Policy, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23161-7203, Attention: *****.  The return will be reviewed and processed, and the assessment will be adjusted as warranted. If the return is not received, a refund including statutory interest will be issued as soon as possible.

The Taxpayers should be aware that the Department may obtain additional information concerning 2014 and 2012 taxable years under IRC § 6103(d). If, as a result of any such information, the Department finds that a refund was issued in error, it may make an assessment to recover an erroneous refund within the time provided under Virginia Code § 58.1-312.

The Code of Virginia sections, regulations, and public documents 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 Department’s Office of Tax Policy, Appeals and Rulings, at *****.

Sincerely,

 

Craig M. Burns
Tax Commissioner

Rulings of the Tax Commissioner

Last Updated 04/19/2019 15:36