What does Virginia Ruling of the Tax Commissioner P.D. 20-175 conclude about Virginia Taxable Income: No Deduction for Out-of-State Income Credit : Taxes Paid to Another State - North Carolina?

Plain-English summary

A Virginia resident couple filed their 2018 Virginia individual income tax return and deducted income earned from a North Carolina business, reasoning that since they had already paid North Carolina tax on it, Virginia should not tax it again. The Department disallowed that deduction and assessed additional tax. The Commissioner's ruling confirms why: Virginia's individual income tax law has no deduction or subtraction for income earned in another state. Virginia taxable income starts from federal adjusted gross income, and income is only excluded from Virginia tax if a specific modification statute (Va. Code § 58.1-322.01 through § 58.1-322.04) says so — and none of those provisions covers "income I already paid tax on elsewhere."

The correct mechanism for avoiding double taxation on multistate income is instead the credit for taxes paid to another state, under Va. Code § 58.1-332 A. That credit is generally capped at the lesser of the tax actually paid to the other state or the Virginia tax imposed on that same income — but Virginia has a special, more generous "border state" rule for residents whose only out-of-state income is earned or Schedule C business income from a single state that borders Virginia (which includes North Carolina). Under that rule, if the requirements are met, the taxpayer can credit the lesser of the tax actually paid to the bordering state or 100% of their entire Virginia tax liability, without the usual per-income-source cap. The Commissioner found the taxpayers' North Carolina income qualified for this border-state rule.

Even so, the taxpayers did not fully win their appeal. The Department had already recalculated the assessment once, converting the disallowed deduction into an allowed credit and lowering the bill — but the taxpayers argued the credit still did not cover all the North Carolina tax they had paid. The Commissioner found that both the North Carolina and Virginia returns submitted were full of errors, making it impossible to pin down the taxpayers' actual North Carolina tax liability, and that the taxpayers appeared to have simply deducted their Virginia-source income on their North Carolina return as well. Based on the information available, it looked like the taxpayers may have overpaid North Carolina, not underpaid Virginia. Without accurate figures, the Commissioner upheld the (already-reduced) assessment.

The bottom line: the Department was right to deny the deduction, right to grant a credit instead, and — absent better records from the taxpayers — right to leave the reduced assessment in place.

What this means for you

Virginia residents with income from another state

You cannot deduct or subtract out-of-state earnings from your Virginia taxable income just because you paid tax on them elsewhere. The only relief Virginia offers for double taxation is the credit for taxes paid to another state (Va. Code § 58.1-332 A), which must be claimed correctly and backed by accurate figures from both states' returns.

Residents with income from a bordering state (e.g., North Carolina)

If your only out-of-state income is earned income or Schedule C business income from a single state that borders Virginia, ask whether the special border-state credit rule applies — it can let you credit up to 100% of your Virginia liability rather than being capped at the tax actually imposed on that specific income. But you still must be able to document what you actually owed and paid to the other state.

Accountants and tax professionals

This ruling is a reminder that sloppy or inconsistent multistate returns can sink a client's credit claim even when the underlying legal theory (border-state credit) is sound. Here, errors on both the Virginia and North Carolina returns — including apparently deducting Virginia-source income on the North Carolina return — left the Commissioner unable to verify the correct credit amount, so the taxpayers bore the consequence of an unsubstantiated assessment.

Common questions

Q: Can I just deduct income I earned and paid tax on in another state from my Virginia return?
A: No. The Commissioner confirmed there is no such deduction or subtraction available under the Code of Virginia. Virginia taxable income starts from federal adjusted gross income, and only the specific modifications listed in Va. Code § 58.1-322.01 through § 58.1-322.04 reduce it — none applies here.

Q: What should these taxpayers have claimed instead?
A: A credit for taxes paid to another state under Va. Code § 58.1-332 A. The Department itself corrected the taxpayers' return to claim this credit once it caught the error, which reduced (but did not eliminate) the assessment.

Q: Why didn't the taxpayers get full credit for what they paid North Carolina?
A: Both their North Carolina and Virginia returns contained numerous errors, and the taxpayers appeared to have deducted Virginia-source income on their North Carolina return too. Without an accurate computation of their actual North Carolina liability, the Commissioner could not verify a larger credit and upheld the reduced assessment.

Q: Does the border-state credit rule apply to any neighboring state?
A: The ruling addresses North Carolina specifically, which the Commissioner treated as a state contiguous to Virginia for purposes of Va. Code § 58.1-332 A's special rule. The rule requires that the out-of-state income subject to tax be less than Virginia taxable income and that all out-of-state income be earned or Schedule C business income from that single contiguous state.

Citations and references

Statutes:

• Va. Code § 58.1-301 (Virginia's conformity to Internal Revenue Code terminology and definitions)
• Va. Code § 58.1-322.01 through § 58.1-322.04 (specific Virginia modifications to federal adjusted gross income)
• Va. Code § 58.1-332 A (credit for income tax paid to another state, including the border-state special rule)
• Va. Code § 58.1-1821 (procedure for appealing a Virginia tax assessment)

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 20-175

Original ruling text

September 29, 2020

Re: § 58.1-1821 Appeal: 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, 2018.

FACTS

The Taxpayers filed a 2018 Virginia resident income tax return, claiming a deduction for income from a North Carolina business. The Department disallowed the Taxpayers’ deduction and issued an assessment. The Taxpayers disputed the assessment, claiming they had paid taxes to North Carolina and were entitled to the deduction.

The Department informed the Taxpayers that a tax credit, rather than a deduction, is available for taxes paid to another state and requested additional information to verify the amount of credit to which the Taxpayers were entitled. Based upon the information provided by the Taxpayers, the Department adjusted the Taxpayers’ Virginia return to claim a credit for taxes paid to another state, resulting in a decrease in the assessment. The Taxpayers appeal the Department’s assessment, claiming the credit allowed did not cover all of the taxes paid.

DETERMINATION

Virginia Taxable Income

Virginia Code § 58.1-301 provides, with certain exceptions, that the 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. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia . For individual income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income (VTI) 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 § 58.1-322.04. Virginia’s individual income tax statutes does not provide a subtraction or deduction for income earned in another state.

Out of State Tax Credit

Virginia Code § 58.1-332 A allows Virginia residents, who are liable for an income tax in another state, to claim a credit on their Virginia return. To claim the credit, the income must be either earned or business income or gain from the sale of a capital asset, derived from sources outside Virginia, and subject to Virginia’s income tax.

As a general rule, the credit is limited to the lesser of: (1) the amount of tax actually paid to the other state; or (2) the amount of Virginia income tax actually imposed on the taxpayer on the income derived in the other state. In the case of a Virginia resident who pays income tax to a state that borders Virginia, like North Carolina, a special rule can apply.

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 Virginia Code § 58.1-332 A. Because the North Carolina income at issue satisfies all the requirements, the special border state credit rule would apply.

Under either rule, in order to claim the credit, Virginia residents must be both liable for and pay the income tax due to the other state. See Virginia Code § 58.1-322 A.

In this case, both the North Carolina and Virginia returns provided contained numerous errors, which made it difficult to calculate the amount of the Taxpayers’ North Carolina income tax liability and corresponding Virginia credit. Similar to the Virginia return, the Taxpayers appear to have simply deducted what they considered to be income from Virginia sources on the North Carolina return. Based on the return information provided, it appears the Taxpayers over paid North Carolina income tax.

CONCLUSION

The Department was correct in disallowing the deduction claimed on the Taxpayers’ Virginia return because there is no such modification available in the Code of Virginia . The Department also correctly recognized the Taxpayers were eligible to claim a tax credit for taxes paid to another state and adjusted their return to claim the credit based upon the best information available. Without an accurate computation of the Taxpayers’ 2018 North Carolina liability, the assessment at issue is upheld.

The Taxpayers will receive an updated bill, which will include accrued interest to date. The Taxpayers should remit the balance due within 30 days of the bill date to avoid the accrual of additional interest.

The Code of Virginia sections cited are available online at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s website. 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/3354-C

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