Rulings of the Tax Commissioner

June 7, 2023

Re:    § 58.1-1821 Application: Individual Income Tax
    
Dear *****:

This will respond to your letter in which you seek a refund of individual income tax paid by your clients, ***** (the “Taxpayers”) for the taxable years ended December 31, 2020, and December 31, 2021. I apologize for the delay in responding to your request.

FACTS

The Taxpayers, a husband and wife, were Virginia residents, and the husband was a shareholder in a Subchapter S corporation (“SSC”) that paid corporate franchise tax to New York and corporate excise tax to Tennessee for the 2020 and 2021 taxable years. SSC did not make the election under Virginia Code § 58.1-390.3 to be taxed at the entity level. 

The Taxpayers claimed a credit for payment of their proportionate share of the taxes on each of their 2020 and 2021 Virginia individual income tax returns. Under review, the Department denied the credits and issued assessments for additional tax due. The Taxpayers paid the assessments and filed an appeal, contending that they were eligible to claim credit against their Virginia income tax liability for payment of the New York and Tennessee corporate franchise and excise taxes.

DETERMINATION

Credit for Tax Paid to Another State

Virginia Code § 58.1-332 A allows Virginia residents a credit on their Virginia return for income taxes paid to another state provided the income is either earned or business income or any gain on the sale of a capital asset. The intent of the credit is to grant Virginia residents relief in situations when they are taxed by both Virginia and another state on these types of income.

The credit is limited to taxes imposed on income. Pursuant to Virginia Code § 58.1-332 A, “no franchise tax, license tax, excise tax, unincorporated business tax, occupation tax or any tax characterized as such by the taxing jurisdiction, although applied to earned or business income, shall qualify for a credit . . . .” 

In addition, Virginia Code § 58.1-332.2 A defines an “income tax” as a term of art that refers to a specific type of tax levied on all of a resident’s earned and unearned income, and all income of a nonresident from sources within the jurisdiction, which is similar to the income tax that Virginia imposes on resident and nonresident individuals. Virginia Code § 58.1-332.2 B clarifies the circumstances in which a franchise, license, excise, business, or occupational tax will not qualify as an income tax. That section includes examples of taxes that do not qualify for the credit, even though they may be measured, in part, by income. Taxes do not qualify because (i) they are labeled as a franchise or license tax, and (ii) they do not tax all income of the individual. See Public Document (P.D.) 12-108 (7/1/2012).

The New York franchise tax is assessed as the highest amount of tax as measured against three bases: business income, business capital, and a minimum amount. See Title 20 of the Code, Rules, and Regulations of the State of New York (CRR-NY) 1-1.2. The Taxpayers explain that SSC chose to be treated as a C corporation for New York state tax purposes and paid the franchise tax on the business income base.

Tennessee imposes an excise tax on business entities that offer their owners limited liability. The tax is imposed at the entity level even where the entity is disregarded for federal income tax purposes. The Tennessee excise tax is based on a percentage of SSC’s net income. See Tenn.Code § 67-4-2007. 

Because the taxes were limited to SSC’s business income, they did not tax all of the respective state-sourced income of the nonresident shareholder. As such, they fail to qualify as an “income tax” for purposes of the credit allowed under Virginia Code § 58.1-332. See P.D. 19-86 (8/12/19) and Pauley v. Va. Dep’t of Taxation, 55 Va. Cir. 215 (2001).

Virginia Addition by Corporations

Virginia Code § 58.1-402 B 4 requires corporations to add back amounts attributable to net income taxes and other taxes based on, measured by, or computed with reference to net income in computing Virginia taxable income. Under Title 23 of the Virginia Administrative Code (VAC) 10-120-101 D, the corporate addition for income taxes would include any income taxes and other taxes, including franchise and excise taxes, which are based on, measured by, or computed with reference to net income, imposed by any other taxing jurisdiction, and deducted in determining federal taxable income.

The Taxpayers believe this implies that the same definition of state income tax paid for purposes of this addition should apply for purposes of Virginia Code § 58.1-332 C 1, which provides that taxes paid by S corporations are deemed paid by the individual shareholders for purposes of Virginia Code § 58.1-332. The term “income tax,” however, for purposes of Virginia Code § 58.1-332, is a defined “term of art” and, as discussed above, neither the Tennessee excise tax nor the New York franchise tax qualify as an “income tax” under that definition. In addition, the corporate and individual income tax provisions of the Code of Virginia are separate regimes which each contain separate definitions of terms. 

Virginia Code § 58.1-401 exempts “electing small business corporations” from Virginia corporation income tax. As a result, S corporations are generally not subject to tax in Virginia. Instead, the income of such corporations is generally taxed to the shareholders. All pass-through entities, including S corporations, are required to file an annual information return with the Department setting forth their income, Virginia modifications, and a list of their owners. Specifically, Virginia Code § 58.1-391 A provides:

In determining Virginia taxable income of an owner, any modification described in § 58.1-322.01, § 58.1-322.02, § 58.1-322.03, and § 58.1-322.04 that relates to an item of pass-through entity income, gain, loss or deduction shall be made in accordance with the owner’s distributive share, for federal income tax purposes, of the item to which the modification relates.

Under these statutes, any addition required by Virginia Code § 58.1-322.01 will flow through from a pass-through entity to an individual taxpayer, who, in turn, must include the addition on their Virginia individual income tax return. The statute limits the type of addition modifications passed through from pass-through entities to those required by Virginia Code § 58.1-322.01. See P.D. 10-274 (12/6/2010), P.D. 18-76 (5/2/2018), and P.D. 22-97 (5/26/2022). Virginia Code § 58.1-322.01 does not require an addition for state income taxes deducted in computing federal taxable income that is comparable to the addition for corporations required by Virginia Code § 58.1-402 B 4. The fact that an individual taxpayer is not required to add back the taxes deducted by the pass-through entity in cases such as the Taxpayers’ situation provides further support for disallowing a credit for those same taxes because doing so would provide a double benefit to the Taxpayers.

Effective for taxable years 2021 through 2025, under legislation enacted by the 2022 General Assembly (House Bill 1121, Chapter 690 of the 2022 Acts of Assembly and Senate Bill 692, Chapter 689 of the 2022 Acts of Assembly), Virginia established a new elective pass-through entity tax. If a Subchapter S corporation makes the election to be taxed at the entity level, Virginia Code § 58.1-390.3 requires the entity, and its eligible owners, to add back to taxable income any deduction for state and local income taxes since the owner is eligible to claim a credit equal to such owner’s pro rata share of the tax paid by the entity. Although this provision does not apply in this case because SSC did not make the election described under Virginia Code § 58.1-390.3, the Department wishes to highlight this recent change in the law.

Commerce Clause

The Taxpayers also contend that the Department must grant a credit for the New York and Tennessee corporate franchise and excise taxes to avoid violating the Commerce Clause of the United States Constitution. They have cited Comptroller of the Treasury v. Wynne, 575 U.S. 542, 135 S. Ct. 1787 (2015), in support of this contention.

It is well established that a state may tax all the income of a resident, even income from outside the taxing jurisdiction. In People of State of New York ex rel. Cohn v. Graves, 300 U.S. 308, 312-313, 57 S. Ct. 466, 467 (1937), the United States Supreme Court explained “[t]hat the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event is universally recognized.”  In Wynne, however, the Supreme Court also recognized that a state’s taxation of a resident’s income may be subject to constitutional scrutiny under the Commerce Clause of the U.S. Constitution.

The Commerce Clause, grants Congress power to “regulate Commerce . . . among the several States.”  Art. I, § 8, cl. 3. Although the Clause is framed as a positive grant of power to Congress, the Court has consistently held this language to contain a further, negative command, known as the dormant Commerce Clause. Wynne, 575 U.S. at 548-549, 135 S. Ct. at 1794. The dormant Commerce Clause prohibits state taxation discriminating against interstate commerce, even when Congress has failed to legislate on the subject. Id. To help identify state tax schemes that discriminate against interstate commerce, the Court uses something known as “the internal consistency test.”  Id. at 562, 135 S. Ct. at 1803. The test “looks to the structure of the tax at issue to see whether its identical application by every State in the Union would place interstate commerce at a disadvantage as compared with commerce intrastate.”  Id. at 562, 135 S. Ct. at 1803 (citations and internal quotation marks omitted).

Accordingly, a state is well within its authority to impose income tax on all of the income of a resident of that state. A state need only ensure that the income tax, to the extent that it substantially affects interstate commerce, does not discriminate against such commerce. While granting a credit against a resident’s income tax may cure an otherwise discriminatory tax, the Supreme Court in Wynne did not order that. In fact, the Court noted that alternative remedies existed, one of which would be for the state to refrain from taxing nonresidents on certain income. Wynne, 575 U.S. at 568,135 S. Ct. at 1806.

Critically, not all situations of double taxation are a result of discriminatory tax schemes. The Court explained:

By hypothetically assuming that every State has the same tax structure, the internal consistency test allows courts to isolate the effect of a defendant State’s tax scheme. This is a virtue of the test because it allows courts to distinguish between (1) tax schemes that inherently discriminate against interstate commerce without regard to the tax policies of other States, and (2) tax schemes that create disparate incentives to engage in interstate commerce (and sometimes result in double taxation) only as a result of the interaction of two different but nondiscriminatory and internally consistent schemes . . . The first category of taxes is typically unconstitutional; the second is not. Id. at 562-563, 135 S. Ct. at 1803 (citations omitted).

If a court were to subject Virginia’s credit to the internal consistency test it would assume that all states, including New York and Tennessee, imposed a broad-based income tax like Virginia’s and would not analyze the actual taxes imposed by each of the other states. Under that assumption, Virginia would grant the credit for income taxes imposed by the other states and no discrimination would be found to exist that could be attributed to Virginia’s tax structure. The fact that a credit has been denied for the New York and Tennessee corporate franchise and excise taxes is attributable to the fact that those states have imposed a tax that is significantly different from Virginia’s income tax. This situation fits into the second type of result of the internal consistency test, which does not violate the Commerce Clause of the United States Constitution. See P.D. 19-86.

CONCLUSION

The New York franchise tax and the Tennessee excise tax are not considered income taxes for which the Taxpayers could claim a credit on their 2020 or 2021 Virginia income tax returns. In addition, in the Department’s opinion, denial of the credit does not violate the Commerce Clause of the United States Constitution. Accordingly, the Taxpayers’ claim for refunds for Virginia income tax paid for the 2020 and 2021 taxable years cannot be granted. The Taxpayers may wish to file amended returns to correct any addition reported for taxes paid by SSC because, as discussed above, such addition was not required for individual taxpayers. If the Taxpayers choose to file amended returns, they should include an explanation of the changes and a copy of this determination letter.

The Code of Virginia sections, regulation, 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/4232.X