February 18, 2020
Re: § 58.1-1821 Application: Individual Income Tax
Dear *****:
This will reply to your letter in which you seek the correction of the individual income tax assessments issued to ***** (the “Taxpayer”), for the taxable years ended December 31, 2016 and 2017.
FACTS
The Taxpayer, through several trusts, was a shareholder in ***** (VASC), a Virginia subchapter S corporation. She did not materially participate in the VASC’s operations.
In 2016, the VASC had a large capital expenditure resulting in it claiming bonus depreciation. It reported a net operating loss (NOL), a component of which was bonus depreciation. The VASC’s NOL passed through to the Taxpayer in her proportional share. The loss could not be used because the NOL was deemed a passive activity for federal income tax purposes and the Taxpayer did not have passive income.
The Taxpayer made a fixed-date conformity addition for the bonus depreciation on her Virginia individual return because Virginia disallows the federal bonus depreciation deduction. She then claimed a fixed-date conformity subtraction attributable to the suspended passive loss to offset the addition. On audit, the Department disallowed the subtraction and issued an assessment. Because the Taxpayer had applied her reported refund for the 2016 taxable year to her 2017 Virginia income tax liability, an assessment was issued for the 2017 taxable year.
The Taxpayer appeals the assessments, contending that she should be allowed to claim a subtraction to offset the fixed-date conformity addition because she was unable to claim a deduction for bonus depreciation on her federal returns.
DETERMINATION
Virginia’s conformity to federal income tax law is set forth in Virginia 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 (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.) 88-165 (6/29/1988) and P.D. 07-99 (6/27/2007). As such, the VASC’s items of income, gain, loss, deduction and credit flow through to its shareholders. Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, and income properly excluded from FAGI is not subject to taxation, unless it is specifically subject to a Virginia modification pursuant to Virginia Code § 58.1-322.01 through § 58.1-322.04.
Generally, a taxpayer may deduct losses from passive activities only from passive activity income. For federal income tax purposes, passive activities include those where the taxpayer doesn’t materially participate in the business, and any rental property activity, whether or not the taxpayer materially participates. Excess passive losses for a taxable year can be carried over to later years and applied against passive activity income. See IRC § 469.
The computation of a passive activity loss has been complicated by exceptions to the IRC terminology and references enacted under Virginia Code § 58.1-301 B. In 2003, Virginia began conforming to the IRC as of a specific or fixed-date. Since then the General Assembly has enacted legislation to move the fixed-date forward each year. Effective for taxable years beginning on and after January 1, 2016, Virginia’s fixed-date of conformity was advanced from December 31, 2016, to December 31, 2017, with limited exceptions. See Virginia Tax Bulletin (VTB) 17-1 (2/6/2017). For the 2016 taxable year, Virginia disallowed federal deductions: (1) for bonus depreciation allowed for certain assets under IRC §§ 168(k), 168(l), 168(m), 1400L, and 1400N; (2) related to applicable high yield discount obligations under IRC § 163(e)(5)(F); or (3) related to cancellation of debt income realized in connection with a reacquisition of business debt at a discount after December 31, 2008, and before January 1, 2011 pursuant to IRC § 108(i) (individuals recognizing income during the 2014 through 2018 taxable years as a result of the federal deferral are permitted a fixed-date conformity subtraction on their corresponding Virginia return). In addition, Virginia does not conform to the five-year carry-back allowed under IRC § 172(b)(1)(H).
Taxpayers who claimed one or more of these fixed date conformity items, such as the bonus depreciation allowance, on their federal returns are required to recompute their FAGI for Virginia purposes as if none of the bonus depreciation or other fixed date conformity items had been enacted. See P.D. 09-104 (6/24/2009). The difference between the recomputed FAGI and the actual amount shown on the federal return is reported as a fixed date addition or subtraction on the taxpayer’s Virginia return.
Fixed-date conformity additions and subtractions are not considered to be Virginia modifications. Rather, these exceptions adjust reported FAGI to a recomputed, or deemed FAGI for Virginia income tax purposes. This can also affect Virginia modifications that are required only to the extent that they are included or excluded from FAGI.
In this case, the Taxpayer’s bonus depreciation deduction was a component of a passive activity loss that was suspended on her federal return. Therefore, both the passive loss and the bonus depreciation included in it were, to the extent they were suspended, not included in FAGI reported on the federal return. According to the federal return, the passive activity loss exceeded the amount of bonus depreciation. The Taxpayer reported the bonus depreciation and passive loss subtraction as two different modifications on her 2016 Virginia return.
The federal rules for the recognition of passive activity income and losses can be complicated. While income is recognized immediately, losses can be carried forward for many years until income is generated to offset them. As indicated above, Virginia’s limited conformity to federal law can add considerable additional complications. For example, a taxpayer may have incurred a passive activity loss for federal income tax purposes, but the lack of recognition of federal depreciation rules by Virginia would reduce and could completely eliminate a loss reported on a federal return. Thus, a taxpayer must be cautious and compute the income or loss resulting from passive activities before they prepare their Virginia returns.
The computation of the allowable income or loss for Virginia purposes would start with the amount reported on the Federal Form 8582 and then adding or subtracting the appropriate fixed date conformity amounts. In some cases, a federal passive activity loss could become passive income for Virginia purposes. The amount of the income would be reported as a fixed date conformity addition.
Conversely, fixed date adjustments to depreciation could turn federal passive activity income into a passive loss for Virginia income tax purposes. Under this scenario, a taxpayer would report a fixed date conformity subtraction to eliminate the amount of passive activity income included on the federal return, but any remaining loss in excess of the income would be carried forward as provided by the IRC.
Essentially, a taxpayer engaging in passive activities will have to keep two sets of records for tax purposes. One for the IRS and one for the Department. Additional complications could arise should the taxpayer be deemed to be materially participating in an activity previously considered to be passive. Taxpayers are advised to attach a revised Form 8582 and computation schedule to their returns to report fixed date conformity adjustments from passive activities.
In this case, the 2016 bonus depreciation adjustment does not eliminate the loss. Under these circumstances, the passive activity loss would offset the fixed date conformity addition for bonus depreciation. Thus, no fixed date addition or subtraction was required. However, the amount of the passive activity loss that can be carried forward to future taxable years would be reduced by the bonus depreciation.
CONCLUSION
Based on the foregoing, it is recommended that the Taxpayer file amended returns for the 2016 and 2017 taxable years reflecting the methodology of reporting passive activity loses as provided in this determination. If the Taxpayer does not file a revised Form 8582 and the requested amended return, the 2016 and 2017 returns will be adjusted based on the information available. In addition, revised Form 8582 and separate schedules should be attached to future returns that track the percentage of the passive activity loss absorbed, the percentage of the passive activity loss absorbed that is a component of bonus depreciation, and the bonus depreciation subtractions.
In subsequent taxable years the Taxpayer’s federal passive activity income may decrease as a result of Virginia’s divergence from federal bonus depreciation deductions. This will result because VASC will claim depreciation in subsequent taxable years on asset purchases that were granted a full or almost full deduction in 2016. However, the Taxpayer will also have less passive activity loss from 2016 to be absorbed by income in future taxable years because it will be reduced by the fixed date conformity depreciation addition.
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 Department’s Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/2046.B