August 10, 2022
Re: § 58.1-1821 Application: Individual Income Tax
Dear *****:
This will respond to your letter in which you seek correction of the individual income tax assessment issued to ***** and ***** (the “Taxpayers”) for the taxable year ended December 31, 2017. I apologize for the delay in responding to your letter.
FACTS
The Taxpayers, a husband and wife, filed a Virginia resident income tax return for the 2017 taxable year claiming itemized deductions. Under audit, the Department requested information to support the deductions. After reviewing the information provided by the Taxpayers, the Department disallowed the deductions for legal and accounting expenses attributable to litigation regarding the husband’s ownership of, and employment by ***** (the “Company”). The Department adjusted the return and issued an assessment. The Taxpayers appeal, contending the information provided was sufficient to support the deductions claimed.
DETERMINATION
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 federal adjusted gross income (FAGI). Income properly 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 Chapter 3 of Title 58.1 of the Code of Virginia.
As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. The Department, however, retains the authority to adjust the FAGI and itemized deductions where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Virginia Code § 58.1-219.
Virginia Code § 58.1-322.03 1 allows an individual to deduct from their Virginia adjusted gross income certain amounts allowed for itemized deductions for federal income tax purposes. These deductions include those for medical expenses, charitable contributions and other expenses provided they are claimed in accordance with the IRC and its related regulations.
IRC § 212 allows individuals a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year - (1) for the production or collection of income; [or] (2) for the management, conservation, or maintenance of property held for the production of income . . . .” [Insert added.] Expenses for the production of tax-exempt income and capital expenditures are not allowed. See Treas. Reg. § 1.212-1(e), (n). Where litigation expenses are at issue, the origin of the underlying claim determines the character of the expense. This test characterizes an expenditure as capital if it is incidental to either the acquisition or disposition of a capital asset. See, e.g., Woodward v. Commissioner, 397 U.S. 572 (1970), United States v. Hilton Hotels Corp., 397 US 580 (1970), and Ralph K.B. Clay, TC Memo 1981-375.
The expenses at issue originated from litigation and arbitration concerning the husband’s relationship with the Company as a shareholder and an employee. He sought both the judicial dissolution of the Company and damages for wrongful dismissal and breach of his employment contract. The Company also counterclaimed for breach of the husband’s employment contract and fiduciary duties to the Company.
The court did not sustain either of the husband’s claims. Had he succeeded, any awards for wrongful termination or breach of employment contract would have produced taxable income and, accordingly, expenses associated with those claims were deductible under IRC § 212(1). The husband’s claim for judicial dissolution, however, if successful would have resulted in the dissolution and liquidation of the Company. Expenses related to the dissolution claim, accordingly, were not deductible under IRC § 212(2) because the origin of the claim involved the disposition of a capital asset, namely the husband’s shares in the Company.
The Taxpayers provided detailed invoices and cancelled checks to support the expenses paid to the husband’s legal counsel and the arbitrator. An examination of the invoices reveals that all payments made in the 2017 taxable year to the arbitrator and the majority of the payments to his legal counsel were related to the husband’s claims for which a deduction is allowable under IRC § 212. Invoices dated in 2015 from the husband’s legal counsel, however, relate in part to the husband’s claim for judicial dissolution and, to that extent, they are nondeductible capital expenditures. Further, the Taxpayers have indicated that they cannot provide invoices to confirm that the payments to their accountant qualify for deduction under IRC § 212. The cancelled checks standing alone cannot support the deductibility of those expenses. See, e.g., Public Document (P.D.) 19-78 (7/29/2019) and P.D. 20-40 (3/13/2020).
Because the Taxpayers have shown that a portion of the legal expenses were eligible to be reported as itemized deductions, the assessment will be adjusted. In order to compute the allowable deduction, the amount claimed on the Taxpayers’ 2017 income tax return as originally filed must be adjusted to exclude the deduction of ***** paid to the husband’s legal counsel that is determined to be a nondeductible capital expenditure related to the dissolution claim. The disallowance of the deduction for the payment to the Taxpayers’ accountant is upheld.
In accordance with this determination, this case will be returned to the auditor to adjust the amount of allowable deduction. The Taxpayers will receive a revised notice of return adjustments. Because the Taxpayers paid most of the outstanding assessment, an updated bill or refund will be issued as warranted. The Taxpayers should remit any balance due within 30 days of the bill date to avoid the accrual of additional interest and possible collection actions.
The Code of Virginia sections and public documents cited are available online at www.tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. 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/3859.X