Tax Type
Individual Income Tax
Description
Income from Virginia Sources
Topic
Appropriateness of Audit Methodology
Computation of Income
Computation of Tax
Taxable Income
Date Issued
05-13-2009
May 13, 2009
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 ***** (the "Taxpayer") for the taxable years ended December 31, 2005 through 2007.
FACTS
The Taxpayer, the sole owner of a Virginia C corporation (VC), moved from Virginia to ***** (State A) in 2004. After establishing domicile in State A, the Taxpayer formed a State A C corporation (AC) for the purpose of providing consulting services to VC.
During the taxable years at issue, VC issued dividends to the Taxpayer. In addition, the Taxpayer earned a salary from AC resulting from consulting services provided by VC. On his Virginia nonresident individual income tax returns for these taxable years, the Taxpayer attributed all of the dividends from VC and salary from AC to State A.
Under review, the Department's auditor stated that the consulting fees paid by VC to AC were not deductible. The auditor concluded that AC lacked economic substance, the transactions between AC and VC were not conducted at arm's length rates and they primarily served as a mechanism to shift income from Virginia to State A. To remedy this, the auditor attributed all of the salary earned by the Taxpayer from AC to Virginia in the nonresident apportionment factor.
In addition, the auditor found that the dividends paid by VC to be excessive because the dividends increased significantly from taxable years prior to those at issue. The auditor determined that the sole purpose for the increase was to avoid Virginia tax.
The Taxpayer contests the assessments, asserting that the dividends were issued out of accumulated earnings for federal tax purposes and did not reduce the Virginia tax liability of VC. In addition, the Taxpayer contends the consulting fees were legitimate fees paid to the AC for needed consulting services.
DETERMINATION
Improper Reflection of Income
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 for the purpose determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year.
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- 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.]
The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54 (1988) has 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 a transaction, or a party to a transaction, lacks economic substance.
Because Va. Code § 58.1-446 specifically addresses transactions between corporations, the Department has limited equitable adjustments to corporate income tax returns. Such adjustments have included adjusting the transaction amount to fair market value, disallowing deductions, and consolidating incomes of corporations involved in such arrangements. Attributing the salaries of employees of such corporations to Virginia does not satisfy the requirement of appropriately reflecting the Virginia income of the corporations at issue. Accordingly, I find no basis for the adjustment.
Income from Virginia Sources
During the course of the Department's review, the Taxpayer acknowledged he worked on behalf of AC in Virginia during the taxable years at issue. 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."
Typically, the factor that most equitably determines the apportionment of salaries and wages is the ratio of the number of days services were performed in Virginia to the number of days services were performed elsewhere. See Public Document (P.D.) 94219 (7/13/1994). The Department has previously ruled that a nonresident who works in Virginia may apportion his or her salary to Virginia using a ratio of (1) the number of days or portion thereof spent in Virginia performing duties for his or her employer, divided by (2) the number of days or portion thereof spent anywhere performing duties for his or her employer. See P.D. 85-134 (6/18/1985).
As a general rule, the Department uses 260 days in the denominator of the ratio for determining wages attributable to Virginia for full-time employees. Taxpayers who claim to have worked more than 260 days during a given taxable year must document that claim. Likewise, taxpayers who worked less than 260 days are limited to using days actually worked in the denominator of the ratio. For part-time employees, semi-retired individuals, and consultants, a ratio of hours worked in Virginia divided by hours worked anywhere may be a better indicator of income from Virginia sources.
For the 2005 through 2007 taxable years, the Taxpayer has provided sufficient documentation to ascertain the number of days he worked in Virginia. As such, the Taxpayer's salary from AC included in the nonresident apportionment factor has been adjusted to reflect the number of days that the Taxpayer worked in Virginia.
Dividends
The auditor found the Taxpayer's dividends from VC to be excessive and attributed the entire amount to Virginia in the nonresident apportionment formula. The Taxpayer argues that dividends are a passive income allocable to the state of domicile. Further, he claims the larger dividends were required in order to avoid the special tax on accumulated earnings under Internal Revenue Code (IRC) § 531.
Under Va. Code § 58.1-302, dividends are not considered Virginia source income to a nonresident individual unless they were derived from intangibles employed in a business, trade, profession or occupation carried on in Virginia. In the instant case, the Taxpayer received dividends from stock owned in VC. The evidence clearly shows this stock was not employed in a business, trade, profession or occupation carried on in Virginia. As such, the dividends issued by VC were not Virginia source income for the 2005 through 2007 taxable years.
CONCLUSION
Based on the foregoing, the audit will be returned to the audit staff to adjust the assessments as noted above. After the auditor makes the appropriate adjustments, the Taxpayer will receive a revised bill if there are any outstanding liabilities. The Taxpayer should remit his payment for the outstanding balance as shown on the revised bill within 30 days from the date of the bill to avoid the accrual of additional interest.
For future taxable years, the Taxpayer should document the time he worked in Virginia and elsewhere. Such documentation should be in the form of a log, calendar, or schedule providing sufficient details to determine which days the Taxpayer worked, the number of hours worked each day, and the number of days worked in Virginia. Given that the Taxpayer may not work a full day for AC, lack of substantiation could result in the Department reducing the number of days or hours worked, resulting in a higher nonresident apportionment percentage.
The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
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- Sincerely,
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- Janie E. Bowen
Tax Commissioner
- Janie E. Bowen
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AR/1-2942182611.B
Rulings of the Tax Commissioner