Document Number
03-41
Tax Type
Individual Income Tax
Description
S corporation tax assessments
Topic
Penalties and Interest
Returns/Payments/Records
Date Issued
04-18-2003

April 18, 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 clients, ************* (the "Taxpayers") for the taxable years ended December 31, 1997 and 1998. I apologize for the delay in the Department's response.
FACTS

The Taxpayers, a husband and wife, moved from Virginia to another state ("State A") and established domicile there late in 1996. They maintain a residence in Virginia. The husband is the sole beneficiary of a trust that is the sole owner of a Virginia Subchapter S corporation ("VSC"), which was in the construction business.

In January 1997, the husband formed a Subchapter S corporation ("ASC") in State A for the purpose of providing consulting services to VSC. For the years at issue, VSC conducted all its business in Virginia. VSC contracted with ASC to perform consulting services.

The Taxpayers filed nonresident individual income tax returns for 1997 and 1998. In determining their allocation percentage for determining Virginia nonresident taxable income, the Taxpayers attributed all of the loss from VSC to income from Virginia sources but none of the income from ASC. In addition, all of the husband's salary from ASC was attributed to State A.

Under audit, the Department discovered that the husband had performed consulting services on behalf of ASC for VSC within Virginia and that the Taxpayers spent in excess of 40% of their time in Virginia, mostly during the spring, summer and fall. Based on this information, the auditor increased the amount of the husband's salaries attributable to Virginia. In addition, the auditor determined that the transactions between VSC and ASC lacked economic substance and attributed all the income from ASC to Virginia sources. As a result, the Department issued assessments of individual income tax and interest against the Taxpayers for the 1997 and 1998 taxable years.

You have contested these assessments, asserting that ASC had no positive apportionment factors in Virginia, and thereby had no income from Virginia sources. In addition, you concede that an additional amount of the husband's salaries should be included in income from Virginia sources, but the amount is less than that proposed by the auditor.
DETERMINATION

Nonresident salaries and wages

Pursuant to Va. Code § 58.1-341, a nonresident individual who has income from carrying on a business, trade, profession, or occupation within Virginia is required to file a Virginia individual income tax return, unless the individual meets the "$3,000 filing exception" described in Va. Code § 58.1-321. The Virginia taxable income of a nonresident is computed by multiplying his Virginia taxable income (computed as if he were a resident) by the ratio of his net income, gain, loss, and deductions from Virginia sources to his net income, gain, loss, and deduction from all sources.

For salaries and wages from an employer, the "net income, gain, loss, and deductions from Virginia sources" would be an amount equal to (1) the total annual salary from the employer, (2) multiplied by the number of days or portion thereof that the nonresident individual spent in Virginia performing duties for their employer, and (3) divided by the number of days or portion thereof spent anywhere performing duties for the employer. See Public Document ("P.D.") 84-90 (7/3/84).

While conceding that the husband did perform some consulting services in Virginia during 1997 and 1998, you contend that the salary attributable to these services is less than determined by the Department's auditor. The information provided on this issue is unclear. During the audit, you initially indicated that no services were performed by the husband in Virginia. Later, the husband conceded that some services were performed in Virginia. In your letter contesting these assessments, you state that as much as 19% of the husband's salary from ASC could be considered Virginia source income.

The Department does not accept your contention that the husband performed services on behalf of ASC only while he resided in State A. The construction industry is generally most active during the months in which the Taxpayers were staying at their Virginia residence. The Taxpayers resided in Virginia for 173 days and 159 days in 1997 and 1998, respectively. The Department finds that the husband spent considerable time performing services for VSC while residing in Virginia. Absent objective evidence to the contrary, the auditor's adjustment to the husband's salaries for the years at issue is upheld.

S corporation income
    • Va. Code § 58.1-445 provides:
    • In any case of two or more related trades or businesses liable to taxation under this chapter owned or controlled directly or indirectly by the same interests, the Department may, and at the request of the taxpayer shall, if necessary in order to make an accurate distribution or apportionment of gains, profits, income, deductions or capital between or among such related trades of businesses, consolidate the accounts of such related trades or businesses.

Title 23 of the Virginia Administrative Code ("VAC") 10-120-350 provides that consolidation of this nature is appropriate in situations in which federal taxable income is accurately stated, but the income from Virginia sources taxable by Virginia is inaccurately stated. The regulation further states that to be an applicable Subchapter S corporation, one of the shareholders must be subject to Virginia income tax.

While the statute and the regulation do not specifically define when Virginia taxable income would be considered to be inaccurately stated, the Department and the courts have provided guidance on this issue in applying Va. Code § 58.1-446. Under this statute, the Department may equitably adjust the tax of a corporation when there exists any arrangements that “improperly ... reflect the business done or the Virginia taxable income earned from business done in this Commonwealth."

The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54 (1988), upheld the Department's authority to equitably adjust the tax of a corporation pursuant to Va. Code § 58.1-446 (or its predecessor) where two commonly-owned corporations structure an arrangement in such a manner as to improperly, inaccurately, or incorrectly reflect the business done in Virginia or the Virginia taxable income. Generally, the Department will exercise its authority if it finds that the consideration for an intragroup transaction does not accurately reflect an arm's length charge or a transaction, or a party to a transaction lacks economic substance.

You contend that the consulting fees were made at an arm's length. You point to a number of factors used by the United States Tax Court to determine if compensation paid to an individual is reasonable. Your argument is supported by general statements about the husband's qualifications to perform the work, the nature and scope of the duties, the size and complexity of the business, the general economic conditions, and VSC's policy regarding compensation. These general statements provide no objective evidence demonstrating that the consulting fees represent an arm's length transaction.

In fact, a number of these statements contradict your contention. You point to the husband's education and experience and VSC's policy of paying "prevailing amounts necessary to attract and retain the best" employees, subcontractors and vendors. The consulting fees, however, are 25 to 30 times higher than the husband's salary from VSC in 1996, the year immediately preceding the years at issue, for the same education and experience under the same compensation policy. There is no evidence that the husband's services were sought after or provided to any other construction companies. Without any external or objective evidence, and given the husband's relationship with VSC, the Department finds it implausible that the consulting fees charged by ASC were required to attract and retain the husband's services.

The consulting agreement between VSC and ASC entitles ASC to a monthly flat fee, plus 30% of VSC's net profits before tax, and an additional bonus as determined by VSC. Fees actually paid for 1997 and 1998 were equal to approximately 73% and 90%, respectively, of VSC's total income before any other deductions. These consulting fees were many times greater than the husband's salary from VSC in years prior to the arrangement. The Department finds that the consulting fees charged by ASC do not reflect an arm's length transaction, and the arrangement grossly misstates the Virginia incomes of VSC, ASC, and the Taxpayers.

VSC reported net operating losses for both 1997 and 1998. For the five years prior to 1997, VSC had reported positive federal taxable income. Interestingly, VSC's income for 1997 and 1998 mirrors the income of the immediately preceding years when the consulting fees are removed. Consequently, the Department finds the consulting agreement between ASC and VSC does not allow for an accurate distribution of gains, profits, income, deductions or capital. The sole identifiable changes in the operations of VSC were the lack of a salary paid to the husband and the consulting fees charged by ASC.

You contend that ASC is not subject to Virginia income tax because it has no positive apportionment factors. You contend that ASC had no property or payroll in Virginia. Further, you state that ASC does not have any sales in Virginia under the "cost of performance" regulation, because the greater proportion of consulting services occurs in State A rather than Virginia. While this may be true, under 23 VAC 10-120-350(B)(3)(d), an S corporation is considered to be liable to taxation in Virginia if any of the S corporation's shareholders is subject to Virginia income tax. In other words, consolidation of accounts for S corporations may be appropriate even if the S corporation would have no positive apportionment factors, as long as one shareholder of the S corporation is subject to Virginia income tax. In this case, the husband is the sole shareholder in ASC and is clearly subject to Virginia income tax, as evidenced by the filing of a Virginia nonresident income tax return.

Conclusion

Because the consulting agreement does not result in an accurate apportionment of Virginia revenues, the accounts of VSC, ASC and the salaries earned by the husband have been consolidated pursuant to Va. Code § 58.1-445 in order to more accurately apportion income among these related trades and businesses. The Taxpayer's Virginia income tax liability for the 1997 and 1998 taxable years has been adjusted according to the enclosed schedules. Please remit payment to the Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 1880, Richmond, Virginia 23218-1880, Attention:*****. If payment is not received within 30 days from the date of this letter, interest will accrue on the outstanding balance and collection action will resume.

Copies of the Code of Virginia sections, regulations and public documents cited, as well as other reference documents, 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 ***** at *****.
                • Sincerely,



                • Kenneth W. Thorson
                  Tax Commissioner




AR/30708B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46