May 12, 2015
Re: § 58.1-1821 Application: Individual Income Tax
Dear *****:
This will respond to your letter in which you seek correction of the individual income tax assessments issued to ***** (the "Taxpayers") for the taxable years ended December 31, 2011 through 2013. I apologize for the delay in responding to your appeal.
FACTS
The Taxpayers, a husband and wife, were Virginia residents during the taxable years at issue. The husband was employed by a Kansas municipality from 1974 through 1999. During his employment, the municipality made contributions on his behalf to the Kansas Public Employees Retirement System (KPERS). When he retired in 1999, he began receiving a pension in the form of annuity payments. On their 2011 through 2013 income tax returns, the Taxpayers claimed subtractions for the full amount of the pension payments.
Under review, the Department disallowed the subtractions and issued assessments. The Taxpayers filed an appeal, contending that they should be permitted to exclude the entire amount of the pension payments from the computation of Virginia taxable income because all of the husband's contributions had been taxable in Kansas.
DETERMINATION
It is well established that a state may tax all the income of its residents, even income earned outside the taxing jurisdiction. In People of State of New York ex rel. Cohn v. Graves, 300 U.S. 308 (1937), the United States Supreme Court explained "[t]hat the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event is universally recognized." Accordingly, Virginia is well within its authority to impose its income tax on all of the income of a resident of the Commonwealth of Virginia.
Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia "conforms" to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322. Virginia Code § 58.1-322 C 19 provides a subtraction for:
any income received during the taxable year derived from a qualified pension, profit-sharing, or stock bonus plan as described by § 401 of the Internal Revenue Code, an individual retirement account or annuity established under § 408 of the Internal Revenue Code, a deferred compensation plan as defined by § 457 of the Internal Revenue Code, or any federal government retirement program, the contributions to which were deductible from the taxpayer's federal adjusted gross income, but only to the extent the contributions to such plan or program were subject to taxation under the income tax in another state.
Effective July 1, 1984, Kansas required employers participating in KPERS to pay the contributions that were otherwise payable by employees. See K.S.A. § 79-4914 (2)(a). The statute designated the contributions as employer contributions under IRC § 414(h)(2), which were excluded from employees' income. See Rev. Rul. 77-462, 1977 C.B. 358. It appears, however, that contributions prior to July 1, 1984, were not classified as employer contributions and thus were not excluded from FAGI. Information obtained from KPERS confirms that contributions made prior to July 1, 1984, were not excluded from income subject to federal income tax.
When taxpayers have previously paid federal income tax on contributions to a pension plan, a portion of the pension payments they later receive is excluded from FAGI pursuant to the pro-rata basis recovery rule under IRC § 72. Because Virginia begins its computation of Virginia taxable income with FAGI, therefore, that portion is also not subject to Virginia income tax. As such, the retirement income subtraction under Va. Code § 58.1-332 C 19 does not apply to contributions that were previously subject to federal income tax, regardless of whether those contributions were previously taxed in another state. Otherwise, taxpayers would receive a double benefit if they were allowed to subtract an amount that is already excluded from income. In this case, therefore, the subtraction does not apply to the husband's contributions prior to July 1, 1984.
Contributions made to KPERS after July 1, 1984, were excluded from FAGI, but were not excluded from income under Kansas law. Because these contributions were included in the husband's income, the Taxpayers would be eligible to subtract the pension payments to the extent these contributions were subject to tax in Kansas.
By reason of their character as legislative grants, statutes relating to deductions and subtractions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell's Motor Freight, Inc., et al. v. Virginia Department of Taxation, Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983).
The complexity of calculating the portion of a retirement plan distribution attributable to previously taxed income was recognized by the Department and communicated to the General Assembly when enacted by House Bill 875 (Chapter 624, Acts of Assembly) in 1996. Because Virginia "conforms" to federal law and starts the computation of Virginia taxable income with FAGI, the Department will generally look to Internal Revenue Service (IRS) treatment of like or similar items of income. In Public Document (P.D.) 10-214 (9/15/2010), the Department ruled that the pro-rata basis recovery rule under IRC § 72 is applied to determine the nontaxable return of basis applicable to distributions from annuities, endowments and life insurance contracts. Under this method, the portion of an annuity payment that represents the nontaxable return of basis is determined by applying a ratio equal to a taxpayer's total investment in the contract divided by the total expected payments over the term of such contract. The Internal Revenue Service (IRS) applies a similar rule to distributions from an individual retirement account (IRA). See IRS Notice 87-16, 1987-1 CB 446.
In this case, KPERS invested the participants' contributions so it could meet its future pension obligations. Upon retirement, the husband was entitled to receive an annuity paid in monthly installments for the rest of his life. In addition, the total amount of payments he could receive was not limited to the total amount of contributions he made. Rather, the cumulative amount of such payments, after a certain amount of time had passed, would eventually exceed the total amount of his contributions, and such payments would continue as long as he lived. Under these circumstances, the issue becomes what portion of the distributions would be considered contributions and thus a nontaxable return of basis and what amount would be considered income.
Depending on the type of plan and the annuity starting date, the portion of a pension or annuity that represents the nontaxable return of basis is determined by applying either the "general rule" or the "simplified method." See IRC § 72(b) and § 72(d), respectively. Taxpayers must use the general rule if they receive payments from (1) nonqualified plans; (2) qualified plans if the annuity starting date was before November 19, 1996, or (3) qualified plans if the annuity starting date was after November 18, 1996, the taxpayer was over the age of 75 and the annuity payments were guaranteed at least five years. Taxpayers who are not required to use the general rule must use the simplified method. In this case, the husband received payments from a qualified plan, the annuity starting date was after November 19, 1996, and it does not appear that he was over 75 on the starting date or that the payments were guaranteed at least five years. Accordingly, the Taxpayers must use the simplified method.
The simplified method is currently explained in detail in IRS Publication 575. In order to perform the calculation, a taxpayer must know the amount he contributed to the plan. This amount is divided by the expected number of monthly payments over the course of the individual's life (according to the tables provided in the Publication) to determine the amount of each month's payment that is a nontaxable return of basis. This figure must be multiplied by twelve to determine the nontaxable amount for the year, then subtracted from the total amount of payments to determine that year's taxable amount. When performing the calculation for the following year, the amount of contributions must be reduced by the nontaxable amount from the previous year. The amount of contributions would then be reduced again in each succeeding year by the nontaxable amount from the prior year until the contribution amount is reduced to zero. From that time forward, payments would be fully taxable.
For purposes of determining the retirement income subtraction, the amount contributed to the plan would be limited to the amount contributed to the plan that was excluded from FAGI but subject to income tax in Kansas. As explained above, this amount would be limited to contributions made to KPERS after July 1, 1984. The nontaxable amount computed would be the amount the Taxpayers could subtract.
Under the provisions of Va. Code § 58.1-205 any proceeding relating to the interpretation of the tax laws of Virginia, an "assessment of a tax by the Department shall be deemed prima facie correct." As such, the burden of proof is on the Taxpayers to show they were not subject to income tax in Virginia. Accordingly, a taxpayer must provide sufficient documentation showing the balance of previously taxed contributions and the total amount of the annual payments. Such documentation may include, but is not limited to, paystubs detailing contribution amounts, tax returns filed in the state where the contributions were made and tax reporting documents from the agency responsible for paying the annuity.
The Taxpayers have provided Kansas income tax returns for several years showing the amount of contributions that were subject to income tax there. The Taxpayers have also provided evidence showing what the husband's contributions were for three previous years. In light of the Taxpayers' demonstrated pattern of filing returns in Kansas and paying tax on the contributions, the Department will accept proof of the contribution amounts for the previous years as sufficient evidence that such contributions were also subject to Kansas income tax. The Taxpayers, however, have been unable to provide sufficient documentation for the remaining years. The amount of contributions shown to be taxed in Kansas after July 1, 1984, is shown on the enclosed schedule.
The case will be returned to the audit staff to compute the Taxpayers' subtractions under Va. Code § 58.1-322 C 19 in accordance with the methodology outlined in this determination. Once the amounts of the subtractions are determined, revised assessments will be issued to the Taxpayers, which will include accrued interest. The Taxpayers should remit payment within 30 days of that bill date to avoid the accrual of additional interest. The remaining amount of contributions that were preciously taxed in Kansas, if any, may be subtracted in later taxable years according to the methodology described above.
The Code of Virginia sections and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions 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 *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/1-5779554079.M