Can a Virginia S corporation shareholder subtract his share of qualified research expenses that the corporation could not deduct federally because it claimed the research credit?

Plain-English summary

A married couple claimed a Virginia subtraction for the husband's share of an S corporation's qualified research expenses. The corporation had claimed the federal research credit, so federal law prevented it from also deducting an equal amount of those expenses. Virginia initially disallowed the shareholders' subtraction.

The Department reversed the adjustment: Virginia law expressly allows the qualified-research-expense subtraction to pass through to an S corporation shareholder.

How the federal credit creates the Virginia subtraction

IRC § 41 provides a federal credit for certain qualified and basic research expenses. IRC § 280C(c) prevents a taxpayer from also deducting research expenses equal to the credit — avoiding a double federal benefit.

Virginia generally follows federal S corporation treatment. The corporation itself is not subject to Virginia income tax; its income, gain, loss, deductions, and credits flow through to shareholders in proportion to ownership (Va. Code § 58.1-401; 23 VAC 10-120-90(E)).

Unlike many federal-credit adjustments, this one has a specific Virginia statutory subtraction. Va. Code § 58.1-322.02(10) permits an individual to subtract qualified research expenses that were eligible for a federal deduction but not deducted because of IRC § 280C(c). The subtraction is available to S corporation shareholders to the same extent and in the same manner as other deductions pass through.

Why the taxpayers won

The husband was an S corporation shareholder, and the corporation claimed the qualified-research credit. The couple subtracted his proportional ownership share of the total research expenses reported on the corporate return.

That matched the statutory pass-through subtraction. The Department reversed the audit adjustment and said a refund would issue as warranted.

What this means for you

• This is an express Virginia subtraction. It differs from situations where a taxpayer asks Virginia to restore a federal deduction without statutory authorization.
• Use the shareholder's proportional share. The subtraction follows the S corporation ownership and pass-through information.
• Tie the individual return to the corporate return. The taxpayers succeeded using the total research expenses reported by the S corporation and the husband's ownership percentage.
• The federal no-double-deduction rule still applies federally. Virginia's subtraction is a state adjustment; it does not restore the federal deduction.

Common questions

Q: Can an S corporation shareholder claim Virginia's qualified-research-expense subtraction?

A: Yes, to the extent qualified expenses disallowed federally under IRC § 280C(c) pass through according to the shareholder's ownership.

Q: Why was this subtraction allowed when Virginia often rejects deductions lost to federal credits?

A: Va. Code § 58.1-322.02(10) specifically authorizes this research-expense subtraction. Without an express statute, Virginia generally does not restore expenses offset by a federal credit.

Q: What was the result of the appeal?

A: The Department reversed the adjustment and directed that a refund be issued if the recomputation showed one due.

Citations and references

• Va. Code § 58.1-301 — federal conformity
• Va. Code § 58.1-401 — S corporation treatment
• Va. Code § 58.1-322.02(10) — qualified-research-expense subtraction
• 23 VAC 10-120-90(E) — S corporation pass-through treatment
• IRC §§ 41, 280C(c) — research credit and reduction of related federal deduction
• Related Virginia rulings cited: P.D. 88-168, P.D. 07-99, P.D. 18-201, P.D. 91-59, P.D. 94-164, P.D. 16-34

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 19-89

Original ruling text

August 15, 2019

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply 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, 2017.

FACTS

The Taxpayers, a husband and wife, filed a Virginia individual income tax return for the 2017 taxable year, claiming a subtraction for qualified research expenses of an S corporation, of which the husband is a shareholder. Under audit, the Department disallowed the subtraction and adjusted the return. The Taxpayer’s appeal, contending the subtraction was valid.

DETERMINATION

Virginia’s conformity to federal income tax law is set forth in Virginia Code § 58.1-301, which provides that terms used in the Virginia income tax statutes will have the same meaning as used in the Internal Revenue Code (IRC). Further, conformity does not extend to terms, concepts, or principles specifically provided for in Title 58.1 of the Code of Virginia . For Virginia, federal taxable income (FTI) and federal adjusted gross income (FAGI), the starting points for determining income taxable in Virginia for corporations and individuals, respectively, are identical to that as defined by the IRC.

In following federal tax policy with respect to S corporations, Virginia Code § 58.1-401 provides that such corporations are not subject to income tax in Virginia. Thus, Virginia has elected to treat S corporations in substantially the same manner as has the Internal Revenue Service (IRS), i.e. , the corporate entity itself is not subject to taxation, but the shareholders will be taxed as individuals on their pro rata share of S corporation income to the extent includable in FAGI. See Title 23 of the Virginia Administrative Code (VAC) 10-120-90 E, Public Document (P.D.) 88-168 (6/29/1988), P.D. 07-99 (6/27/2007) and P.D. 18-201 (12/7/2018). As such, the S corporations’ items of income, gain, loss, deduction and credit flow through to its shareholders.

Under IRC § 41, a credit is permitted for a percentage of certain research expenses that include “qualified research expenses” and “basic research expenses”. Pursuant to IRC § 280 C (c), however, a taxpayer cannot then claim a deduction for those certain research expenses equal to the credit claimed under IRC § 41(a).

Virginia does not allow a taxpayer to claim a subtraction for expenses offset by a credit at the federal level unless allowed by statute. See P.D. 91-59 (3/29/1991), P.D. 94-164 (5/25/1994) and P.D. 16-34 (3/23/2016). Individuals are permitted to subtract the amount of qualified research expense eligible for deduction for federal purposes, but which were not deducted, on account of the provisions of IRC § 280 C (c) and which are available to shareholders of S corporations to the extent and in the same manner as other deduction may pass through to such shareholders. See Virginia Code § 58.1-322.02 10 and P.D. 18-201.

The evidence shows that the husband is a shareholder of the S corporation, and the S corporation claimed a credit for qualified research. Because of the S corporation’s nature as a pass-through entity, a subtraction for the qualified research expenses proportional to the husband’s ownership was available. Consistent with the information on the corporate return, the Taxpayers’ individual Virginia income tax return subtracted the husband’s proportional share of the total expenses of research activities claimed on the S corporations return. Pursuant to Virginia Code § 58.1- 322.02 10, the Taxpayer is entitled to this subtraction. Accordingly, the adjustment is reversed and a refund will be issued as warranted.

The Code of Virginia sections, regulation, 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/1969.A

Related Documents

88-168

07-99

18-201

91-59

94-164

16-34