Tax Type
Individual Income Tax
Description
VA may tax certain income of a nondomiciliary even if it is not unitary
Topic
Basis of Tax
Constitutional Provisions
Taxable Income
Date Issued
08-25-2006
August 25, 2006
Re: § 58.1-1821 Application: Individual Income Tax
Dear *********:
This will reply to your letter in which you seek correction of the Virginia individual income tax assessment issued to ***** (the "Taxpayer") for the taxable year ended December 31, 2002. I apologize for the delay in responding to your appeal.
FACTS
The Taxpayer was a nonresident of Virginia during the 2002 taxable year. The Taxpayer held a membership interest in ***** ("VALLC").
VALLC was involved in a lawsuit with a business located in ***** ("State B") in 2001 and 2002. As the result of the lawsuit, VALLC received a substantial settlement from the State B business in 2002. The Taxpayer, in turn, received his share of the proceeds from the lawsuit in December 2002.
The Department obtained information from the Internal Revenue Service indicating that the Taxpayer received Virginia source income from a pass-through entity conducting business in Virginia and, therefore, may be required to file a Virginia nonresident individual income tax return for the 2002 taxable year. Based on this information, the Department issued an assessment based on income identified as being from VALLC.
The Taxpayer contends that the income from VALLC was interest income exempt from income taxation under a tax treaty (the "Treaty") between the United States and the ***** ("Country A"). The Taxpayer further contends that the Department improperly classified the income as Virginia source income. Consequently, the Taxpayer requests abatement of the assessment issued for the 2002 taxable year.
DETERMINATION
Tax Treaty
Virginia's conformity to federal income tax law is set forth in Va. Code § 58.1-301, which provides that the terms used in the Virginia income tax statutes will have the same meaning as used in the Internal Revenue Code (I.R.C.). For Virginia, federal taxable income (FTI) and federal adjusted gross income (FAGI), the starting points for determining income taxable in Virginia for corporations and individuals, respectively, are identical to that as defined by the I.R.C.
Under conformity, the Virginia taxable income of a resident of a foreign country will generally include all income, gains and deductions included in his FAGI, but will not include such income if it is exempt from a taxpayer's FTI or FAGI pursuant to a treaty between the United States and a foreign country.
The income in question is ordinary business income from a Virginia business and, therefore, included in computation of federal adjusted gross income on the Taxpayer's federal nonresident individual income tax return. No evidence has been provided to indicate that the income was removed from the federal return pursuant to the Treaty. Accordingly, it must be included in federal adjusted gross income for computation of the Taxpayer's Virginia nonresident taxable income.
Income From Virginia Sources
Individuals who are neither domiciliary nor actual residents of Virginia and have income from Virginia sources are taxed as nonresidents. The Virginia taxable income of a nonresident is defined under Va. Code § 58.1-325 as "an amount bearing the same proportion to his Virginia taxable income, computed as though he were a resident, as the net amount of his income, gain, loss and deductions from Virginia sources bears to the net amount of his income, gain, loss and deductions from all sources." Under Va. Code § 58.1-302, "income and deductions from Virginia sources" includes income from "a business, trade profession or occupation carried on in Virginia."
In Public Document (P.D.) 97-343 (8/28/97), the Department ruled that it would follow the federal election made by a limited liability company pursuant to the "check the box" regulations under Treas. Reg. § 301.7701-1 et seq. In fact, Virginia's conformity statute requires such a ruling because a limited liability company that is treated as a partnership or a disregarded entity for federal income tax purposes will have no federal taxable income as a starting point for computing its Virginia taxable income.
Virginia generally conforms to the federal treatment of partnerships. A partnership, as such, is not subject to income tax. Any income tax arising from the income of the partnership is the liability of the partners. I.R.C. § 702(b) states, "The character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share . . . shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership." Each item of pass-through entity income, gain, loss or deduction has the same character for an owner for Virginia income tax purposes as for federal income tax purposes. See Va. Code § 58.1-391 B. This would include a limited liability company that elects to be treated as a partnership for federal income tax purposes.
In this case, VALLC is a limited liability company located in and operating in Virginia that elected to be treated as a partnership for income tax purposes. For the 2002 taxable year, VALLC received income as a result of settling a lawsuit with a State B business. This income was properly reported as ordinary income on VALLC's federal partnership return. Although the suit was filed in court in State B, no evidence has been provided to show that VALLC had nexus for income tax purposes with any state other than Virginia. Accordingly, all of VALLC's income is considered to be income from Virginia sources. Further, the income received by VALLC was properly reported as ordinary income on its federal income tax return. Pursuant to Va. Code § 58.1-391 B, the character of that income distribution will be the same to the Taxpayer.
Due Process
The Taxpayer contends that the proceeds from the settlement of the lawsuit do not represent income from Virginia sources and that taxation of the proceeds is not permitted under the Due Process Clause and the Commerce Clause of the United States Constitution.
The operation of the Due Process Clause as a limitation on the taxing power of the states usually involves one of two basic issues: (1) the relationship between the state exercising taxing power and the object of that exercise of power, and (2) whether the degree of contact is sufficient to justify the state's imposition of a particular obligation. In this case, VALLC is headquartered in Virginia and conducts all of its operations in Virginia. Accordingly, the Department is well within its jurisdictional rights to impose tax on the income of VALLC.
Commerce Clause
In evaluating the validity of an income tax under the Commerce Clause, the United States Supreme Court offered a four-pronged test. Under this test, a tax must be: (1) applied to an activity with a substantial nexus with the taxing authority; (2) fairly apportioned; (3) nondiscriminatory to interstate commerce; and (4) fairly related to the services provided by the state or locality. See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). In the case at hand, it appears that a Commerce Clause analysis is not required because the Taxpayer has not shown that VALLC is subject to tax in any state other than Virginia.
The Taxpayer argues that the membership in VALLC is more akin to that of a limited partner. As such, the Taxpayer believes that the income from VALLC should be treated like any other investment income. Because he is not a resident of Virginia, the Taxpayer contends that the investment income from VALLC should not be considered Virginia source income.
As a limited liability company, VALLC elected to be treated as a partnership for federal income tax purposes on the income earned by a limited liability company. There is no question that the Department would have the express authority to tax the income of VALLC if such tax were imposed at the entity level. Because VALLC was not treated as a separate entity for federal taxation purposes, however, it will not have any FTI. Although VALLC continued its legal existence and business activities, it had no FTI for computing a Virginia taxable income and was not required to file a Virginia income tax return for its 2002 taxable year.
For federal income tax purposes, the members were considered the owners of all VALLC's assets and liabilities. Consequently, the Department regards the members, including the Taxpayer, as having the attributes and conducting the activities of VALLC. Because this election was made at the discretion of the members of VALLC, the Department's imposition of tax on VALLC's income on the returns of its members is not prohibited by the Commerce Clause.
Allocation
The Taxpayer further contends that his relationship as a passive investor with VALLC precludes taxation of the VALLC income, and an analysis of his relationship with VALLC is required. The Taxpayer contends that the United States Supreme Court noted that a state may tax certain income of a nondomiciliary, even though the business is not unitary, where the income at issue bears an operational relationship to the taxpayer's in-state activities. See Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992). To that end, the Taxpayer argues that his business activities were not related in any way to VALLC's business activities and that the distribution received pursuant to the settlement represented nothing more than a return on investment in VALLC.
The Taxpayer held a membership interest in VALLC. The lawsuit filed by VALLC, which resulted in the income whose source is at issue, was filed as a result of activities by another company with respect to one of VALLC's primary products.
The question as to the relationship and function of the Taxpayer's interest in VALLC is irrelevant to this case. The members made the election to have the income of VALLC passed through to the members for income tax purposes. As stated earlier, under federal law, to which Virginia conforms, the character of the income will not change when passed through to a taxable entity or individual.
Clearly, VALLC had a functional interest in the lawsuit for patent infringement on a product it had developed. In fact, it is likely that VALLC's viability as a going concern would have been significantly impaired if the lawsuit were not successful. Accordingly, the proceeds from the lawsuit were properly included in the ordinary income of VALLC.
Furthermore, without any evidence that VALLC was subject to income tax in any other state, including State B, Virginia is well within its authority to impose tax on the income of VALLC. If, in fact, VALLC had elected to be treated as a corporation, there would be no question as to whether Virginia could impose tax on VALLC's income. The result is no different just because an election was made to pass the income through to its members. As such, pursuant to Va. Code § 58.1-325, I find it appropriate to include all of VALLC's income as income from Virginia sources in determining the Taxpayer's nonresident income tax liability for the 2002 taxable year.
CONCLUSION
Income, properly excludible from federal adjusted gross income on the Taxpayer's nonresident federal income tax return pursuant to the Treaty will be exempt from Virginia income taxation. The income distributed from VALLC, however, is income from Virginia sources and subject to income taxation by Virginia.
Accordingly, the Taxpayer is required to file a taxable year 2002 Virginia nonresident individual income tax return, reporting his total federal adjusted gross income the same as any other nonresident. A copy of the Taxpayer's federal income tax return, as filed with the Internal Revenue Service, must be attached to the Virginia tax return.
The assessment issued for the taxable year ending 2002 is upheld pending the filing of a Virginia nonresident return. Upon receipt of the return, the Department will make necessary adjustments to the assessments.
Please submit the 2002 Virginia nonresident return and all attachments, along with the appropriate payment to: *****, Virginia Department of Taxation, Office of Policy and Administration, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261-7203.
If the 2002 income tax return is not filed within 30 days from the date of this letter, the assessment will be upheld as issued. In that event, an updated bill with interest accrued to date will be mailed to the Taxpayer and collection action will resume.
The Code of Virginia sections and public document cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. The 2002 Virginia nonresident individual income tax forms are also available for download. If you have any questions about this determination, you may contact ***** at *****.
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- Sincerely,
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- Janie E. Bowen
Tax Commissioner
- Janie E. Bowen
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AR/57000E
Rulings of the Tax Commissioner