Tax Type
Individual Income Tax
Description
Minimum earnings payment represents a "guaranteed payment"
Topic
Assessment
Date Issued
03-16-2005
March 16, 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 assessment issued to you (the "Taxpayer') for the taxable year ended December 31, 2001. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer resides in ***** ("State A") and was a partner in a partnership that operated exclusively in State A. In January 2001, the State A partnership merged with a Virginia partnership. Pursuant to the merger agreement, the Taxpayer received a minimum earnings payment from the Virginia partnership. This guaranteed minimum payment was reported by the Virginia partnership as partnership income on the Schedule K-1.
The Department audited the Taxpayer and assessed income tax, penalty and interest on the basis that the guaranteed minimum payment was Virginia source income subject to Virginia income tax. The Taxpayer contests the assessment, asserting that the minimum earnings payment represents a "guaranteed payment" as described in Internal Revenue Code ("IRC") § 707(c), and is not Virginia source income for nonresident income tax purposes.
DETERMINATION
Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Virginia Code will generally have the same meanings as provided in the IRC unless a different meaning is clearly required. Virginia "conforms" to federal law because it starts the computation of Virginia taxable income with federal adjusted gross income ("FAGI").
When a partner's percentage of profits is less than his guaranteed minimum earnings, the partner's prorated share of partnership income before deduction of guaranteed payments is his distributive share of partnership income; the difference between the partner's guaranteed minimum earnings and his distributive share of partnership income before taking into account the guaranteed payment is treated as a guaranteed payment. See example 2 of Treas. Reg. § 1.707-1 c.
In this case, the merger agreement between the State A partnership and the Virginia partnership included a provision whereby the Taxpayer and his partners would receive guaranteed minimum earnings for the fiscal years ended June 30, 2001 through 2003. Thereafter, the Taxpayer and the other former partners of the State A partnership were integrated into the regular compensation procedures of the Virginia partnership.
Because Virginia conforms to the IRC, great weight is given to how a taxpayer reports an item of income, gain, loss, or deduction on their federal return. No guaranteed payments were reported on the Taxpayer's 2000 Schedule K-1, and the amount reported as ordinary income from a trade or business exceeded the amount of the minimum earnings guaranteed in the merger agreement. This income was also included in the analysis of partner's capital account on the Schedule K-1.
Further, partnerships are required to deduct guaranteed payments as a business expense. See Treas. Reg. § 1.707 c. A review of the Virginia partnership's return for the taxable year at issue does not indicate a deduction for a guaranteed payment to the Taxpayer as a business expense. Accordingly, the minimum earnings are not guaranteed payments as defined in IRC § 707.
Moreover, the plain language of the agreement supports the federal reporting. The merger agreement provides that the guaranteed minimum earnings can be adjusted if the net fees accrued by the State A partnership decrease by more than 10 percent for the calendar year preceding the merger. This reduction is clearly tied to revenues and earnings of the State A partnership and not services performed by the partners. Such a stipulation runs counter to the requirement that guaranteed payments are to be made without regard to partnership income. It is clear that the minimum earnings stated in the merger agreement are meant to transition the partners in the State A partnership into the normal earning distribution policies of the Virginia partnership. The minimum earnings are not payment for services or for the use of capital as set forth in Treas. Reg. § 1.707-1 c.
As such, the Taxpayer had partnership income from both Virginia and State A. Partnerships that have income from business both within and without Virginia compute their Virginia source income in accordance with the corporate statutory formula set forth in Virginia Code §§ 58.1-406 through 58.1-421, making such changes as necessary after considering the differences between corporations and partnerships. See Public Document ("P.D.") 88-165 (6/29/88).
Based on this determination, the documentation provided by the Taxpayer will be forwarded to the Department's audit staff to make the necessary adjustments to the audit. A member of the audit staff will contact you regarding the documentation provided and any additional information needed to review and verify the apportionment of partnership income between Virginia and State A. The apportioned partnership income will then be included in the formula to compute the Taxpayer's income tax liability as a nonresident in accordance with Title 23 of the Virginia Administrative Code 10-110-180. The auditor will provide audit revisions to you. Any outstanding balance remaining after the revisions are made should be paid within 30 days to avoid the accrual of additional interest. Payment may be mailed to: Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P. O. Box 27203, Richmond, Virginia 23261-7203, Attention: *****.
The Code of Virginia sections, regulation and public document cited, as well as other reference documents, 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 ***** at *****.
-
-
-
-
-
-
-
- Sincerely,
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Kenneth W. Thorson
Tax Commissioner
-
-
-
-
-
-
-
-
AR/52070B
Rulings of the Tax Commissioner