When may a Virginia resident subtract pension income attributable to contributions that another state taxed, and is tax-software guidance enough proof?

Plain-English summary

A married couple claimed a Virginia subtraction for part of the husband's federal military retirement income. They said pension contributions had previously been taxed and that their tax software directed them to the subtraction. Virginia disallowed it.

The Department upheld the assessment because the couple did not prove the statutory prerequisite: federally deductible retirement contributions must have been taxed by another state when contributed. Showing that South Carolina later taxed the pension distributions was not enough.

The two-part eligibility test

Va. Code § 58.1-322.02(11) covers certain qualified pensions, IRAs, deferred-compensation plans, and federal retirement programs. Before any distribution is subtracted, the underlying contributions must satisfy both conditions:

1. They were deductible for federal income-tax purposes; and
2. They were nevertheless subject to another state's income tax.

The subtraction prevents the same contribution from being taxed by a state once when contributed and again when distributed. It does not cover contributions already taxed federally or the investment earnings on contributions.

Why the couple's records did not qualify

The husband contributed during military service from 1973 through 1994. The couple said they paid Virginia income tax on his military pay for many of those years. But Virginia does not require taxpayers to add retirement contributions back when computing state income, so Virginia tax on wages did not show that the contributions themselves met the two-part test.

Their Forms 1099-R showed South Carolina tax on retirement distributions after retirement, not tax on the original contributions. After a Department request, they still supplied no state returns or other evidence showing that any contributions had been added back and taxed when made.

How an eligible subtraction would be calculated

The ruling describes two methods:

• Pro-rata method (P.D. 10-214): annual distributions multiplied by the ratio of total previously taxed contributions to the year-end account value plus annual distributions.
• Simplified method (P.D. 15-104; IRC § 72(d)(1)(B)): previously taxed contributions divided by the designated anticipated monthly payments, then multiplied by months paid during the year.

Because the husband retired in 1994, the Department said an otherwise qualifying simplified-method subtraction could extend through 2024. But without proof of qualifying previously taxed contributions, no subtraction could be allowed.

Tax software did not establish eligibility

Virginia reviews approved tax software for processing compatibility, not guaranteed computational accuracy. A software prompt or calculation does not replace the taxpayer's duty to prove that a subtraction's legal conditions are met.

The couple received one final 30-day opportunity to submit additional supporting information.

What this means for you

• Trace the contribution-year state treatment. Distribution-year Forms 1099-R do not prove that another state taxed contributions when made.
• Keep old returns and plan records. This subtraction can require decades-old proof of federal deductibility and state addbacks.
• Separate contributions from earnings. The statute does not broadly exempt all pension income.
• Do not rely solely on software. You remain responsible for proving eligibility and the calculation.

Common questions

Q: Does another state's tax on my pension checks qualify me for the Virginia subtraction?

A: No. The statute looks for another state's tax on federally deductible contributions when made, not merely tax on later distributions.

Q: Did paying Virginia tax on military wages prove the contributions were taxed?

A: No. The Department said Virginia does not add retirement contributions back, so tax on the wages did not establish the required contribution-level taxation.

Q: Can the simplified pension method create eligibility?

A: It calculates the amount only after eligibility is proven. It cannot substitute for evidence that the contributions met the two-part test.

Citations and references

• Va. Code § 58.1-301 — federal conformity
• Va. Code §§ 58.1-322.01 through 58.1-322.04 — Virginia modifications
• Va. Code § 58.1-322.02(11) — qualifying retirement-income subtraction
• IRC § 72 and § 72(d)(1)(B) — basis recovery and simplified pension method
• IRC §§ 401, 408, 457 — covered retirement plans
• Howell's Motor Freight, Inc. v. Virginia Department of Taxation, Law No. 82-0846 (Roanoke Cir. Ct. 10/27/1983)
• Related Virginia rulings cited: P.D. 10-214, P.D. 15-104, P.D. 13-50

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 19-75

Original ruling text

July 29, 2019

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 ended December 31, 2015.

FACTS

The Taxpayers, a husband and wife, filed a Virginia resident individual income tax return and claimed a subtraction for pension contributions previously taxed by another state. Under audit, the Department denied the subtraction and issued assessments for additional tax and interest. The Taxpayers filed an appeal, contending they received retirement income from the husband’s federal employment for approximately 21 years and claimed the subtraction in accordance with tax preparation software.

DETERMINATION

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). 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 Virginia Code § 58.1-322.01 through Virginia Code § 58.1-322.04.

Virginia Code § 58.1-322.02 11 (formerly 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 IRC § 401, an individual retirement account or annuity established under IRC § 408, a deferred compensation plan as defined by IRC § 457, 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 reason Virginia allows the subtraction is because when taxpayers have previously paid income tax on contributions to a pension plan, a portion of the pension payments they later receive is excluded from FAGI pursuant to the pro-rata basis recovery rule under IRC § 72. Because Virginia begins its computation of Virginia taxable income with FAGI, therefore, income excluded from FAGI under IRC § 72 would also be excluded from Virginia taxable income. Thus, the retirement income subtraction is not allowed for contributions that were previously subject to federal income tax, regardless of whether those contributions were previously taxed in another state. Without the limitation for contributions previously subject to federal tax, the subtraction would allow for the possibility of a double benefit by allowing individuals to subtract income already excluded from FAGI.

If the contributions to a pension plan were initially deductible for federal income tax purposes, however, the pension distributions would generally be excluded from FAGI that would flow through to the Virginia return. If another state had required that the contributions be included in its taxable income even though they were excluded from FAGI, the retirement income subtraction can reduce the possibility of the income being taxed for state purposes both at the time of contribution and distribution. The subtraction provided under Virginia Code § 58.1-322.02 11, however, does not include pension contributions included in FAGI and income earned on contributions.

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 Virginia Code § 58.1-322.02 11 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 cases where the year-end value of the pension fund is not available, the Department has ruled that a simplified method may be used. See P.D. 15-104 (5/12/2015). Under IRC § 72(d)(1)(B), a simplified method for determining the tax-free portion of pension payments has been established. Under the simplified method, the investment in the contract as of the annuity starting date (the total contributions previously taxed) is divided by a designated number of anticipated monthly payments to determine a monthly non-taxable payment. Assuming annuity payments are made monthly, the non-taxable payment is multiplied by the number of months an annuitant receives payments during the taxable year to determine excludable retirement income.

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.

The Taxpayers contend that the husband made contributions to his retirement account from 1973 to 1994 as a member of the military. They state that they paid Virginia income tax on the husband’s military pay from 1975 through 1991. The subtraction allowed under Virginia Code § 58.1-322.02 11, however, can only be claimed to the extent the contributions to such plan or program were subject to taxation under the income tax in another state. Virginia does not require its taxpayers to add back contributions to retirement plans when determining their Virginia income tax liability. Therefore, the Taxpayers would not have paid income tax on the contributions when they were made and would not be eligible for the subtraction for those taxable years.

The only documentation provided by the Taxpayers to support their claim are Form 1099Rs showing amounts of retirement income distributed to the husband that was subject to South Carolina income tax after his retirement from the military. South Carolina taxes the distribution, not the contribution of retirement income.

The Taxpayers have indicated that Virginia income tax was not paid on the husband’s military income for 1973, 1974 and the 1992 through 1994 taxable years. Because state tax statutes can change, it may be difficult to determine if the contributions for those years met the statutory requirements depending on which state the husband resided during the period he was employed by the military. By letter dated December 17, 2018, the Department requested additional documentation to support the Taxpayers’ claim. The Taxpayers have provided no evidence that the any contributions were added back for state income tax purposes.

If the Taxpayers qualify for the simplified method, they may be entitled to claim a subtraction on the tax free portion of the pension payments for up to 30 years under IRC § 72(d)(1)(B). The husband asserts he retired in 1994; as such, he would be entitled to the subtraction until the 2024 taxable year. Absent of proof that the contributions were added back to his state income tax returns, no subtraction may be allowed.

Tax Preparation Software

The Taxpayers state that they were following the instructions provided by the tax software when claiming the subtraction. The Department recognizes that tax preparation software is commonly used by tax professionals and individuals for tax return completion. The fact that a particular software program has been approved by the Department, however, is not meant to imply its computational accuracy. Software presented to the Department for approval is reviewed to test conformity to the Department's processing requirements. The Department provides test case specifications, but does not guarantee computational accuracy of the software. See P.D. 13-50 (4/24/2013).

CONCLUSION

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). As such, it is incumbent upon a taxpayer to prove he is entitled to a subtraction reported on a Virginia return. Based on the information provided, the Taxpayers’ request for relief cannot be granted and the assessment is upheld.

The Taxpayers will be given one final opportunity to provide additional information. The return or additional information should be submitted within 30 days from the date of this letter to: Virginia Department of Taxation, Office of Tax Policy, Appeals and Rulings, P.O. Box 27203, Richmond, Virginia 23161-7203, Attention: *. Upon receipt, the information will be reviewed and the assessment will be adjusted, as appropriate. If no new information is received within the allotted time, the assessment will be considered correct and collection actions may result.

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/1895.B

Related Documents

10-214

15-104

13-50