Were LLC members liable for their shares of unreported partnership income even if another member controlled the books and they received no benefit?

Subject

LLC members owed tax on their shares of underreported income

Plain-English summary

Virginia held the LLC members responsible for tax on their proportional shares of the LLC's increased income. A sales-tax audit found underreported sales, and the LLC's income-tax sales figures were almost identical to its sales-tax figures. Virginia therefore adjusted the LLC's income and attributed the increase to members using their ownership percentages.

The couple argued that another member had taken over bookkeeping, caused the underreporting, and should bear the liabilities. They also said they received no economic benefit from the extra income. Neither point changed the pass-through rule: the LLC had elected partnership treatment, so income tax arising from partnership income belonged to the partners through their distributive shares.

Virginia nevertheless found the original member assessments defective. The auditor had simply multiplied underreported sales by each ownership percentage and applied the individual rate schedule. That method did not account for how the added income affected the rest of each return. It also failed to address unreported cash wages discovered in the withholding audit.

The Department returned the case to the auditor for corrected calculations and revised bills.

What this means for you

• Partnership and LLC members can owe tax on allocated income even when another person controls the books or cash is not distributed.
• Ownership percentages and Schedule K-1 treatment matter, but an assessment must still compute the owner's full return correctly.
• A sales-tax finding can lead to corresponding income-tax adjustments when reported sales are likewise understated.

Common questions

Q: Could the couple transfer their tax liability to the managing member?
A: No. The ruling treated income tax on partnership income as each member's liability.

Q: Did lack of economic benefit eliminate distributive income?
A: No. The pass-through allocation, not receipt of a cash benefit, controlled the stated tax responsibility.

Q: Were the assessments upheld exactly as issued?
A: No. Liability was proper in principle, but the amounts required recalculation.

Citations and references

• Va. Code §§ 58.1-219, 58.1-301, and 58.1-391(B).
• IRC §§ 61(a)(13) and 702(b).
• Treas. Reg. § 301.7701-1 et seq.
• Public Documents 04-64 and 97-343.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 14-35

Original ruling text

March 18, 2014

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you request correction of the individual income tax assessment issued to * (the "Taxpayers") for the taxable years ending December 31, 2008 through 2010. I apologize for the delay in responding to your letter.

FACTS

The Taxpayers, a husband and wife, were members of * (VALLC). Under audit, VALLC was assessed for underreporting sales for the period April 2007 through July 2010. VALLC was also assessed for failure to withhold income tax from employee's wages for the taxable periods January 2008 through September 2009.

In addition, individual income tax assessments for the taxable years at issue were issued to each member based on the increased sales of VALLC. The assessments were computed by multiplying the underreported sales for each taxable year by the member's ownership percentage and then applying Virginia's individual income tax rate schedule to determine the amount of tax.

The Taxpayers appeal the assessments, contending one of the other members of VALLC took over control of the bookkeeping sometime during the spring of 2008. They believe this member was responsible for the underreporting of sales, and the sales through June 2008 were reported accurately. Further they assert that they did not receive any economic benefit from the additional income and request that all liabilities of the partnership be transferred to managing partners.

DETERMINATION

Conformity

Virginia Code § 58.1-301 provides 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. 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).

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. However, the Department retains the authority to adjust FAGI where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Va. Code § 58.1-219.

Income of VALLC

The Department has found that when a dealer underreports sales, receipts reported on its income tax return may be likewise understated. In such circumstances, the Department has found it appropriate to make corresponding adjustments to the dealer's income tax return. See Public Document (P.D.) 04-64 (8/24/2004).

The sales reported on VALLC's income tax returns were almost identical to that which was reported for sales and use tax purposes. Pursuant to Va. Code § 58.1-219, the Department was within its authority to adjust VALLC's sales reported on its 2008 through 2010 income tax returns.

Income from Limited Liability Companies

In P.D. 97-343 (8/28/1997), the Department ruled that it would follow the federal election made by a limited liability company pursuant to the "check the box" regulations under Treas. Reg. § 301.7701-1 et seq . In fact, Virginia's conformity statute requires such a ruling because a limited liability company that is treated as a partnership or a disregarded entity for federal income tax purposes will have no federal taxable income as a starting point for computing its Virginia taxable income. See Va. Code § 58.1-301.

In this case, VALLC elected to be treated as a partnership for federal income tax purposes. Virginia generally conforms to the federal treatment of partnerships. A partnership, as such, is not subject to income tax. Any income tax arising from the income of the partnership is the liability of the partners. Under IRC § 702(b), "The character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share . . . shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership." In addition, each item of pass-through entity income, gain, loss or deduction has the same character for an owner for Virginia income tax purposes as for federal income tax purposes. See Va. Code § 58.1-391 B. This would include a limited liability company that elects to be treated as a partnership for federal income tax purposes.

Under IRC § 61(a)(13), gross income also includes a taxpayer's distributive share of partnership gross income. When an LLC elects to be treated as a partnership for federal income tax purposes, a distributive share of the income would be included in a member's FAGI. Based on this reasoning, the auditor attributed the increase in VALLC's sales proportionally to each member based on ownership percentages reported on Form K-1.

Computational Errors

As indicated above, the income tax assessments were computed directly from the underreported sales. This computation fails to account for impacts the additional income might have on the Taxpayers' income tax returns. In addition, information gathered during this review indicates that some employees were paid in cash. As a result, withholding assessments were issued against VALLC. However, the income tax assessments fail to consider any unreported salary and wages discovered during the withholding audit. As such, the assessments for the 2008 through 2010 taxable years contain computational errors.

CONCLUSION

As members of VALLC, the Taxpayers were responsible for income tax resulting from their proportional share of VALLC's income. Because VALLC underreported sales, the Department acted within its authority under Va. Code § 58.1-219 to adjust VALLC's sales and proportionally attribute the increase to the members. Accordingly, the Department was correct in issuing assessments against the Taxpayers for the 2008 through 2010 taxable years.

However, as indicated above, the Department's method for determining the additional liability requires revision. Accordingly, the audit will be returned to the auditor in order to adjust the audit report and assessments in accordance with this determination. Once the auditor makes the appropriate adjustments, the Taxpayers will receive revised bills for the 2008 through 2010 taxable years. The Taxpayers should remit payment for the outstanding balance as shown on the revised bill within 30 days from the date of the revised bill 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 determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-5186766722.D