Document Number
95-167
Tax Type
Individual Income Tax
Description
Federal adjusted gross income; S corporation income from foreign activities
Topic
Taxable Income
Date Issued
06-23-1995
June 23, 1995



Re: §58.1-1821 Application; Foreign Source Income


Dear***********

This will reply to your letter of April 27, 1995, in which you contest the assessment of additional individual income taxes to********(the "Taxpayers") for the 1990, 1991, 1992 and 1993 taxable years.
FACTS

The Taxpayers hold, either directly or as beneficiaries of qualified subchapter S trusts, shares of stock in corporations which have elected to be treated as S Corporations pursuant to Internal Revenue Code §1362. Certain of these S Corporations (the "corporations") conduct business activities in foreign countries as branches or divisions. Although the Taxpayers' full distributive share of the corporations' income was included in their federal adjusted gross income, the Taxpayers claimed a subtraction for Virginia purposes attributable to the corporations' foreign activities. The department disallowed these subtractions, as they do not meet the definition of foreign source income for Virginia purposes. You have contested the department's disallowance on several grounds, which shall be addressed separately below.
DETERMINATION


You believe that the Taxpayers should be able to exclude income from S Corporations which had no Virginia business operations or income. Furthermore, you believe Code of Virginia §§58.1-406, et seq. provides a basis for such treatment, as these sections of Virginia law insure that tax is only applied to a corporation's Virginia based operations. You further believe that this treatment is reinforced by the 1995 General Assembly's amendments to Code of Virginia §58.1-302.

It is the department's position that a Virginia resident shareholder of an S Corporation which does not conduct 100% of its business within Virginia must include all of his pro rata share of the S corporation's income in his Virginia taxable income. In lieu of allocation and apportionment, the Virginia resident may claim a credit for taxes paid to other states in accordance with Code of Virginia §58.1-332. This a longstanding written policy which is clearly delineated by the department's regulations and rulings, and judicial decisions.

Virginia Regulation (VR) 630-3-401 E, promulgated in January 1985, provides as follows:
    • Electing small business corporations which avail themselves of the election under Subchapter S of the Internal Revenue Code to have the income of the corporation included in the income of the shareholders are exempt from corporate income tax. All such income then becomes income taxable to the shareholder under laws and regulations applicable to individuals.... (Emphasis added.)
In Public Document (P.D.) 82-125 (9/20/82), copy attached, the department ruled that a Virginia resident shareholder of an S Corporation which conducted business in California was not permitted to claim a subtraction on his Virginia individual income tax return for income which was attributable to the S Corporation's business activity in California. In this ruling, it was also held that the tax paid by the S Corporation to California (California did not recognize the S election) was not eligible for the credit for taxes paid to other states. Although the possibility of double taxation of some of the S Corporation's income was acknowledged, this situation was found to be similar to the double taxation which is possible where C Corporation earnings are taxed at the corporate level, and again to the shareholders as dividends. (Note: The Code of Virginia has since been amended to allow a credit at the individual shareholder level for state income taxes paid by an S Corporation).

In P.D. 83-69 (4/13/83), copy attached, the department reached a similar conclusion. The department also litigated this issue in the Circuit Court of the City of Roanoke. In this case the individual plaintiffs asserted that the resulting double taxation was a violation of the intent of Virginia law, an undue burden on interstate commerce, and a violation of due process. The Court upheld the department's position, and found that there had been no violation of constitutional principles or a burden on interstate commerce as a result of the application of Virginia's statutes. See Howell's Motor Freight. Inc.. et al. v. Virginia Department of Taxation, Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/83), copy attached. The department issued Virginia Tax Bulletin 84-1 (2/20/84), copy attached, in response to this decision.

Where a corporation has made a federal election as an S Corporation, it is exempt from Virginia taxation pursuant to Code of Virginia §58.1-401. Accordingly, no Virginia income tax is assessed to an S Corporation at the corporate level.

Code of Virginia §58.1-408 provides in pertinent part:
        • The Virginia taxable income of any corporation ... shall be apportioned to the Commonwealth by multiplying such income by a fraction...
      Code of Virginia §58.1-402 provides in pertinent part:
        • For purposes of this article, Virginia taxable income for a taxable year means the federal taxable income and any other income taxable to the corporation under federal law for such year of a corporation adjusted as provided in subsections B, C and D. (Emphasis added.)
Given the fact that an S Corporation generally has no federal taxable income, and is specifically exempt from Virginia taxation, the department cannot conclude that the provisions of Code of Virginia §§58.1-406 et seq. are intended to apply to an S Corporation.

Where a nonresident individual is a shareholder in an S Corporation which conducts business in Virginia, the department applies the provisions of Code of Virginia §§58.1-407 et seq. in order to determine such individual's Virginia taxable income. The basis for this treatment is provided in Code of Virginia §58.1-325 B, which provides statutory guidance for the treatment of a nonresident shareholder of an S Corporation with Virginia activity:
    • For a nonresident individual who is a shareholder in an electing small business corporation (S corporation), there shall be included in his Virginia taxable income his share of the taxable income of such corporation, and his share of any net operating loss of such corporation shall be deductible from his Virginia taxable Income.

      VR 630-2-325, promulgated in December 1986, provides in pertinent part:

      A non-resident individual who is a shareholder in an electing small business corporation (S corporation) must include in Virginia taxable income his share of the taxable income of such corporation. ... The amount to be included or deducted shall be that which is attributable to a business, trade, profession or occupation carried on in this state.

The treatment of a nonresident individual is inherently different from that of a resident. Whereas the United States Supreme Court has made it clear on numerous occasions that a state may tax all of a resident's income regardless of its source, the limitations of due process require that a nonresident only be taxed on income which is attributable to activity conducted within that state. In recognition of this difference, the General Assembly has provided legislative guidance with respect to nonresident shareholders of an S Corporation.

Virginia, like most states that impose a broad based individual income tax, taxes its residents on all of their income regardless of where such income is earned. The exceptions to this rule are embodied in statutory exemptions and subtractions which have been specifically provided by the General Assembly. Thus, to the extent that income from an S Corporation has been included in an individual's federal adjusted gross income, it is included in the starting point for determining Virginia taxable income. Absent a specific statutory exception, the department finds no authority to exclude a resident shareholder's share of foreign business income of an S Corporation through apportionment or otherwise.

The department has reviewed its policy regarding the treatment of resident and nonresident shareholders of an S Corporation, and believes that such policy properly accounts for the inherent difference in the taxation of residents and nonresidents. The department has also considered the application of the provisions relating to corporate apportionment to a resident individual. Whereas by a corporation determines its Virginia tax through allocation and apportionment, the General Assembly has provided that a resident individual shall determine his tax on all of his income, and shall be allowed a credit for income taxes paid to other states. Again, the department finds that its policy is consistent with the intent of the overall scheme of taxation as crafted by General Assembly.

Chapter 602 of the 1995 Acts of Assembly changed the definition of foreign source income. As amended by the Act, the foreign source income subtraction has been broadened to include net income attributable to a foreign source qualified business unit of an S Corporation. The amendment is effective for taxable years beginning on or after January 1, 1994. However, pursuant to enactment clauses, the decrease in tax resulting from this change attributable to the 1994 and 1995 taxable years can only be claimed on tax returns for the 1996 and 1997 taxable years, respectively.

It is a well established rule of statutory construction that a change in the law was intended when new provisions are added to prior legislation by an amendatory act. Boyd v. Commonwealth. 216 Va. 16 (6/13/75). In addition, the General Assembly's careful attention to the timing of when the benefits of this statutory change can be claimed by taxpayers is a clear indication that existing law produces a different result. The department can find no basis to conclude that the 1995 amendment was designed to clarify what was contemplated by existing law. Rather, the department must conclude that the General Assembly acted to create a new exemption for income previously subject to tax.

You also state that the department has denied credit for taxes paid by these S Corporations to foreign jurisdictions. You believe that these taxes, however characterized by the taxing authorities, are in fact income taxes based upon the income of the S Corporations in the foreign jurisdictions, and that denial of credit for these taxes violates the Commerce Clause and denies the Taxpayer's equal protection under the law.

The courts have long recognized that the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event. It is also a long established that the risk of double taxation does not violate a taxpayer's constitutional rights. In Guaranty Trust Co. of New York v. Commonwealth of Virginia, 305 US 19, 59 S. Ct. (1938), copy attached, the United States Supreme Court held that the imposition of an income tax under Virginia laws on income received as beneficiary of trust established in New York did not violate the due process clause of the Constitution, notwithstanding that the trust was also subject to tax in New York, nor did such treatment deny equal protection. Likewise, in Howell's Motor Freight (supra) the court found:
    • ..the double taxation which has resulted is not forbidden, nor does it constitute an undue burden on interstate commerce, nor does it amount to the taking of property without due process, nor are any citizens being unfairly denied the equal protection of the laws.
Given the clear language of the courts' findings in these analogous cases, the department can only conclude that any resulting double taxation which may have existed is unfortunate, but not prohibited. The General Assembly exercised its right to remedy this situation in 1995, and although it could have done so retroactively, it chose to make the change prospective with a deferred application.

Finally, you state that the Taxpayers in each case properly reported the income and distributive share items of the corporations provided them in the form of their respective K-1's, and were not in a position to determine whether the items were correctly treated by the respective corporations.

Although I am sympathetic to the shareholders' position, the fact that information has been improperly presented by an S corporation on schedules to the shareholders does not relieve any individual shareholder from the obligation to determine his proper Virginia taxable income. Because the foreign source income was included in each shareholder's federal adjusted gross income, a specific statutory subtraction was required in order to remove it from taxation. Regardless of the presentation of information on a schedule K-1, it is incumbent on every taxpayer to determine and self assess the proper Virginia tax.

In summary, the department finds this issue to be well established by longstanding written policy, which is consistent with the intent of the law and supported by numerous judicial decisions. Accordingly, the department finds no alternative under Virginia law but to uphold the assessments. The assessments have been corrected to reflect the various adjustments requested in your meeting with department personnel on ********** and are reflected on the attached schedules.

Although a meeting has been scheduled to discuss the case with you and ***** on**********we believe that the issuance of this ruling prior to that meeting will help you and*******to focus on the department's formal position. Please be sure to obtain the proper power of attorney for ***** prior to the meeting.

The department will withhold collection action through our meeting on*************However, the assessments must be satisfied within 30 days of the date of this letter to avoid the accrual of additional interest.

                        • Sincerely,



                          Danny M. Payne
                          Tax Commissioner

OTP/8223M



Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46