Could a holding-company S corporation subtract gain from distributing portfolio-company stock because the companies were not unitary?

Plain-English summary

Virginia required the S corporation to include the stock-distribution gain in apportionable income and denied its refund. The lack of a unitary relationship did not make the gain a passive, nonoperational item.

The out-of-state S corporation filed a unified Virginia nonresident return for its shareholders. It subtracted gain recognized when it distributed stock of a company in which it owned a 7% interest. Virginia disallowed the subtraction.

Multistate pass-through entities apportioned Virginia-source income under the corporate rules in Va. Code §§ 58.1-408 through 58.1-421. Apart from specified dividends, Virginia generally subjected adjusted federal taxable income to apportionment. The protest was treated as a request for an alternative method under § 58.1-421.

Virginia agreed that the taxpayer and the distributed company were not unitary. Under the U.S. Supreme Court authorities discussed in the ruling, however, income could still be apportioned when an investment served an operational rather than passive function.

The taxpayer was a holding company whose primary function was to hold and manage operating entities for shareholder return. Holding companies also facilitated reorganizations and investment transfers. A stock sale or distribution was therefore part of its normal operations even if it happened infrequently and generated only a paper gain rather than cash proceeds.

Va. Code § 58.1-391(B) preserved the federal character of pass-through gain. The Department generally presumed pass-through income operational, and the taxpayer did not provide clear and cogent evidence supporting a different allocation method.

What this means for you

• Proving that two companies are not unitary does not automatically exclude investment gain from apportionment.
• Identify whether the investment serves the taxpayer's operating function or is merely passive.
• A holding company's normal operations can include infrequent stock distributions and reorganizations.
• Alternative apportionment requires strong fact-specific proof.

Common questions

Q: Did Virginia find a unitary relationship?
A: No.

Q: Why was the gain still apportioned?
A: Managing and transferring operating-company investments was part of the holding company's normal operational function.

Q: Did the lack of cash proceeds matter?
A: No. The ruling rejected the argument that a paper gain was necessarily nonoperational.

Citations and references

• Va. Code §§ 58.1-402, 58.1-403, 58.1-407, 58.1-408 through 58.1-421, and 58.1-391(B).
• IRC § 311(b)(11), as cited in the ruling.
• Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992).
• Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980).
• F. W. Woolworth Co. v. Taxation and Revenue Department of New Mexico, 458 U.S. 352 (1982).
• P.D. 07-150 and P.D. 07-197.

Subject

No clear and cogent evidence that an alternative method of allocation and apportionment is appropriate

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 12-218

Original ruling text

December 21, 2012

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek a refund of corporate income tax paid by * (the "Taxpayer") for the taxable year ended December 31, 2010. I apologize for the delay in responding to your letter.

FACTS

The Taxpayer is an out-of-state S corporation that generates Virginia taxable income. It files a unified nonresident return on behalf of its numerous nonresident shareholders. On its 2010 return, the Taxpayer subtracted a gain resulting from the distribution of stock of * (Corporation A) to its shareholders. During processing, the Department disallowed the subtraction and reduced the amount of refund claimed by the Taxpayer.

The Taxpayer filed an appeal, contending it did not have a unitary relationship with Corporation A, and its ownership in Corporation A stock was not operational in nature. The Taxpayer requests a refund of Virginia income tax paid for the taxable year ended December 31, 2010.

DETERMINATION

If the entire business of the pass-through entity is not deemed to have been transacted or conducted within Virginia, then such pass-through entity's income from Virginia sources is the portion of income allocated and apportioned to Virginia in the same manner as corporations. See Public Document (P.D.) 07-150 (9/21/2007). Accordingly, S corporations that have income that is subject to tax in Virginia and at least one other, state are required to apportion income as provided in Va. Code §§ 58.1­408 through 58.1-421. The Code of Virginia does not provide for the allocation of income other than certain dividends. Accordingly, a taxpayer's entire federal taxable income, adjusted and modified as provided in Va. Code §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Va. Code § 58.1-407, is subject to apportionment. The Taxpayer's protest has been treated as a request for an alternative method of allocation and apportionment in accordance with Va. Code § 58.1-421.

In any proceeding with the Department, the Taxpayer bears the burden of showing that the imposition of Virginia's statute is in violation of the standards enunciated by the United States Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation , 504 U.S. 768 (1992). In this matter, the Taxpayer must demonstrate that its investments are not operational assets involved in a unitary business. In considering the existence of a unitary relationship, the Supreme Court has focused on three objective factors: (1) functional integration; (2) centralization of management; and (3) economies of scale. (See Mobil Oil Corp. v Commissioner of Taxes , 445 U.S. 425 (1980); F. W. Woolworth Co. v. Taxation and Revenue Dept. of N.M. , 458 U.S. 352 (1982); and Allied-Signal .)

The decision of the United States Supreme Court in Allied-Signal also made it clear that the payee and payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. In the absence of a unitary relationship, apportionment is permitted when the investment serves an operational rather than a passive investment function. The Court also made it clear that the test is fact sensitive.

Based on the information provided, it is clear that no unitary relationship existed between the Taxpayer and Corporation A at the time of the distribution. As such, the issue to be addressed in this case centers upon whether the Taxpayer's investment in Corporation A fulfilled an operational function rather than a passive investment function.

The Taxpayer held a 7% interest in Corporation A. Under Internal Revenue Code (IRC) § 311(b)(11), a gain was recognized from the distribution of the stock of Corporation A. The Taxpayer asserts that the distribution did not fulfill an operational function because the gain was a paper gain; therefore, there were no proceeds to reinvest into the operations of the business.

Virginia Code § 58.1-391 B provides "[e]ach item of pass-through entity income, gain, loss or deduction shall have the same character for a partner under this chapter as for federal income tax purposes." For Virginia income tax purposes, income retains its character as income from the operations of a pass-through entity in computing Virginia taxable income and is properly included in the apportionable income of the shareholder. This means that the shareholders are considered to be operating in the business conducted by the pass-through entity. As such, the Department generally presumes that the income passed through from a pass-through entity to be operational. See P.D. 07-197 (11/30/2007).

The Taxpayer was a holding company that held investments in a number of operating entities. Its primary function is to hold and manage these companies in order to provide a return for its shareholders. While they normally own a controlling interest in the entities in which they invest, holding companies are also used to facilitate entity reorganizations and investment transfers. As such, the Department considers the sale of, or distribution of stock to its shareholders to be an activity conducted within the normal operations of a holding company, even if such transactions rarely occur.

Accordingly, the Taxpayer has not demonstrated by clear and cogent evidence that an alternative method of allocation and apportionment is appropriate. Therefore, the disallowance of the subtraction of the gain from the distribution of Corporation A's stock to its shareholders was correct. Accordingly, the Taxpayer's request for a refund is denied.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules, and Decisions section of the Department's web site. If you have any questions about this determination, you may contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-5091011709.B