August 15, 2019
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 ***** (the “Taxpayers”) for the taxable year ended December 31, 2017.
FACTS
The Taxpayers, a husband and wife, filed a Virginia individual income tax return for the 2017 taxable year, claiming a subtraction for qualified research expenses of an S corporation, of which the husband is a shareholder. Under audit, the Department disallowed the subtraction and adjusted the return. The Taxpayer’s appeal, contending the subtraction was valid.
DETERMINATION
Virginia’s conformity to federal income tax law is set forth in Virginia Code § 58.1-301, which provides that terms used in the Virginia income tax statutes will have the same meaning as used in the Internal Revenue Code (IRC). Further, conformity does not extend to terms, concepts, or principles specifically provided for in Title 58.1 of the Code of Virginia. 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 IRC.
In following federal tax policy with respect to S corporations, Virginia Code § 58.1-401 provides that such corporations are not subject to income tax in Virginia. Thus, Virginia has elected to treat S corporations in substantially the same manner as has the Internal Revenue Service (IRS), i.e., the corporate entity itself is not subject to taxation, but the shareholders will be taxed as individuals on their pro rata share of S corporation income to the extent includable in FAGI. See Title 23 of the Virginia Administrative Code (VAC) 10-120-90 E, Public Document (P.D.) 88-168 (6/29/1988), P.D. 07-99 (6/27/2007) and P.D. 18-201 (12/7/2018). As such, the S corporations’ items of income, gain, loss, deduction and credit flow through to its shareholders.
Under IRC § 41, a credit is permitted for a percentage of certain research expenses that include “qualified research expenses” and “basic research expenses”. Pursuant to IRC § 280 C (c), however, a taxpayer cannot then claim a deduction for those certain research expenses equal to the credit claimed under IRC § 41(a).
Virginia does not allow a taxpayer to claim a subtraction for expenses offset by a credit at the federal level unless allowed by statute. See P.D. 91-59 (3/29/1991), P.D. 94-164 (5/25/1994) and P.D. 16-34 (3/23/2016). Individuals are permitted to subtract the amount of qualified research expense eligible for deduction for federal purposes, but which were not deducted, on account of the provisions of IRC § 280 C (c) and which are available to shareholders of S corporations to the extent and in the same manner as other deduction may pass through to such shareholders. See Virginia Code § 58.1-322.02 10 and P.D. 18-201.
The evidence shows that the husband is a shareholder of the S corporation, and the S corporation claimed a credit for qualified research. Because of the S corporation’s nature as a pass-through entity, a subtraction for the qualified research expenses proportional to the husband’s ownership was available. Consistent with the information on the corporate return, the Taxpayers’ individual Virginia income tax return subtracted the husband’s proportional share of the total expenses of research activities claimed on the S corporations return. Pursuant to Virginia Code § 58.1- 322.02 10, the Taxpayer is entitled to this subtraction. Accordingly, the adjustment is reversed and a refund will be issued as warranted.
The Code of Virginia sections, regulation, and public documents 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/1969.A