Document Number
05-33
Tax Type
Individual Income Tax
Description
Subchapter S corporation; domicile
Topic
Accounting Periods and Methods
Allocation and Apportionment
Date Issued
03-15-2005

March 15, 2005




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, moved from Virginia and established domicile in another state ("State A") in 1999. They continued to maintain a residence in Virginia. The husband is the majority owner of a Virginia S corporation ("VSC"), which is an automobile dealership.

In late 1999, the Taxpayers 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. ASC provided consulting services to VSC.

The Taxpayers filed Virginia part-year resident individual income tax returns for the 2000 and 2001 taxable years. They allocated all the distributions and salaries of ASC to State A. Under audit, the Department discovered that the husband had performed consulting services on behalf of ASC for VSC within Virginia. Based on this information, the auditor increased the amount of the husband's salary attributable to Virginia for 2001. 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 to the Taxpayers for the 2000 and 2001 taxable years.

The Taxpayers contest the assessments, asserting that ASC lacked nexus with Virginia, and therefore is not subject to Virginia income tax. In addition, the Taxpayers contend the auditor erroneously apportioned 20% of the husband's 2001 wages to Virginia based on the number of days that the husband resided in Virginia, maintaining the husband spent little or no time conducting business in Virginia during that year.

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).

You contend that none of the husband's salary should be allocated to Virginia because he spent little or no time conducting business when he was in Virginia. The information provided on this issue is unclear. In your letter contesting these assessments, you state that less than 20% of the husband's salary from ASC could be considered Virginia source income.

I do not accept your contention that the husband performed services on behalf of ASC only while he resided in State A. In October 1999, VSC entered into an agreement with ASC to operate, supervise and, when necessary, specifically manage VSC. The husband, as the majority shareholder and employee of ASC, performed all of the consulting services for ASC. These are essentially the same services he performed as an employee of VSC when he lived in Virginia.

The management agreement lists many responsibilities for the consultant including, but not limited to, preparing forecasts and operating goals, hiring management, controlling inventory management and financial reports, recruiting, training and managing a sales force residing in Virginia. You have also provided an executive summary that purports to show that the husband only performed consulting activities on behalf of ASC 3.44% of the time while being present in Virginia.

Further, the husband has categorized his days as either business or pleasure pursuant to his credit card receipts. I find the summary of the husband's credit card purchases inconclusive. The fact that the husband paid for personal activities with a credit card on a particular day does not preclude him performing consulting services on the same day. It is inconceivable that the husband could perform all of these consulting services when outside Virginia or that the husband spent so little time attending to his Virginia business while in Virginia. The auditor's adjustment to the husband's salaries for the years at issue is, therefore, upheld.

Consulting S Corporation

Virginia 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. While the statute and the regulation do not specifically refine 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."

You contend that under Public Law ("P.L.") 86-272, the Department lacks the authority to tax ASC because ASC lacks any physical presence in Virginia. Public Law 86-272, codified at 15 U.S.C. §§ 381-384, prohibits Virginia from imposing a net income tax on a taxpayer when the only contact with Virginia is the solicitation of sales of tangible personal property. Public Law 86-272 protection has been extended by the U.S. Supreme Court to include activities that are ancillary to direct sales solicitation, as well as de minimis activities. See Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992).

While it is true that P.L. 86-272 prohibits the taxation of a taxpayer when it lacks physical presence in Virginia, the Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54, 372 S.E.2d 599 (1988) upheld the Department's authority to adjust equitably 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 reflect improperly, inaccurately, or incorrectly the business done in Virginia or the Virginia taxable income. Further, Va. Code § 58.1-446 provides the Department with 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."

You contend that the consulting fees were made pursuant to an arm's length arrangement. You argue that ASC maintains separate bank accounts and offices, and is responsible for its own transactions. You also state all payments from VSC to ASC were made in cash pursuant to a management agreement. These general statements provide no objective evidence that the consulting fees represent an arm's length transaction.

The consulting agreement between VSC and ASC entitles ASC to a monthly flat fee against a management fee of 90% of the annual profit. The consulting fees for the 2000 and 2001 taxable years were nearly four times higher than the husband's salary from VSC in 1999. There is no evidence that the husband's services were sought after or provided to any other automobile dealerships. Without any external or objective evidence, and given the husband's relationship with VSC, I find it implausible that the consulting fees charged by ASC were required to attract and retain the husband's services.

Furthermore, ASC lacked economic substance in State A. It had no assets or corporate offices in State A. The Taxpayers used ASC's bank account to pay personal expenses on numerous occasions. Such personal expenses include payments for estimated income tax, property taxes and school tuitions.

The taxable income of VSC for the 2000 and 2001 taxable years was significantly reduced compared to the prior taxable years. The Department's analysis shows that the only significant change in revenues and expenses were the fees VSC was charged by and paid to ASC. Based on this information, I find the consulting fees charged by ASC do not reflect an arm's length transaction, and the arrangement grossly, misstates the Virginia income of the Taxpayers.

Accordingly, 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 apportion income among these related trades and businesses more accurately. The Taxpayer's Virginia income tax liability for the 2000 and 2001 taxable years has been adjusted according to the enclosed schedules. A consolidated bill, with interest accrued to date, will be mailed shortly to the Taxpayer. No further interest will accrue provided the outstanding assessments are paid within 30 days from the date of this letter. The Taxpayers should remit their 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 *****. Failure to submit full payment within 30 days may also result in the imposition of an additional 20% penalty on the tax due under the terms of Virginia's recent Amnesty. See the enclosure entitled "Important Payment Information."

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.policylibrary.tax.virginia.gov. If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
                • Sincerely,


                    • Kenneth W. Thorson
                      Tax Commissioner


AR/46616B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46