How does Virginia calculate the retirement-income subtraction when pension contributions were deductible federally but taxed by another state before later distributions?

Plain-English summary

Virginia agreed that a wife's pension contributions from 1984 through 1986 could support the retirement-income subtraction because they were excluded from federal adjusted gross income but added back and taxed by another state.

The taxpayers could not simply subtract the old contributions dollar for dollar. Virginia required the pro-rata method established in P.D. 10-214 to reflect that retirement distributions combine contributions and investment earnings.

The eligibility test

Va. Code § 58.1-322 C 19 required both:

1. The retirement contributions were deductible or excluded in computing federal adjusted gross income; and
2. The same contributions were subject to another state's income tax.

The federal and State A returns established those points for the 1984-1986 contributions.

The pro-rata formula

The eligible annual subtraction was calculated as:

Annual retirement distributions × (total previously taxed contributions ÷ (year-end retirement account value + annual distributions))

The Department had the total contribution information but still needed the wife's 2013 pension distribution statement and her annuity balance as of December 31, 2013.

What this means for retirees

• Preserve old federal and state returns proving the different treatment of contributions.
• The subtraction applies only to the eligible portion of each distribution, not automatically to the full distribution or full historical contribution amount.
• Current distribution statements and year-end account values are necessary to compute the fraction.
• Missing documentation can leave the assessment upheld even when contribution eligibility is established.

Common questions

Did Virginia accept that the contributions qualified? Yes, based on the records showing federal exclusion and State A taxation.

Was the assessment immediately removed? No. The Department needed two additional 2013 statements and allowed 45 days to provide them.

What happened if the taxpayers did not respond? The 2013 assessment would be upheld and collection could continue.

Citations and references

• Va. Code §§ 58.1-301 and 58.1-322 C 19
• IRC §§ 401, 408, and 457
• P.D. 10-214
• Howell's Motor Freight, Inc. v. Virginia Department of Taxation, Law No. 82-0846 (Roanoke Cir. Ct. Oct. 27, 1983)

Subject

Department's pro-rata approach that accurately reflects the nature of a distribution from a retirement plan should be used.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 17-91

Original ruling text

June 9, 2017

Re: § 58.1-1821 Application:

Individual Income Tax

Dear

This will respond to your letter in which you seek correction of the individual income tax assessment issued to * (the “Taxpayers”) for the taxable year ending December 31, 2013. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayers, a husband and wife, filed a 2013 Virginia individual income tax return and claimed a subtraction for pretaxed pension contributions made in taxable years 1984 through 1986. Under audit, the subtraction was denied and an assessment was issued. The Taxpayers appealed the assessment and provided copies of their federal and * (State A) state income tax returns as proof that the contributions were exempt from their federal adjusted gross income (FAGI) and added back for State A income tax purposes.

DETERMINATON

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 FAGI. Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322.

Virginia Code § 58.1-322 C 19 provides a subtraction for any income received during the taxable year derived from a qualified pension, profit-sharing, or stock bonus plan as described by § 401 of the Internal Revenue Code, an individual retirement account or annuity established under § 408 of the Internal Revenue Code, a deferred compensation plan as defined by § 457 of the Internal Revenue Code, or any federal government retirement program, the contributions to which were deductible from the taxpayer's federal adjusted gross income, but only to the extent the contributions to such plan or program were subject to taxation under the income tax in another state. Before taxpayers are permitted to subtract any portion of their retirement income, contributions to the retirement plan must satisfy a two-part test: (1) they must have been deductible for federal income tax purposes; and (2) they must still have been subject to income tax in another state.

The complexity of calculating the portion of a retirement plan distribution attributable to previously taxed income was recognized by the Department and communicated to the General Assembly when enacted by House Bill 875 (Chapter 624, Acts of Assembly) in 1996. In its Fiscal Impact Statement (FIS), the Department explained that it is generally difficult, if not impossible, to determine what portion of a distribution would be a return of a contribution or income generated from the investments because deferred compensation plan accounts can include multiple investment vehicles in which income is usually reinvested to and from funds which can be moved depending on the objectives of the owner of the account. Also, it is possible that an individual may have lived in several different states, and made retirement plan contributions under both conformity and nonconformity rules.

By reason of their character as legislative grants, 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).

In Public Document (P.D.) 10-214 (9/15/2010), the Department established a pro-rata approach that accurately reflects the nature of a distribution from a retirement plan. Accordingly, a taxpayer who receives a distribution from a retirement plan as described in Va. Code § 58.1-322 C 19 and whose contributions to such plan were subject to income taxation in another state would determine the portion of the annual distribution(s) eligible for the subtraction by multiplying the total amount of the annual distribution(s) by a ratio equal to the total balance of previously taxed contributions divided by the sum of the value of the retirement account at the end of the taxable year plus the total amount of the annual distribution(s).

In this case, the Taxpayers' records show the contributions to the wife's retirement account were excluded from their FAGI and added back to their State A income tax computation. As such, the contributions made from taxable years 1984 through 1986 are eligible for the retirement subtraction provided in Va. Code § 58.1-322 C 19. Because the subtraction is granted on a pro-rata basis, the subtraction must be computed based on the formula provided in P.D. 10-214. The Taxpayers provided sufficient information to determine total contributions, but information showing total distributions received during the 2013 taxable year, and the value of the annuity account as of December 31, 2013, are required to complete the computation. The Taxpayers are requested to provide a 2013 pension distribution statement and an annuity statement showing the balance of the wife's annuity account as of December 31, 2013.

The requested information should be provided within 45 days from the date of this letter. Once this information is received, the Department will compute the proper subtraction and adjust its assessment accordingly. The requested documentation should be mailed to: Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23261­-7203, Attn: *. If the requested documentation is not provided within the allowed time, the 2013 assessment will be upheld and collection actions may continue.

The Code of Virginia sections and public document 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/859.D