April 6, 2021
Re: § 58.1-1821 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 “Taxpayer”) for the taxable year ended December 31, 2016.
FACTS
The Taxpayers, a husband and wife, filed joint Virginia individual income tax returns for the 2016 taxable year, claiming a fixed date conformity (FDC) subtraction. Under review, the Department requested additional information to determine if the Taxpayers qualified for the subtraction. After reviewing the information provided, the Department disallowed the subtraction because the Taxpayers had not previously reported an FDC addition and issued an assessment. The Taxpayers appeal, contending the FDC subtraction on their return is correct.
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 was specifically exempt as a Virginia modification pursuant to pursuant to Chapter 3 of Title 58.1 of the Code of Virginia.
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 date of conformity forward each year. Effective for taxable years beginning on and after January 1, 2015, Virginia’s conformity date was advanced from December 31, 2014 to December 31, 2015, with limited exceptions. See Virginia Tax Bulletin (VTB) 16-1 (2/5/2016). Effective for taxable years beginning on and after January 1, 2016, Virginia’s conformity date was advanced from December 31, 2015 to December 31, 2016 with limited exceptions. See VTB 17-1 (2/6/2017). For both taxable years Virginia continued to prohibit bonus depreciation allowed for certain assets under IRC § 168 (k).
Because Virginia does not fully conform to the IRC, any bonus depreciation must be adjusted to determine the depreciation amount for Virginia income tax purposes. FDC additions and subtractions, therefore, are not considered to be a Virginia modification. Rather, any exceptions identified in Virginia Code § 58.1-301 are added or subtracted from FAGI as computed under the IRC in order to determine an individual taxpayer’s FAGI for Virginia income tax purposes.
For example, if a taxpayer computed their FAGI using bonus depreciation for one or more assets, then the FAGI for Virginia purposes must be recomputed as if those assets had not received bonus depreciation, resulting in a Virginia addition. In a later tax year, when the Virginia depreciation amounts are less than the federal depreciation amounts, the taxpayer would recognize the difference by taking a Virginia subtraction. Although, FDC subtractions can be taken in the immediate taxable years following the return on which an FDC addition was reported, required FDC additions will generally be equal to or greater than the total of FDC subtractions claimed in subsequent years.
FDC additions and subtractions are often taken on an individual’s return pursuant to an ownership interest in a pass through entity (PTE). A PTE is “any entity… that is recognized as a separate entity for federal income tax purposes, in which the partners, members or shareholders report their share of the income, gains, losses, deductions and credits from the entity on their federal income tax returns.” See Virginia Code § 58.1-390.1. In determining Virginia taxable income of an owner of a PTE, each item of income, gain, loss, deduction or credit shall be in the same proportion as the owner’s distributive share, for federal income tax purposes, and have the same character and be incurred in the same manner for an owner as if realized directly from the source from which it was realized by the PTE. See Virginia Code § 58.1-391. Owners of a PTE usually are liable for tax in their individual capacities only on income that is passed through to them, while the PTE is liable for taxes imposed on the PTE itself. See Virginia Code § 58.1-390.2.
This statutory regime implies that when a PTE provides tax information to an individual owner and they accurately report the amounts on their Virginia return, the information is presumed to be correct. If it is determined that an error was made by a PTE, a change or correct would happen first to the PTE, then the change or correction would pass through to the individual owners.
In this case, the Department denied the Taxpayers’ FDC subtraction because there is no record of the Taxpayers taking an FDC addition in a prior taxable year. The Taxpayers explain that they acquired ownership of the PTE from a prior owner, who had taken the FDC addition. They provided Virginia VK-1 forms, showing that the FDC subtractions were taken for depreciation of assets that were placed in service prior to the taxable years at issue for which bonus depreciation was calculated for at the federal level but not for Virginia. They assert that, because bonus depreciation was claimed in prior taxable years on the federal level but not for Virginia, they are now entitled to recognize that difference by taking a Virginia subtraction.
Virginia’s conformity to federal law is limited. See Public Document (P.D.) 98-158 (10/20/1998) and P.D. 07-195 (11/27/2007). Further guidance can be instructive in determine how the Department could approach the administration of Virginia’s income tax structure. Under Treas. Reg. § 301.6221-1(a)(a), the tax treatment of income, loss, deductions, and credits are determined at the partnership level. This means that the IRS, in general, cannot change a partner’s treatment of partnership items of the partner’s return. In P.D. 20-31 (3/4/2020), the Department opined that IRS procedures should be considered when making adjustments to amounts reported on a federal return. Because FDC additions and subtractions are essentially a modification to federal income tax laws, the Department must, likewise, consider the implications of IRS procedures. Examining FDC additions and subtractions reported by a PTE on the PTE’s return provides a more complete audit trail and record keeping consistency.
When the original owner reported the FDC addition, it would have affected their FAGI and basis in the PTE. When they sold the interest in the PTE, the new owner reports whatever FDC adjustments are passed through from the PTE. The fact that the Taxpayers were not the original owners who reported the FDC addition does not affect the Taxpayers ability to claim the FDC subtraction. Because the Taxpayers properly reported their FDC subtraction as indicated on their federal and Virginia PTE tax forms, they are entitled to claim the subtraction on their 2016 Virginia joint individual income tax return. Accordingly, the assessment at issue has been abated.
If the Department determined that there has been an error in reporting an FDC addition in prior taxable years, then the Department must correct the Taxpayers’ return for the taxable year in which an addition was required but not taken. As such, correction must be made within the applicable statute of limitations. Further, if the Department ascertains there has been a reporting error on the returns provided by the Taxpayers’ PTE, then the Department must audit and make adjustments at the PTE level. Pursuant to Virginia Code § 58.1-394.1, the Department is authorized to impose a penalty equal to 6% of the PTE’s Virginia taxable income when such PTE fails to file a required return within the time required.
The Code of Virginia sections, Virginia Tax Bulletins 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 Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/3484.A