Could a Virginia resident use Maryland rental income and tax to claim the special border-state credit without Virginia's ordinary limitation?

Subject

Taxpayer incorrectly claimed a credit for income tax paid to another state.

Plain-English summary

Virginia denied the refund because it had correctly limited the taxpayer's credits for Maryland income tax. The taxpayer's Maryland-source income was rental income reported on Schedule E, not earned income or Schedule C business income. It therefore failed the special rule for a single state bordering Virginia.

Under the general rule, the credit was limited to the lesser of Maryland tax actually paid or Virginia tax imposed on the Maryland income. Because Maryland first computed tax as if the taxpayer were a resident and then applied a nonresident allocation percentage, Virginia used the Maryland taxable net income produced by that allocation in its credit-limitation fraction.

The return instructions described that method. Virginia also made the adjustments within the assessment period. Interest was mandatory on the underpayments and could not be waived unless the related tax was reduced, so the request to refund both tax and interest was denied.

What this means for you

• Schedule E rental income does not satisfy the Schedule C requirement for the special contiguous-state rule in this ruling.
• When another state computes resident-style tax and then applies an allocation percentage, use the allocated nonresident income in Virginia's limitation calculation.
• Retain both states' returns, allocation schedules, income details, and credit workpapers.
• Interest does not disappear because the Department found the error later within its lawful assessment period.

Common questions

Q: Why did the border-state rule not apply?

A: The Maryland income was rental income on Schedule E, not earned income or Schedule C business income.

Q: What Maryland income amount did Virginia use?

A: The Maryland taxable net income resulting from the nonresident allocation percentage.

Q: Could Virginia waive the interest?

A: Not while the associated tax remained due; the ruling described interest as mandatory.

Citations and references

• Va. Code §§ 58.1-102, 58.1-104, 58.1-332(A), 58.1-1812, 58.1-1821, and 58.1-1824.
• Howell's Motor Freight, Inc. v. Virginia Department of Taxation, Law No. 82-0846 (Roanoke Cir. Ct. Oct. 27, 1983).
• P.D. 94-91, P.D. 95-96, P.D. 95-151, P.D. 95-174, P.D. 97-301, and P.D. 04-125.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 15-58

Original ruling text

April 3, 2015

Re: § 58.1-1824 Application: Individual Income Tax

Dear *:

This will reply to your letter in which * (the "Taxpayer") requests a refund of individual income taxes paid for the taxable years December 31, 2011 through 2013.

FACTS

The Taxpayer filed Virginia resident individual income tax returns for the 2011 through 2013 taxable years. On each return, the Taxpayer claimed a credit for income tax paid to the state of Maryland. Under review, the Department adjusted the credits and issued assessments. The Taxpayer paid the additional amounts due and filed a claim for refund, contending that the Department did not properly calculate the credits. In addition, if the Department determines that its calculations are correct, the Taxpayer contests the inclusion of interest charges, contending that the Department should have discovered her calculation errors sooner.

DETERMINATION

Protective Claim

Virginia Code § 58.1-1824 permits any person who has paid an assessment of taxes administered by the Department of Taxation to file a protective claim for refund within three years of the date of an assessment. Pursuant to the authority granted the Tax Commissioner under Va. Code § 58.1-1824, a protective claim for refund can be held pending the outcome of another case before the courts or the claim may be decided based upon its merits pursuant to Va. Code § 58.1-1821. As permitted by statute, the Taxpayer's request has been treated as an appeal under Va. Code § 58.1-1821.

Out of State Tax Credit

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, 57 S.Ct. 466 (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." Thus, a state may tax all of the income of a resident regardless of whether such income is subject to tax in another state.

As a matter of fairness and equity most states, including Virginia, provide a mechanism to relieve residents from being taxed by both their state of residence and the state in which the income was derived. Virginia's method of limiting taxation of income by more than one state has been to permit a credit for taxes paid to other states pursuant to Va. Code § 58.1-332. By reason of their character as legislative grants, however, statutes relating to deductions and subtractions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell's Motor Freight, Inc., et al. v. Virginia Department of Taxation , Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983).

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 on 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 Public Document (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.

If certain' criteria are met, the limitation that restricts the credit to the amount of Virginia income tax actually imposed on the taxpayer on the income derived in the other state is disregarded. The special rule will apply if the income subject to tax in a single state contiguous to Virginia is less than Virginia taxable income and all of the income from sources outside Virginia is earned income or business income reported on federal form Schedule C from that single contiguous state. In such instances, the Virginia resident will be entitled to a credit equal to the lesser of: (1) the amount of income tax actually paid to the contiguous state; or (2) 100% of their Virginia income tax liability. See Va. Code § 58.1-332 A. In this case, this special border state rule did not apply because the Taxpayer's income from Maryland sources consisted of rental income reported on federal form Schedule E. As such, it was not earned income or business income reported on federal form Schedule C. See P.D. 04-125 (9/16/2004).

For the taxable years at issue, Maryland required nonresidents to compute both Maryland taxable income and income tax as if the nonresident were in fact a resident. The tax computed as if a resident was converted to a nonresident tax by applying a fraction, the numerator of which was taxable net income from Maryland sources, and the denominator of which was taxable net income from all sources.

The Department has previously ruled on the method in which a Virginia resident will compute a credit for income tax paid to a state which determines the tax on a nonresident in a manner similar to Maryland. See P.D. 95-96 (5/1/1995) and P.D. 94-91 (3/29/1994), each dealing with New York income tax. See also P.D. 95-151 (6/12/1995) and P.D. 95-174 (6/27/1995).

An analysis of the Maryland and New York nonresident individual income tax formulas described in P.D. 95-96 and P.D. 94-91 shows these computations to be the same in all material respects. Both computations require the nonresident to compute taxable income and tax as if they were a resident. Both computations then convert a resident tax to a nonresident tax by applying a proportion that references nonresident income to total income. Therefore, the Department finds its written policy as described in the aforementioned rulings to be appropriate for a Virginia resident in computing a credit for income tax paid to Maryland when the special border state rule does not apply.

In P.D. 94-91 (3/29/1994), the Department required that the allocation percentage calculated on the New York nonresident return (which was used to convert the resident tax to the nonresident tax) must be applied to the New York taxable income calculated as a resident in order to determine the New York nonresident taxable income. The result was used in the numerator of the fraction to compute the limitation imposed by Code of Virginia § 58.1-322 A.

In this case, the result of the methodology described in P.D. 94-91 was reflected in the amounts of Maryland Taxable Net Income reported on the Maryland returns and used to compute the Taxpayer's Maryland nonresident tax for each of the taxable years at issue. The Department used these amounts to compute the limitation imposed by Va. Code of § 58.1-322 A. As such, the Department's adjustments properly limited the credits to the amount of Virginia income tax imposed on the Taxpayer's Maryland net income for each taxable year.

Tax Form Instructions

The Taxpayer contends that Virginia's resident income tax return instructions do not clearly indicate what the Taxpayer should report as the income on which the other state's tax is based. Consistent with the methodology described in P.D. 94-91, the instructions state:

In some states, the tax is computed on total taxable income (from all sources) and then reduced by an allocation percentage. In these cases, you must multiply the total taxable income shown on the other state's return by the allocation percentage to determine the amount of [income on which the other state's tax is based.]

Accordingly, the instructions put the Taxpayer on notice that the credit may be limited. For each taxable year at issue, if the Taxpayer had multiplied the total taxable income used to compute her Maryland tax as if she were a resident by the nonresident allocation percentage, the result would have been the Maryland nonresident taxable income the Department used to compute the applicable limitation. This also corresponded to the amount of "Maryland Taxable Net Income" reported on the Taxpayer's Maryland return.

Further, tax form instructions merely paraphrase the statute and generally make no reference to the requirements for reporting amounts on a particular line of a return. The information provided in Virginia's tax return instructions is intended to provide helpful guidance to taxpayers. It is not intended to provide a detailed explanation of every provision or nuance of Virginia's tax law. In particular, it would not be practical for the Department to provide detailed instructions concerning how to calculate income tax credits for every state, because of the number of states involved, the fact that terminology differs from state to state, and income tax laws can change.

Interest

The Taxpayer states that interest should not have been imposed in this case because the Department's employees neglected to recompute her correct tax liability in a timely fashion.

Virginia receives approximately 3.5 million individual income tax returns per year. Only a small portion of the individual taxpayers can be audited or reviewed annually. As such, it is incumbent on the taxpayer to retain and review suitable records and documents to determine his proper Virginia income tax liability. See Va. Code § 58.1­-102. In addition, Virginia law generally allows the Department to make an assessment of underpaid tax within three years from the last day prescribed by law for the timely filing of the return. See Va. Code § 58.1-104.

The last day for timely filing the earliest return at issue, the return for the 2011 taxable year, was May 1, 2012. The Department notified the Taxpayer that it was making adjustments to the Taxpayers' 2011, 2012 and 2013 returns in October 2014, well before the three year period had expired for even the 2011 taxable year. As such, the Department's adjustments were timely made in accordance with Virginia law.

The application of interest to tax underpayments is mandatory under Va. Code § 58.1-1812, and it cannot be waived unless the associated tax is adjusted. Interest is not assessed as a penalty for noncompliance, but represents a fee for the use of money that was properly due the Commonwealth. The Virginia statute is clear with respect to the assessment of interest.

CONCLUSION

Based on the methodology described in P.D. 94-91, the Department correctly limited the credits the Taxpayer claimed for income tax paid to Maryland to the amount of Virginia income tax imposed on the income she earned in Maryland during the 2011 through 2013 taxable years. This methodology is also explained in the instructions to the Virginia resident income tax returns at issue. In addition, the application of interest to underpayments of tax is mandatory under Va. Code § 58.1-1812 and cannot be waived unless the associated tax is adjusted.

After reviewing all the facts and circumstances presented and the applicable law, the Taxpayer's request for a refund of the additional taxes and interest paid for the 2011 through 2013 taxable years is denied.

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/1-5899631276.M