03-29 | Virginia Tax

Tax Type

Individual Income Tax

Description

Adjusted sales factor S corporation

Topic

Accounting Periods and Methods

Appropriateness of Audit Methodology

Collection of Tax

Date Issued

04-01-2003

April 1, 2003

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 assessments issued to your client, ********* (the "Taxpayer"), for the taxable years ended December 31, 1998 and 1999. I apologize for the delay in the Department's response.

FACTS

The Taxpayer, who is not a resident of Virginia, is the sole owner of a Virginia S corporation ("S") engaged in the production and sale of medical products. S operates in Virginia and one adjacent state ("State A").

During the 1998 and 1999 taxable years, S incurred gains from the sale of technology resulting from a joint venture between the Taxpayer, S and a third party, ("P"). Under the joint venture, P funded and conducted clinical trials for a new medical technology and S provided the medical products needed to develop the new technology. The research and development were conducted primarily in another state ("State B"). The Taxpayer prepared the report that was submitted by S to gain approval for the new technology from the Food and Drug Administration ("FDA").

S submitted the application because of its reputation in this medical field. The joint venture agreement specifically stated that revenues from any S manufacturing, supply, and/or research and development arrangements were not part of the agreement respecting obtaining Investigational Device Exemptions (IDE rights).

P and S sold the rights to the technology to an unrelated third party, ("B"). S subsequently entered into a supply arrangement with B to provide medical products to support the new technology.

S reported capital gain earned through sales of medical technology on Schedule K-1 and distributed them to the Taxpayer. The Taxpayer reported these gains as income from sources outside Virginia for the 1998 and 1999 taxable years. Under audit, the Department adjusted the sales factor reported by S to include the proceeds from the sales of medical technology in the numerator and the denominator of the sales factor.

The Taxpayer asserts that Virginia is not entitled to apportion the gain because: (1) the research was not conducted in Virginia, (2) neither the Taxpayer nor S was involved in the management of the joint venture, (3) the proceeds were passed through S solely for the convenience of the Taxpayer, (4) the proceeds were not needed to fund S's operations, and (5) the technology was wholly distinct from the business in which S is engaged. As such, the Taxpayer has appealed the Department's right to apportion and tax the capital gain from the sale of the technology incurred by S and asserts that the income is allocable to the Taxpayer's state of residence.

- - - - DETERMINATION

Apportionment/Allocation

The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Va. Code §§ 58.1-402 and 58.1-403, less dividends allocated pursuant to Va. Code § 58.1-407, is subject to apportionment.

Va. Code § 58.1-402 does not provide for the subtraction of the income at issue. To the extent, however, that income is derived from an investment function as set forth in the U.S. Supreme Court's decision in Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992), an alternative method of allocation and apportionment under Va. Code § 58.1-421 may be appropriate. To facilitate this, the Department permits an adjustment on the Virginia corporation income tax return if a taxpayer can demonstrate that the application of Virginia's statutory apportionment factor for the taxable year would be contrary to the principles established in Allied-Signal.

The Taxpayer asserts that the income in question is from an investment function unrelated to S's operational activities within Virginia and, therefore, should be allowed as a subtraction on its Virginia return. The decision of the U.S. Supreme Court in Allied-Signal made it clear that in order for a state to tax a nondomiciliary corporation, certain minimal connections must exist between the interstate activities and the taxing state. Because S is domiciled in Virginia, the judicial doctrines controlling Allied-Signal and prior cases do not apply to this situation. See Public Document ("P.D.") 97-285 (6/25/97). Accordingly, the audit adjustment made by the Department to apportion the income under the existing three-factor formula set forth in Va. Code §§ 58.1-400, et seq., is upheld.

Individual Income Tax

Individuals who are neither domiciliary nor actual residents of Virginia and have income from Virginia sources are taxed as nonresidents. The Virginia taxable income of a nonresident is defined under Va. Code § 58.1-325 as "an amount bearing the same proportion to his Virginia taxable income, computed as though he were a resident, as the net amount of his income, gain, loss and deductions from Virginia sources bears to the net amount of his income, gain, loss and deductions from all sources."

Under Va. Code § 58.1-302, "income and deductions from Virginia sources" includes income from "[a] business, trade, profession or occupation carried on in Virginia."

Income received by an S corporation, which is determined to be income from Virginia sources, will remain Virginia source income in the hands of the shareholders. P.D. 88-165 (6/29/88). S had Virginia taxable income, which it passed through to its sole shareholder, the Taxpayer. Accordingly, the Taxpayer had Virginia taxable income.

The issue in this instance is not whether the Taxpayer is subject to Virginia individual income tax, but rather how much of the S corporation's income is Virginia source income. Because the audit adjustment to apportion the income from S under the existing three-factor formula has been upheld, the subsequent audit adjustment to include that portion of the income distribution as Virginia source income on the Taxpayer's 1998 and 1999 Virginia income tax returns is also upheld.

- Accordingly, the assessments issued to the Taxpayer for the 1998 and 1999 taxable years are correct and remain due and payable. The Taxpayer should remit his payment, as shown on the enclosed schedule. No further interest will accrue provided the outstanding balance is paid within 30 days from the date of this letter. The Taxpayer should remit his payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attention: *****. If you have any questions concerning payment of the assessment, you may contact ***** at *****.

Copies of the Code of Virginia sections and public documents cited are available online in the Tax Policy Library section of the Department's web site, located at www.tax.state.va.us. If you have any questions regarding this determination, you may contact ***** in the Department's Office of Policy and Administration, Appeals and Rulings, at *****.

Sincerely,

- - - - Kenneth W. Thorson
        Tax Commissioner

AR/36716E

Rulings of the Tax Commissioner