April 21, 2015
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 "Taxpayers") for the taxable years ended December 31, 2011 and 2012.
FACTS
The Taxpayers, a husband and wife, were residents of Delaware from 1977 through 1995. The husband was employed by an agency of the federal government from 1976 until he retired in 2002. During his employment, the husband made contributions to the Civil Service Retirement System (CSRS). The contributions were included in federal adjusted gross income (FAGI). Upon retirement, the husband began receiving pension payments from CSRS, in the form of an annuity payable in monthly installments. The Taxpayers claimed subtractions on their 2011 and 2012 Virginia income tax returns for the full amount of the retirement distributions.
Under review, the Department disallowed the subtractions and issued assessments. The Taxpayers appealed, contending that they should be permitted to subtract the entire amount of the payments because they paid both federal and Delaware income tax on the contributions to CSRS.
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 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.
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).
In addition, 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 Taxpayer to show that the Department's assessment based on the disallowance of the subtraction is erroneous.
Before taxpayers may subtract any portion of their retirement income under Va. Code § 58.1-322 C 19, contributions to the retirement plan must satisfy a two-part test: (1) they must have been deductible for federal income tax purposes; and (2) they must still have been subject to income tax in another state. When taxpayers have previously paid 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, income excluded from FAGI under IRC § 72 would also be excluded from Virginia taxable income. Thus, the retirement income subtraction is not allowed for contributions that were previously subject to federal income tax, regardless of whether those contributions were previously taxed in another state. Without the limitation for contributions previously subject to federal tax, the subtraction would allow for the possibility of a double benefit by allowing individuals to subtract income already excluded from FAGI.
If the contributions to a pension plan were initially deductible for federal income tax purposes, however, the pension distributions would generally be included in FAGI and flow through to the Virginia return. If another state had required that the contributions be included in its taxable income even though they were excluded from FAGI, the retirement income subtraction can reduce the possibility of the income being taxed for state purposes both at the time of contribution and distribution. The subtraction provided under Va. Code § 58.1-322 C 19, however, does not include pension contributions included in FAGI and income earned on contributions. The Department has previously ruled that the pro-rata basis recovery rule under IRC § 72 is also used to determine the portion of retirement income that represents the nontaxable return of basis attributable to contributions previously taxed in another state. See Public Document (P.D.) 10-214 (9/15/2010).
In this case, the Taxpayers contend that they were eligible to subtract the entire amount of the pension payments because the contributions were previously subject to both federal and Delaware income tax. The information provided indicates that the husband's contributions to CSRS were, in fact, taxable for federal income tax purposes. In addition, because Delaware, like Virginia, starts the computation of Delaware taxable income with FAGI, it appears that the contributions would have also been subject to income tax in Delaware.
Because the retirement income subtraction in Va. Code § 58.1-322 C 19 does not apply to contributions previously subject to federal income tax, the Taxpayers were not eligible to claim the subtraction, regardless of whether they paid income tax on the contributions in Delaware. Accordingly, the assessments for the 2011 and 2012 taxable years are upheld. Revised bills, with accrued interest to date, will be issued shortly. The Taxpayers should remit payment within 30 days of the bill date to avoid the accrual of additional interest.
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/1-5888720797.M