Tax Type
Individual Income Tax
Description
Taxes paid by residents to other states; S corporation shareholders
Topic
Credits
Date Issued
11-27-1996
November 27, 1996
Re: §58.1-1821 Application: Individual Income Tax
Dear**************
This will reply to your letter in which you contest the assessment of additional individual income tax against your clients, ******* the "Taxpayers") for the 1979 through 1990 taxable years.
FACTS
The Taxpayers, a husband and wife, were audited by the department. It was determined that the husband has been a resident of Virginia since 1979. Assessments were made on the husband's income for 1979 though 1981 and on the joint income of the Taxpayers for 1982 through 1990. Some of the assessments include income from qualified small business corporations (S corporations), which do business exclusively in Texas and Illinois.
You believe that the Taxpayers should be able to exclude the husband's distributive share of income from S corporations because the income did not come into Virginia and the S corporations have no nexus with Virginia.
DETERMINATION
You question the constitutionality of the department taxing income of a corporation derived from business done outside the Commonwealth. You have cited F. S. Royster Guano Co. v. Commonwealth of Virginia. 253 U.S. 412 (1920) and Commonwealth v. P. Lorillard Company. Inc.. 129 Va. 74 (1921). Both of these cases dealt with taxing in come of a corporation earned outside the Commonwealth. It is well established that Virginia is limited in taxing income of corporations by Public Law (P.L.) 86-272 (15 U.S.C.A. 381-384). However, this case does not involve taxing the income of a corporation, but the income of a domiciliary resident of Virginia.
In following federal tax policy with respect to S corporations, Code of Virginia §58.1-401 provides that such corporations are not subject to corporation income tax in Virginia. Thus, Virginia has elected to treat S corporations in substantially the same manner as has the federal government, 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 federal adjusted gross income (FAGI).
Code of Virginia §58.1-322(A) defines the taxable income of a resident individual as his FAGI, with certain additions, subtractions, and modifications. There is no specific Virginia adjustment for income of an S corporation earned outside the Commonwealth. To the extent that the distributive share of an S corporation's income is included in an individual's FAGI, it is included in an individual's Virginia taxable income.
It is the department's position that a Virginia resident shareholder of an S corporation which does not conduct 100% of its business within Virginia must include his entire pro rata share of the S corporation's income in his Virginia taxable income. Virginia Regulation (VR) 630-3-401 E, promulgated in January 1985, provides as follows:
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- Electing small business corporations which avail themselves of the election under Subchapter S of the Internal Revenue Code to have the income of the corporation included in the income of the shareholders are exempt from corporate income tax. All such income then becomes income taxable to the shareholder under laws and regulations applicable to individuals.... (Emphasis added.)
In this instance, the S corporations are both doing business exclusively outside of Virginia. You believe the Virginia Supreme Court's reasoning in Ryan v. Commonwealth of Virginia.169 Va. 414 (1937) is applicable to this case. In Ryan, the court reasoned that the analyses of the relevant case law ". . . shows that each turns upon the determination of the situs of property for taxation." The court did, in fact, affirm that situs is used to determine tax on property.
This being said, the court went on to differentiate between tax on property and tax on income. Income tax is not a tax on property, but a tax levied on the individual measured by the net income received by the individual. The court pointed to its case of Hunton v. Commonwealth. 166 Va. 229 (1936), in which the court held "the Virginia income tax is an excise tax and not a property tax: that is not a tax on the property from which the income was derived." (Emphasis added). Thus situs of the property from which the income is derived does not necessarily determine where the income will be taxed.
The court in Ryan determined that the Virginia income tax "is a tax levied upon Mrs. Ryan measured by the net income received and enjoyed" in the Commonwealth of Virginia and upheld the assessment of income tax against Mrs. Ryan. In Guaranty Trust Co. Of New York v. Commonwealth of Virginia. 305 U.S. 19 (1938), the United States Supreme Court upheld the judgement of the Virginia Supreme Court in Ryan.
In another United States Supreme Court case, People of the State New York ex rel.. Cohn v. Graves et. al.. 300 U.S. 308 (1937), the court held the net income tax may be applied to the taxable income of a resident at his place of domicile, not withstanding the fact that the property producing the income is located outside the state. The court stated "A state may tax its residents upon net income from a business whose physical assets, located wholly without the state, are beyond its taxing power." See also Lawrence et al. v. State Tax Commission of State of Mississippi. 286 U.S. 276 (1932) and Shaffer v. Carter. State Auditor. et al.. 252 U.S. 37 (1920). The court also asserted "It would be pressing the protection which the due process clause throws around the Taxpayers too far to say that because a state is prohibited from taxing land which it neither protects nor controls, it is likewise prohibited from taxing the receipt and command of income from the land by its resident, who is subject to its control and enjoys the benefits of its laws."
In this case, the Taxpayers received the income from the S corporations as a domiciliary resident of Virginia, and enjoyed and commanded the income by freely choosing to reinvest substantially all of the income back into the S corporations while a resident of Virginia. Accordingly, the department finds that the assessments must be upheld.
When a Virginia resident receives income that is subject to tax in another state, Code of Virginia §58.1-332 may allow the resident a credit against their Virginia income tax. A Virginia resident who is a shareholder of an S corporation that has paid income tax to another state may also be entitled to this credit. Code of Virginia §58.1-332(C) provides;
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- "the amount of any state income tax paid by an electing small business corporation (S corporation) shall be deemed to have been paid by its individual shareholders in proportion to their ownership of the stock of such corporation."
Consequently, the Taxpayers may be entitled to a credit for state income tax paid by the S corporations on their behalf. However, legislation enacted by the 1991 General Assembly (Chapters 362 and 456) of the 1991 Acts of Assembly expressly precludes individuals from claiming a credit for franchise and similar taxes paid to other states.
Texas imposes a tax on corporations, including S corporations, operating in the state. Because the Texas tax imposed on corporations is a franchise tax, the Taxpayers would not be entitled to a credit for this tax. Nonetheless, the department has previously ruled that the Illinois personal property replacement tax imposed on S corporations operating in the state qualifies for the Virginia credit. See Public Document 95-282, (1116195), copy attached.
In order to be allowed a credit for tax paid to Illinois, the Taxpayers should submit copies of the S corporation's personal property replacement income tax returns along with proof of payment within 30 days to ********* c/o Office of Tax Policy, Department of Taxation, P.O. Box 1880, Richmond, Virginia 23218-1880. Otherwise, payment should be made. If you should have any further questions, you may contact**********at**********.
Sincerely.
Danny M. Payne
Tax Commissioner
Rulings of the Tax Commissioner