August 9, 2023
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, 2020, and December 31, 2021.
FACTS
The Taxpayers filed Virginia resident individual income tax returns for the 2020 and 2021 taxable years, claiming subtractions for distributions taken from retirement accounts and, in 2021, for capital gains from the sale of land and timber located in North Carolina. Under audit, the Department disallowed the subtractions and issued assessments. The Taxpayers appeal, contending that their retirement distributions are not subject to state taxation pursuant to a settlement (the “Bailey Settlement” ) resulted from the North Carolina Supreme Court’s decision in Bailey v. North Carolina, 500 S.E.2d 54, 348 N.C. 130 (1998) (Bailey). The Taxpayers further assert that the gain from the sale of the land and timber in 2021 should be subtracted because it was taxed in North Carolina.
DETERMINATION
Taxation of Residents
Virginia Code § 58.1-301 provides, with certain exceptions, that the 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 (VTI) 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 Chapter 3 of Title 58.1 of the Code of Virginia.
It is well established that a state may tax all the income of its residents, even income earned outside the taxing jurisdiction. In New York ex rel. Cohn v. Graves, 300 U.S. 308, 312-313, 57 S. Ct. 466, 467 (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.”
Retirement Subtraction
The Taxpayers believe that their retirement distributions were not subject to tax in Virginia because the Bailey Settlement provided that retirement distributions to certain North Carolina state and local government retirees would not be subject to tax in North Carolina. The Taxpayers contend that the Bailey Settlement provided that distributions would not be taxed by the state because the contributions were taxed by North Carolina when they were made. They believe that, if Virginia were allowed to tax the distributions, they would be subject to double taxation.
The Bailey Settlement resulted from a decision by the North Carolina Supreme Court prohibiting the state from imposing income tax on the retirement benefits of certain vested North Carolina state employees. See Bailey. The case was filed after North Carolina made the decision to cap its state income tax exemption for state employee retirement income in response to the United States Supreme Court decision in Davis v. Mich. Dep’t of Treasury, 489 U.S. 803, 109 S.Ct. 1500 (1989). In Davis, the court determined that such exemptions violated a federal statute that prohibited tax discrimination based on the federal source of pay because they did not provide similar state tax exemptions for federal employee retirement benefits. The decision in Bailey, and the subsequent Bailey Settlement, were based on the North Carolina court’s determination that there was a contractual agreement between the state and the employees that such distributions would not be subject to North Carolina state income tax.
The Department has carefully reviewed the decision in Bailey and has found no indication that the North Carolina Supreme Court considered the issue of double taxation based on the employees’ contributions having been taxed by the state when contributed. See also NCDOR Directive PD-99-1 (3/4/1999). Regardless, the Bailey Settlement is limited to state retirement income subject to North Carolina’s tax and has no applicability as to whether the Taxpayers’ retirement benefits were taxable in Virginia. See also Public Document (P.D.) 04-57 (8/18/2004).
As stated above, 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 Chapter 3 of Title 58.1 of the Code of Virginia. Pursuant to Virginia Code § 58.1-322.02 11, Virginia residents may subtract from FAGI certain retirement distributions to the extent of contributions that, at the time of contribution, were not subject to tax at the federal level, but were subject to tax by the state. There is no evidence that the Taxpayers’ contributions were subject to North Carolina income tax, but not federal income tax, at the time of contribution.
In addition, based on the federal and state tax laws that existed at the time the Taxpayers made retirement contributions, it is likely that some of those contributions were not deductible for federal or state income tax purposes. If any of the contributions were made with after-tax dollars, then a portion of the distributions would have been excluded from federal taxable income as a return of contribution. This is evident from the Taxpayers’ Forms 1099-R, which show taxable distributions that are less than the gross distributions. To the extent any part of a distribution was so excluded, it would not have been eligible for a Virginia subtraction because it would not have been included in FAGI. Subtracting them on the Virginia return would result in a double benefit because the same amount would be subtracted in determining FAGI and then again when determining VTI. See P.D. 18-100 (5/22/2018).
Capital Gain Subtraction
In determining their VTI for the 2021 taxable year, the Taxpayers subtracted capital gains attributable to sales of land and timber in North Carolina. Virginia law allows a subtraction for capital gains attributable to certain investments in technology businesses. See Virginia Code § 58.1-322.02 24. Capital gains from the sale of real property such as that described by the Taxpayers are not eligible for this subtraction. See P.D. 15-53 (4/3/2015).
Credit for Tax Paid to Another State
The Taxpayers contend that, by denying the claimed subtractions, the Department is not allowing them to take credit for taxes paid to North Carolina. Instead of providing a subtraction, however, Virginia provides a direct credit for tax paid to another state.
Virginia Code § 58.1-332 A allows Virginia residents a credit on their Virginia return for income taxes paid to another state provided the income is either earned or business income or gain from the sale of a capital asset. Virginia law does not necessarily allow a taxpayer to claim a credit for the total amount of tax paid to another state. Rather, the credit is limited to the lesser of the amount of tax actually paid to the other state or the amount of Virginia income tax actually imposed on the taxpayer on the income earned or derived in the other state. See P.D. 97-301 (7/7/1997). The limitation is computed by multiplying the individual’s Virginia tax liability by a fraction, the numerator of which is the income upon which the other state’s tax is imposed, and the denominator of which is Virginia taxable income.
Under the circumstances in this case, the credit is only allowable if the Taxpayers actually paid tax to North Carolina. Because no tax was paid to North Carolina on their retirement distributions, they are not entitled to a credit based on such distributions. For the 2021 taxable year, the Taxpayers’ North Carolina return indicates that they paid income tax to North Carolina attributable to the sale of land and timber located in that state. This tax may be eligible for the credit. In order to get credit for tax paid to North Carolina, however, the Taxpayers would be required to complete and attach a Virginia Schedule OSC to an amended Virginia income tax return.
CONCLUSION
To the extent included in FAGI, retirement income and capital gains received by an actual or domiciliary resident of Virginia would be included in the computation of VTI, unless specifically exempted as a Virginia modification pursuant to Chapter 3 of Title 58.1 of the Code of Virginia. In this case, no evidence has been presented to show that the Taxpayers qualified for a subtraction of any portion of their retirement distributions or capital gains.
Because the Taxpayers were residents of Virginia for the 2020 and 2021 taxable years, they were subject to tax on their entire VTI. Their retirement distributions and capital gains were properly included in their VTI and were not eligible for any subtraction. Based on the foregoing, the Taxpayers’ request for relief cannot be granted and the assessments are upheld. A review of the Department’s records show that the assessments have been paid in full and no further action is required.
As discussed above, the Taxpayers may be eligible for a credit on their 2021 Virginia return for tax paid to North Carolina on the gain from the sale of land and timber there. The Taxpayers may submit a 2021 amended return, including Virginia Schedule OSC, within the statute of limitations for a refund. See Virginia Code § 58.1-1823. Should the Taxpayers choose to file an amended return, they should also include a copy of this determination letter.
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 determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/4468.X