04-153 | Virginia Tax

Tax Type

Corporation Income Tax

Description

Enterprise Zone General Business Credit

Topic

Credits

Date Issued

09-17-2004

September 17, 2004

Re: Request for Ruling: Corporate Income Tax

Dear **********:

This will reply to your letter in which you request a ruling regarding the amount of income passed through from an S corporation eligible for the Enterprise Zone General Business Credit (the "Credit"). I apologize for the delay in this response.

FACTS

You believe an inequity exists in determining the amount of the Credit available for S corporations and for other types of pass-through entities. The Credit is based on the tax liability resulting from business activity carried on within an enterprise zone.

You aver that the statutes governing the taxation of S corporations, sole proprietorships, partnerships, and limited liability companies are similar for both the Internal Revenue Service and Virginia in that the liability for the income tax is passed through to the owners of these types of entities. Because of federal rules governing self-employment taxes, S corporations have a higher obligation to pay salaries and wages for services performed by shareholders. Deducting these salaries in determining the net income of an S corporation reduces the amount of tax liability on which the Credit is determined.

You maintain that S corporations should be allowed to add back shareholder wages when computing Virginia taxable income for purposes of the Credit. Accordingly, you request a ruling that would permit such an add back for purposes of computing the
Credit.

RULING

Pass-Through Entities and Self-Employment Taxes

Generally, pass-through items from an S corporation are not included in net income under the self-employment tax rules. Compensation paid to S corporation shareholders who perform services for the S corporations is subject to income tax withholding and Federal Insurance Contribution Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes. Because some S corporations have attempted to avoid paying these FICA taxes by having the shareholders take distributions other than salaries, distributions have been recharacterized federally as reasonable compensation in order to subject such distributions to income tax withholding, FICA, and FUTA taxes.

Income resulting from a trade or business organized as a sole proprietorship or partnership is considered net earnings from self-employment. Individual owners or partners are required to compute and pay self-employment tax on such income. The self-employment tax payments are similar to the tax withheld from salaries and wages of employees for social security retirement benefits ("OASDI") and hospital insurance benefits ("Medicare" or "HI"). Thus, the issue of reasonable compensation may not be as critical for these types of entities.

Enterprise Zone General Business Credit

Under Va. Code § 59.1-280, an eligible taxpayer called a "qualified business firm" can qualify for a Credit of up to 80% of its tax liability for an initial taxable year of eligibility and up to 60% for the next nine taxable years. Virginia Code § 59.1-280(G) sets forth the standard for determining the amount of tax liability eligible for the credit. This statute provides, in pertinent part:

- Tax credits provided for in this section shall only apply to taxable income of a qualified business firm attributable to the conduct of business within the enterprise zone. Any qualified business firm having taxable income from business activity both within and without the enterprise zone shall allocate and apportion its Virginia taxable income . . . .

Thus, according to the Code of Virginia, the Credit is based on the tax liability resulting from the amount of Virginia taxable income attributable to the enterprise zone. The computation of Virginia taxable income starts with federal taxable income ("FTI").

Virginia's conformity to federal law is set forth in Va. Code § 58.1-301. This section states that, except as otherwise provided, the terms used in the Virginia income tax statutes will have the same meanings as used in the Internal Revenue Code ("IRC") as of December 31, 2002. Therefore, FTI for corporations is identical to that as defined by the IRC. Under federal law, "[t]he character of any item included in a shareholder's pro rata share ... shall be determined as if such item were realized directly from the source from which realized by the corporation or incurred in the same manner as incurred by the corporation." See IRC § 1366(b).

As such, because an S corporation is permitted a deduction of salaries and wages (including those paid to a shareholder), the shareholder's pro rata share of the S corporation's deduction will be characterized as such.

Likewise, the salaries and wages received by a shareholder would be classified as compensation for services performed for the S corporation pursuant to IRC § 61 and not income passed through from the S corporation. Under Va. Code § 58.1-301, this salary would have the same character on the shareholder's Virginia individual income tax return.

When a qualified business firm is an S corporation, the amount of tax liability on which the Credit may be determined would be the S corporation's Virginia taxable income attributable to the enterprise zone. Accordingly, Virginia statutes do not allow S corporations to add back salaries and wages paid to its shareholders in determining its income attributable to the enterprise zone.

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

Sincerely,

- - - - Kenneth W. Thorson
        Tax Commissioner

AR/46874B

Rulings of the Tax Commissioner