Tax Type
Individual Income Tax
Description
Virginia S corporation; Independent consultant
Topic
Appropriateness of Audit Methodology
Computation of Income
Taxable Income
Date Issued
06-02-2004
June 2, 2004
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, 2000 and 2001. I apologize for the delay in the Department's response.
FACTS
The Taxpayers, a husband and wife, were domiciled in another state ("State A") during the taxable years at issue. The husband owns 49% of a Virginia S corporation ("VSC"), which is in the vehicle sales and service business.
In April 2000, the husband formed an S corporation ("ASC") in State A for the purpose of providing consulting services to businesses involving vehicle sales and services and thoroughbred horse breeding. For the years at issue, VSC conducted all its business in Virginia. VSC made an oral agreement with ASC to perform consulting services. In addition, the husband and wife received wages for performing services for VSC.
The Taxpayers filed Virginia nonresident individual income tax returns for 2000 and 2001. In determining their allocation percentage for determining Virginia nonresident taxable income, the Taxpayers did not attribute any of the income derived from ASC as income from Virginia sources. The husband and wife attributed all wages from VSC as income from Virginia sources. In addition, the Taxpayers had numerous other sources of income, some of which was reported as Virginia source income, and some of which was reported as State A income.
Under audit, the Department determined that the transactions between VSC and ASC improperly reduced the income from business performed in Virginia by VSC. The auditor concluded that all income from ASC was Virginia source income and issued assessments of individual income tax and interest to the Taxpayers for the 2000 and 2001 taxable years.
You contend that the Department's auditor inappropriately relied on Public Document ("P.D.") 97-290 (6/26/97). Further, you contend that if the Department is correct in challenging the transactions between VSC and ASC, the appropriate remedy is to adjust the fair market value of those services pursuant to Title 23 of the Virginia Administrative Code ("VAC") 10-120-361.
You have appealed the fairness of these assessments on the basis that the husband spent approximately 70% of his working days in State A and 30% of his working days in Virginia and allocated approximately 40% of his income as Virginia source income. You contend this represents a fair allocation between Virginia and State A.
DETERMINATION
S Corporation Income
You contend that the Department improperly relied on P.D. 97-290 in determining that the income of ASC is Virginia source income when determining the Taxpayer's Virginia income tax liability. You aver that P.D. 97-290 deals with a group of corporations in which the Tax Commissioner found that the parent entity lacked economic substance.
Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers, Va. Code § 58.1-446 provides, in pertinent part:
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- When any corporation liable to taxation under this chapter by agreement or otherwise conducts the business of such corporation in such manner as either directly or indirectly to benefit the members or stockholders of the corporation . . . by either buying or selling its products or the goods or commodities in which it deals at more or less than a fair price which might be obtained therefor, or when such a corporation . . . acquires and disposes of the products, goods or commodities of another corporation in such manner as to create a loss or improper taxable income, and such other corporation . . . is controlled by the corporation liable to taxation under this chapter, the Department may . . . determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year.
In case it appears to the Department that any arrangements exist in such a manner as improperly to reflect the business done or the Virginia taxable income earned from business done in this Commonwealth, the Department may, in such manner as it may determine, equitably adjust the tax. [Emphasis added.]
- When any corporation liable to taxation under this chapter by agreement or otherwise conducts the business of such corporation in such manner as either directly or indirectly to benefit the members or stockholders of the corporation . . . by either buying or selling its products or the goods or commodities in which it deals at more or less than a fair price which might be obtained therefor, or when such a corporation . . . acquires and disposes of the products, goods or commodities of another corporation in such manner as to create a loss or improper taxable income, and such other corporation . . . is controlled by the corporation liable to taxation under this chapter, the Department may . . . determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year.
In Commonwealth v. General Electric Company, 236 Va. 54 (1988), the Virginia Supreme Court 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.
While the Department acknowledges the differences in the facts, the concepts of Va. Code § 58.1-446 as set forth in P.D. 97-290 are not limited to one set of facts and are applicable in this case. First, the terms "owned" and "controlled" are used when describing the relationships that would allow the Department to proceed under Va. Code § 58.1-446. Title 23 VAC 10-120-360 further provides that a group subject to Va. Code § 58.1-446 may include a corporation not eligible for inclusion in a federal consolidated return "if other facts demonstrate that one corporation has sufficient influence over another corporation's affairs to cause the corporations to enter into transactions with each other on terms that would not be offered to unrelated parties." In other words, the mere fact that the husband owns only 49% of the VSC does not preclude the Department from finding it necessary to make an equitable adjustment to the Taxpayer's income.
In addition, as stated above, the Department is not limited to invoking Va. Code § 58.1-446 only when it finds a lack of economic substance. The Department will also consider the arm's length nature of the transaction and the substance of such transactions. These principles are clearly set forth in P.D. 97-290.
Further, Va. Code § 58.1-446 provides the Department broad authority to "equitably adjust the tax." Title 23 VAC 10-120-363 provides a list of some of the remedies that may be used and states, "Other remedies not listed herein may be incorporated as necessary." As such, the fact that P.D. 97-290 does not specifically address income allocation does not make the concept of an equitable adjustment inapplicable in this case. This regulation also refutes your assertion that the only remedy in this case is limited to adjusting the fair market value of the services provided by ASC.
Pursuant to Va. Code § 58.1-446, the auditor found that the arrangement between VSC and ASC resulted in intragroup transactions that improperly reflected the business done in Virginia by VSC and made an equitable adjustment to the tax based on a review of the facts. As such, the auditor's reliance on the principles set forth in P.D. 97-290 is not inappropriate.
In this case, there was no written consulting agreement between VSC and ASC specifically stating the compensation of ASC for its services. It is unlikely that any unrelated third party would enter into a half million dollar consulting contract without a written agreement.
You contend that the consulting fees were made based upon the value of the services that ASC provided. 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 and the general economic conditions. You indicate that the services to be provided include the analysis of inventory levels and order points, the development of marketing plans, the review of operating results and the analysis of employee compensation and benefit packages. These general statements provide no objective evidence to convince the Department that the consulting fees represent an arm's length transaction.
According to your letter, the husband spent 70% of his working days performing consulting work on behalf of ASC in State A during 2000 and 2001. Presuming that the husband worked eight hours each day and seven days a week, the consulting fee charged by ASC exceeded $200.00 per hour for 2000 and $300.00 per hour for 2001. Meanwhile, ASC paid no salary in 2000, and again assuming a standard eight-hour workday, paid the husband at a rate of less than $5 per hour for the 2001 taxable year. In addition, the consulting fees far exceed the salary paid to the husband in the years preceding 2000. No evidence has been presented that demonstrates the husband's services were worth the consulting fees charged by ASC. In fact, the husband's salary history contradicts the amounts of the consulting fees.
The husband also continued to perform significant services for VSC as an employee. You argue that the husband was an employee while in Virginia, but an independent consultant while he was in State A. The Department finds this arrangement to be incompatible. As Vice President of VSC, the husband cannot also be an independent contractor for VSC. The husband does not cease to be an officer of VSC when he is in State A. Further, it is inconceivable that the husband does not perform consulting functions when he is in Virginia.
Thus, because the husband is not independent from VSC and the intercompany consulting fees do not reflect fair market intercompany transactions, the facts fit that of Commonwealth v. General Electric Company and satisfy the Court's requirement of (1) an arrangement (2) between two commonly owned corporations (3) in such a manner improperly, inaccurately, or incorrectly to reflect (4) the business done or the Virginia taxable income earned from business done in Virginia. Accordingly, the auditor was correct in applying the standards of Va. Code § 58.1-446.
Allocation of Taxpayer Income
You contend that the Taxpayer's total income should be allocated according to the number of days that the husband worked in Virginia as compared to the number of days he worked outside of Virginia. You support your position by citing P.D. 01-27 (3/28/01) and P.D. 02-106 (6/28/02).
Public documents 01-27 and 02-106 address the apportionment of individual income for Virginia individual income tax purposes when a nonresident taxpayer earns income both within and without Virginia. These two public documents, citing P.D. 94-219 (7/13/94), held that an individual taxpayer must apportion his wage and salary income based on activities occurring within Virginia. Typically, the factor that most equitably determines the apportionment of salaries and wages is the ratio of the number of days that services were performed in Virginia to the number of days that services were performed elsewhere. Nothing in Virginia law provides for the apportionment by the number of days that a Taxpayer's income from sources other than salaries or wages. These rulings are only applicable to the Taxpayer's salaries and wages, but have no bearing on the Taxpayer's income received from VSC and ASC. Income from S Corporations is usually apportioned in accordance with Va. Code § 58.1-406 et. seq. Accordingly, a nonresident Taxpayer's income subject to tax may have very little to do with the amount of time he spends in Virginia.
Combining Income
Virginia Code § 58.1-445 provides:
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- 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 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 for consolidation to be applicable, a corporation must be liable to taxation in Virginia, i.e., subject to the 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. As stated above, the Department may equitably adjust the tax of a corporation under this statute when there exists any arrangements that " improperly ... reflect the business done or the Virginia taxable income earned from business done in this Commonwealth." The Department has concluded that the consulting agreement between ASC and VSC does not allow for an accurate distribution of gains, profits, income, deductions or capital.
The auditor made his adjustments by allocating all of ASC's income to Virginia sources under Va. Code § 58.1-446. This approach does not account for the fact that the husband performed some work for the VSC while he was in State A; however, the Department finds that it is more appropriate that all income from ASC and VSC, including the Taxpayer's wages from ASC and VSC, be combined under 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 2000 and 2001 taxable years has been adjusted according to the enclosed schedules. Please remit payment to: Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 1880, Richmond, Virginia 23218-1880, Attention: *****. The Taxpayer should remit its payment within 30 days to avoid the accrual of additional interest and penalties.
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 questions regarding this determination, you may contact ************** at *************.
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- Sincerely,
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Kenneth W. Thorson
Tax Commissioner
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AR/46159B
Rulings of the Tax Commissioner