Tax Type
Individual Income Tax
Description
Taxation of nonresidents; Stock options
Topic
Taxpayers' Remedies
Date Issued
04-20-1999
April 20, 1999
Re: § 58.1-1821 Application: Individual Income Tax
Dear***
This will reply to your letter in which you protest the assessment of individual income tax against * * * * * (the "Taxpayer') as a result of an audit by this department for the 1996 taxable year.
FACTS
The Taxpayer, while a Virginia domiciliary resident, was granted a series of incentive stock options (ISOs) from September 1987 through April of 1993 by his Virginia employer. On January 15, 1996, the Taxpayer changed his domicile from Virginia to another state but continued to commute to work in Virginia during 1996. On April 30, 1996, the Taxpayer terminated his employment with this employer.
The Taxpayer exercised his ISOs on December 18, 1995 and on May 21, 1996. The Taxpayer subsequently disposed of the shares purchased under the ISO plan over the period beginning June 19, 1996 and ending December 30, 1996.
The Taxpayer filed as a part-year resident for 1996. On audit, the department made adjustments including an adjustment to include the gain from the sale of stock purchased under the ISO in Virginia taxable income. You assert this adjustment is erroneous and request relief from the resulting assessment.
DETERMINATION
Virginia imposes an income tax on every individual with Virginia taxable income during the taxable year. Code of Virginia § 58.1-325 describes the computation of the Virginia taxable income of a nonresident individual. A nonresident individual will have Virginia taxable income if the individual has income from Virginia sources during the taxable year. Code of Virginia § 58.1-302 provides in pertinent part:
-
- "Income and deductions from Virginia sources' includes:
1. Items of income, gain, loss and deduction attributable to:
a. The ownership of any interest in real or tangible personal property in Virginia
b. A business, trade, profession or occupation carried on in Virginia; or
c. Prizes paid by the Virginia Lottery Department, and gambling winnings from wagers placed or paid at a location in Virginia. (Emphasis added).
- "Income and deductions from Virginia sources' includes:
The determinative question here is whether the gain from the sale of stock acquired under the ISO plan constituted income from Virginia sources. Nonresident individuals who receive compensation attributable to employment in Virginia will have income from Virginia sources.
In Commissioner of Internal Revenue v. Lo Bue, 76 S.Ct. 800 (1956), (copy enclosed), the U.S. Supreme Court held that ISOs are compensation if their purpose is to confer any economic or financial benefit upon the employee. Clearly, ISO's are compensation if the intent is to award an employee's past performance or to motivate future performance. The Taxpayer's employer's ISO plan states that the purpose of the ISOs is to "attract such [key] people, to induce them to work for the benefit of the [c]ompany and to provide an additional incentive for them to promote the success of the [c]ompany.'
ISOs are a recognized form of employee compensation and a review of the Taxpayer's ISO plan indicates his employer intended them as such. Therefore, the Taxpayer, as a nonresident of Virginia, has income from Virginia sources because the ISOs represent compensation attributable to employment in Virginia.
However, because of Virginia's conformity to federal income tax law under Code of Virginia § 58.1-301, the actual amount of the compensation cannot be ascertained until the ISOs are exercised and the stock is subsequently sold. Furthermore, the nature of ISOs must be considered in order to determine the extent to which they represent compensation.
ISOs are usually exercisable when granted. Internal Revue Code § 422(b)(4) requires the option price, with a limited exception, must equal the fair market value of the stock when the option is granted. The employee's compensation stems from the employer's willingness to let the employee benefit from market appreciation in the stock that can occur between the time the ISO is granted and the time the ISO is exercised without the employee risking his own capital. After an ISO is exercised, however, the employee's capital is at risk. Any appreciation realized from an increase in the fair market value of the stock between the time an ISO is exercised and the time the stock is sold is investment income rather than compensation as the employee has risked his own capital and is subject to gain or loss thought market fluctuations.
Therefore, the amount of a nonresident's Virginia source income with respect to ISOs granted in connection with Virginia employment will be determined at the time the stock is sold and income or gain is recognized for federal income tax purposes. The amount of Virginia source income of a nonresident is limited to the lesser of the income or gain recognized for federal income tax purposes or the amount by which the fair market value of the stock exceeded the option price at the date the ISO was exercised. Any appreciation in the value of the stock realized by a nonresident between the time an ISO is exercised and the time the stock is sold is investment income and not compensation attributable to employment in Virginia.
Nevertheless, the department has reviewed its prior rulings with respect to ISOs constituting Virginia source income for nonresidents of Virginia. In Public Document (P.D.) 92-58 (4/29/92), copy enclosed, the department addressed the withholding of tax from certain retirement benefits paid to nonresidents. This ruling also stated in dicta that Virginia residents who once worked in Virginia, but are no longer residents, need not pay Virginia income tax on gains attributable for "stock option awards.' However, this ruling provided no analysis regarding the reasoning for reaching this conclusion.
Recognizing the fact that P.D. 92-58 could be reasonably interpreted to hold that Virginia excludes from taxation the Virginia source income of a nonresident that results from ISOs attributable to employment in Virginia, the department revokes those provisions of P.D. 92-58 on a prospective basis and replaces them with the finding contained in this ruling. Therefore, to the extent P.D. 92-58 conflicts with this ruling, it is hereby modified, and is replaced with this ruling effective for the first taxable year beginning after the date of this ruling.
Accordingly, the Taxpayer's assessment has been adjusted to exclude the gain attributable to the sale of stock acquired under the ISO plan. Enclosed is a schedule showing the balance that remains outstanding. Please send your payment in full to * * * * *, Office of Tax Policy, Virginia Department of Taxation, P.O. Box 1880, Richmond, Virginia, 23218 within 30 days to prevent the accrual of additional interest. If you have any questions, you may contact * * * * * at * * * * *.
Sincerely,
Danny Payne
Tax Commissioner
Rulings of the Tax Commissioner