Document Number
21-84
Tax Type
Individual Income Tax
Description
Subtraction : Long-Term Capital Gain - Eligible Investment
Topic
Appeals
Date Issued
07-13-2021

July 13, 2021

Re:  § 58.1-1821 Appeal: Individual Income Tax

Dear *****: 

This will respond 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, 2014. I apologize for the delay in the Department’s response.

FACTS

The Taxpayers, a husband and wife, co-founded ***** (VALLC) in 2007, then converted VALLC into ***** (VACP) in 2014. The Taxpayers sold shares of VACP later in 2014, and reported the income from the sale as a long-term capital gain on their federal return. The Virginia Secretary of Technology issued VACP a Letter of Certification, verifying that it was a “qualified business” for purposes of Virginia’s long-term capital gain subtraction. 

The Taxpayers filed a Virginia individual income tax return for the 2014 taxable year, claiming a long-term capital gain subtraction for the income they received from the sale of VACP stock. Under review, the Department denied the subtraction because the investment that created the capital gain was not a qualified investment. The Taxpayers appealed, contending that they met all the statutory requirements to claim the subtraction.

DETERMINATION

Virginia Code § 58.1-301 provides, with certain exceptions, 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. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia.  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 properly 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 Virginia Code §§ 58.1-322.01 through 58.1-322.04. 

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 Dep’t of Taxation, Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983). 

For individual income tax purposes, Virginia Code § 58.1-322.02 24 provides for a subtraction for any income taxed as a long-term capital gain for federal income tax purposes. The following restrictions apply: 

To qualify for a subtraction . . . , such income shall be attributable to an investment in a “qualified business,” as defined in 58.1- 339.4, or in any other technology business approved by the Secretary of Technology, provided that the business has its principal office or facility in the Commonwealth and less than $3 million in annual revenues in the fiscal year prior to the investment. To qualify for a subtraction . . . , the investment shall be made between the dates of April 1, 2010, and June 30, 2020. No taxpayer who has claimed a tax credit for an investment in a “qualified business” under 58.1-339.4 shall be eligible for the subtraction under this subdivision for an investment in the same business. 

By using the term “investment” and referring to the eligibility criteria found in Virginia Code § 58.1-339.4, it appears that the General Assembly intended for only equity and subordinated debt investments to be eligible for the subtraction. That is because Virginia Code § 58.1-339.4 pertains to the Qualified Equity and Subordinated Debt Tax Credit, for which only equity and subordinated debt investments in technology businesses are eligible. Virginia Code § 58.1-322.02 24 provides that if a taxpayer has already claimed the credit, he is not eligible to claim the subtraction. Thus, the overall statutory scheme involves the same types of investments, either equity or subordinated debt. See Public Document (P.D.) 16-83 (5/16/2016) and P.D. 16-181 (9/6/2016). Based on the Department’s understanding of the General Assembly’s intent, investments must be a direct transfer of cash or other property with a determinable monetary value to a qualified business in exchange for equity or subordinated debt.

It is not necessary, however, for investments to meet all the requirements of a “qualified investment” under Virginia Code § 58.1-339.4. See P.D. 18-131 (6/27/2018). The Department has also reiterated that the statutory restrictions must be satisfied at the time the investment is made rather than when the income is realized. See P.D. 17-108 (6/21/2017).

Equity is defined as “common stock or preferred stock, regardless of class or series, of a corporation; a partnership interest in a limited partnership; or a membership interest in a limited liability company, which is not required or subject to an option on the part of the taxpayer to be redeemed by the issuer within three years from the date of issuance.”  See Virginia Code § 58.1-339.4 A. 

When an individual or entity invests in stock of a corporation, they receive a stock certificate equal to the value of the investment. Matching cash payments to stock certificate dates makes tracking the amount and time of investments for purposes of the subtractions reasonably straight forward.

For pass through entities such as LLCs and partnerships, the determination of contribution values and dates is much more complicated. When an LLC is formed, an owner (called a “member”) or owners make a capital contribution or an investment into the business to get it started. Member contributions can include payments of cash or assignments of non-cash resources (i.e. property, assumptions of liability or services). Non-cash capital is measured based on the fair market value of property. The value of services, however, is generally not recognized in an individual's capital account to avoid tax implications. 

Under Virginia Code § 13.1-1002, a “membership interest” is defined as a member’s share of the profits and the losses of the limited liability company and the right to receive distributions of the limited liabilities company’s assets. A member’s capital or equity can be reflected as a percentage, certificates or units. The membership interest or capital account percentages or units are kept separate from profit and loss allocations and distributions based on terms of the company’s operating agreement. Thus, a membership interest or equity percentage will generally remained unchanged as the capital account is adjusted. Because the issuance of new certificates or units can be readily identified as new investments, the Department cannot discriminate against a contribution made by a member to a capital account even if their ownership percentage does not change.

Unlike stock, however, for which the value remains static at the date of purchase, an LLC members capital or equity account into which the initial investment was made will be impacted by subsequent profits and losses of the business and distributions paid out to such member. This places additional demands on both the accounting system of the business and the record keeping of the member in order to accurately track the actual value of amounts invested during periods for which the long-term capital gain subtraction is permitted.

At the end of each fiscal year, a member’s share of the LLC’s profit or loss is reflected in their capital account. When a member takes a distribution, or draws from the LLC, a corresponding decrease is reported in their capital account. If an additional capital contribution is made, the amount is recorded as another investment in the member’s capital account. Thus, the amount and timing of a member’s equity or capital is constantly fluctuating. 

The issue of the timing of the investment is not an issue when all of the investments are made within the effective dates of the long-term gain subtraction. Under the current statute, the subtraction is limited to the gain on investments made in a qualified business between April 1, 2010, and June 30, 2020. See Virginia Code § 58.1-322.02 24. For a qualified business that was started prior to the effective date of the subtraction, however, the issue becomes determining the amount of the gain attributable to the investment made by a member during periods eligible for the subtraction. Any gain attributable to an investment made prior to April 1, 2010, would not be eligible for the subtraction. 

For purposes of determining the amount of the gain included in taxable income, the proceeds from the sale of membership interests would generally be netted against a member’s balance in their capital account. For purposes of the subtraction however, not all of the amounts included in a members capital account would be considered to be investments. Because an investment would include only monetarily valued contributions by a member, adjustments resulting from the profits and losses from ongoing operations and distributions correlated to those profits and losses would not be included in the amount of a member’s investment for purposes of determining how much of a gain is eligible for the subtraction. Thus, for purposes of the long term gain subtraction, a member’s investment would be limited to the net of the fair market value of their investments (contributions to capital) and any distributions not attributable to the earnings of the business (i.e. distributions in excess of current and retained earnings). It will be the member’s responsibility to maintain records of their net investments in a qualified business.

When a member has made investments in a qualified business on dates both prior to and during the eligibility period, a computation must be done to determine the portion of the gain eligible for the subtraction. The eligible portion of the gain would be the portion of the gain of attributable to net investments made during the eligibility period (currently April 1, 2010 through June 30, 2020). The statute is silent as to how to determine the amount of the eligible gain. If a taxpayer is able, they may provide evidence that clearly attributes gains to specific net investments. Absent such evidence, a taxpayer’s long-term gain eligible for the subtraction would be calculated by dividing their net investments made during the eligibility period by their total net investment and multiplying the resulting percentage with the total gain included in federal taxable income or FAGI. 

It may be is easiest to understand the computation of net investments and the amount of eligible gain by considering an example. An individual (H) forms APP, LLC (APP) in 2009 and contributes $100 to help start the business. APP reports net losses of $50 in both 2009 and 2010. In 2011, H invests another $100 and APP reports $10 profit. In early 2012, H takes a $20 distribution and sells APP for $1,000. At the time of the sale, H’s capital account has a balance of $90 (See Table 1) resulting in a gain of $910.

Table 1 - H’s Capital in App, LLC

 

Year

Contributions (Investments)

 

Distributions

Profits and Losses

 

Net Capital

2009

$100

 

($50)

 $50

2010

   $0

 

($50)

   $0

2011

$100

 

$10

$110

2012

 

$50

 

  $90

 

 

 

 

 

While the gain is based on total net capital, the eligible subtraction is based only on the portion of the net investment made during the eligibility period. First, H must determine his net investment. H’s total investment in APP was $200. However, because the distribution in 2012 exceeded current and retained earnings, a computation is required in order to determine how much, if any, H’s investment must be reduced. The distribution in 2012 ($20) exceeded the most current income of $10 in 2011 and exceeded the total prior retained earnings. Consequently, H received a return of his capital investment equal to $50 because his retained loss exceeds net income. Thus his net investment at the time of the sale of APP was $150.

H made a $100 investment in APP in 2009 prior to the eligibility period for the subtraction. Thus any gain attributable to this portion of the investment would not be eligible for the subtraction. H also made $100 investment in 2011 during the eligibility period, but also took a distribution that resulted in a $50 reduction in his investment. As a result of the excess distribution, H’s net investment during the eligibility period was $50. 

To determine the eligible portion of the gain, the total net gain would be multiplied by the percentage of the investment made investment during the eligibility period or $50 divided by $150 (33.33%). $910 multiplied by 33.33% would result in a subtraction of $303.33.

In this case, the Taxpayers earned income from the sale of VACP stock, and the income was taxed as a long-term capital gain for federal income tax purposes. In addition, VACP was certified by the Virginia Secretary of Technology as a “qualified business,” had its principle office or facility in Virginia, and earned less than $3 million in annual revenue in the fiscal year prior to investment. 

The Taxpayers assert that a majority of their investment was “sweat equity,” but that they did invest cash through capital contributions. The Taxpayers provided a capital contributions spreadsheet showing cash deposits made from 2007 through 2014, as well as balance sheets, profit and loss statements, and federal schedules K-1 from 2007 through 2014. At issue, therefore, is what portion of the gain was attributable to an equity or subordinated debt investment made after April 1, 2010.

Based on the information provided by the Taxpayers, the Department has recomputed the Taxpayers’ long-term gain in accordance with this determination. The attached schedule shows the computation of the eligible subtraction. The assessment will be returned to compliance staff to be adjusted in accordance with this schedule and an updated bill with accrued interest to date will be sent to the Taxpayers. The Taxpayers should remit payment of the balance within 30 days from the bill date to avoid the accrual of additional interest. 

The Code of Virginia sections 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 ruling, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.

Sincerely,

 

Craig M. Burns
Tax Commissioner

                    

AR/1609-C
 

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Last Updated 09/16/2021 13:50