Can a pass-through entity claim the IRC 965(c) repatriation deduction and an IRC 754 basis deduction when computing its 2017 Virginia nonresident withholding tax?

Plain-English summary

The taxpayer is an out-of-state limited liability partnership that is a partner in a Virginia LLC with Virginia-source income. Because of special allocations, 100% of the partnership's income and deductions flowed to a corporate partner (a C corporation) that filed a Virginia return but owed nothing thanks to a net operating loss carryforward. The partnership filed its pass-through entity withholding return reporting a liability but sent no payment, so the Department assessed the reported amount. On appeal, the partnership argued two federal Tax Cuts and Jobs Act (TCJA) deductions should have wiped out the liability.

How Virginia withholding works. A pass-through entity with Virginia-source income allocable to a nonresident owner must withhold and remit 5% of that owner's share (Va. Code Sec. 58.1-486.2). Owners are taxed on their distributive share (Va. Code Sec. 58.1-390.2).

The conformity question. Virginia ties its tax base to the Internal Revenue Code as of a fixed date (Va. Code Sec. 58.1-301). Although VTB 19-1 says Virginia conforms to the TCJA beginning with 2018, the Commissioner explained that Virginia still follows TCJA provisions for pre-2018 years unless it expressly deconformed from them. That distinction decided both deductions:

• IRC Sec. 965(c) repatriation deduction -- allowed. IRC Sec. 965 forced a one-time "repatriation" tax on untaxed foreign earnings, with a paired deduction to lower the effective rate. Virginia's fixed-date conformity law contains no exception for the 965(c) deduction, so the partnership could claim it.
• IRC Sec. 754 basis deduction -- denied. The 754 election adjusts partnership property basis (via IRC Sec. 743) when an interest is sold. Post-TCJA rules let a partnership take that adjustment as first-year bonus depreciation under IRC Sec. 168(k). Virginia deconforms from all bonus depreciation (VTB 17-1 and 19-1), so the 754/bonus-depreciation deduction was disallowed.

Because the allowed 965(c) deduction offset the partnership's net income, the withholding tax assessment for January through December 2017 was abated.

What this means for you

Pre-2018 TCJA provisions can still apply in Virginia

Virginia's "conforms starting 2018" language does not mean earlier-year TCJA provisions are off-limits. Virginia follows a federal provision for a pre-2018 year unless it expressly deconformed -- so the 965(c) repatriation deduction was available for 2017.

Bonus depreciation is a firm Virginia carve-out

Any deduction that runs through IRC Sec. 168(k) bonus depreciation -- including a 754 basis adjustment taken that way -- is disallowed for Virginia. This is a long-standing deconformity item (VTB 17-1, 19-1).

Withholding still traces to the owner's actual tax picture

The entity withholds on Virginia-source income allocated to nonresident owners, but deductions that reduce that net income reduce the withholding base.

Common questions

Why was the 965(c) deduction allowed but the 754 deduction denied? The 965(c) deduction has no Virginia exception, so conformity carries it. The 754 deduction was claimed as bonus depreciation, and Virginia deconforms from bonus depreciation entirely.

Does Virginia conform to the TCJA only from 2018 forward? Formally yes, but the Department follows TCJA provisions for earlier years too unless it expressly deconformed -- which it had not for 965(c).

Why did the assessment disappear? The 965(c) deduction offset the entity's net income, leaving nothing to withhold for the 2017 period.

Citations and references

• Va. Code Sec. 58.1-486.2 / 58.1-486.1 -- pass-through entity withholds 5% of a nonresident owner's Virginia-source income.
• Va. Code Sec. 58.1-390.2 -- owners are taxed on their distributive share.
• Va. Code Sec. 58.1-301 -- fixed-date conformity to the IRC, with express exceptions.
• IRC Sec. 965(c) -- repatriation deduction; no Virginia exception, so allowed.
• IRC Sec. 754 / 743 / 168(k); VTB 17-1, 19-1 -- basis adjustment taken as bonus depreciation; Virginia deconforms, so denied.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 20-79

Original ruling text

May 12, 2020

Re: § 58.1-1821 Application: Withholding Tax

Dear *:

This will respond to your letter submitted on behalf of your client * (the “Taxpayer”), in which you seek correction of the pass-through entity withholding tax assessment issued for the taxable period of January 2017 through December 2017. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer, a limited liability partnership, is a pass-through entity domiciled in * (State A). It is a partner in (VLLC). ** (the “Corporation”) is a C corporation and a partner in VLLC. The VLLC had Virginia source income during the 2017 taxable year. Due to special allocations, 100% of the Taxpayer’s income and deductions were allocated to the Corporation. The Corporation filed a 2017 Virginia corporate income tax return but reported no liability because of a net operating loss (NOL) carryforward from prior taxable years.

The Taxpayer filed a pass-through entity return of income and return of nonresident withholding tax on which it reported a withholding tax liability but remitted no payment. As such, the Department issued an assessment for the withholding tax liability reported on the return. The Taxpayer appeals, contending that it was eligible to claim two deductions in accordance with the provisions of the Tax Cuts and Jobs Act (the “TCJA”) that would result in the abatement of the assessment.

DETERMINATION

Nonresident Withholding Requirement

Virginia Code § 58.1-486.2 A provides that “a pass-through entity that has taxable income for the taxable year derived from or connected with Virginia sources, any portion of which is allocable to a nonresident owner” must pay withholding tax. The amount of tax that must be withheld is equal to 5% of the nonresident owner’s share of income from Virginia sources of all nonresident owners that may lawfully be taxed by Virginia and which is allocable to a nonresident owner. See Virginia Code § 58.1-486.2 B 1.

Under Virginia Code § 58.1-486.1, a “nonresident owner” is any person treated as a partner, member, or shareholder of the pass-through entity for federal income tax purposes and, in the case of an individual, is not a domiciliary or actual resident of Virginia. Pursuant to Virginia Code § 58.1-390.2, owners of pass-through entities are liable for tax “only in their separate or individual capacities on income passed through to the owners of pass-through entities.” As such, owners are subject to tax on their distributive share of items of income, gain, loss, deduction, or credit of the pass-through entity. Therefore, when nonresidents are owners of pass-through entities, the pass-through entity must compute, report and remit withholding tax. See Virginia Code § 58.1-486.1 A and the Guidelines for Pass-Through Entity Withholding , issued as Public Document (P.D.) 15-240 (12/22/2015).

Pass-through entities that have taxable income from Virginia sources and that must allocate any portion of that income to at least one nonresident owner during any portion of the taxable year must pay the withholding tax unless an exemption applies. See P.D. 15-240. Generally, pass-through entities must remit the required withholding tax with the Pass-Through Entity Return of Income and Return of Nonresident Withholding (Form 502). In such cases, the pass-through entity withholding must be remitted by the 15th day of the fourth month following the close of the taxable year on the Pass-Through Entity Withholding Tax Payment form (Form 502W).

Conformity

Virginia Code § 58.1-301 provides, with certain exceptions, 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. Conformity does not extend to terms, concepts, or principles not specifically provided in 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.

On December 22, 2017, Congress enacted Public Law 115-97, known as the TCJA, which substantially changed the federal income taxation of individuals and businesses. Although the TCJA is typically effective for taxable years beginning in 2018, certain provisions of the act effect prior years.

House Bill 2529 and Senate Bill 1372 (Chapter 17, 2019 Acts of Assembly and Chapter 18, 2019 Acts of Assembly , respectively) were enacted to advance Virginia’s date of conformity to the IRC from February 9, 2018 to December 31, 2018. This legislation allows Virginia to generally conform to the TCJA and the Bipartisan Budget Act of 2018 for the 2018 taxable year and after. Pursuant to Tax Bulletin (VTB) 19-1 (2/15/2019), Virginia will also generally conform to the provisions of the TCJA that affect businesses for the 2018 taxable year and thereafter. It will also continue to deconform from certain provisions of the IRC as explained in VTB 17-1 (2/6/2017).

The Taxpayer contends that because Virginia conforms to the TCJA, the Taxpayer should have been allowed to claim both an IRC § 965(c) deduction and an IRC § 754 deduction when calculating its pass-through entity withholding liability for the 2017 taxable year. Although VTB 19-1 states that Virginia would conform to the TCJA beginning with the 2018 taxable year, the Commonwealth will follow the TCJA for taxable years prior to 2018 provided that it has not expressly deconformed from such provisions.

IRC § 965(c) Deduction

Multinational companies and individual investors have been keeping some of their foreign profits untaxed by holding such profits abroad in foreign corporations for many years. The TCJA forces the domestic parent corporation (or United States individual shareholder) to pay a one-time income tax, known as “repatriation,” at reduced rates on all their untaxed foreign profits in the 2017 taxable year.

The repatriation inclusion under IRC § 965 consists of two parts. In the first part, the gross inclusion of post-1986 accumulated, untaxed earnings and profits (“E&P”) is calculated, which is prescribed as additional subpart F income. Under the second part, a deduction is permitted to account for the lowered effective tax rate on E&P. Virginia’s fixed date conformity legislation has not provided an exception for the IRC § 965(c) deduction.

IRC § 754

IRC § 754 generally allows a partnership to make an election to adjust the basis of its property when a partnership interest is sold. This basis adjustment is governed by IRC § 743. Under IRC § 743, when one taxpayer sells his partnership interest to another taxpayer for a profit, the partnership is allowed to increase the basis of its property. The increase in basis is beneficial because, when the partnership property is ultimately sold by the partnership for a profit, it results in less gain realized.

The post-TCJA proposed regulations allow a partnership (under certain circumstances and when it holds qualifying property) to immediately deduct the IRC § 743 amount as first-year bonus depreciation deduction under IRC § 168(k). Virginia continues to deconform from any bonus depreciation allowed for certain assets under IRC §§ 168(k), 168(l), 168(m), 1400L, and 1400N. See VTB 17-1 and 19-1. As such, the Taxpayer could not claim an IRC § 754 deduction when calculating its pass-through withholding tax liability.

CONCLUSION

Under Virginia’s fixed date conformity provisions, taxpayers are permitted to claim an IRC § 965(c) deduction, but cannot deduct excess depreciation as provided under IRC § 754 when calculating its pass-through withholding tax liability for the 2017 taxable year. Because the amount of the IRC § 965(c) deduction offsets the Taxpayer’s net income, the assessment of pass-through entity withholding tax for the taxable period of January 2017 through December 2017 will be abated.

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/1936.B

Related Documents

15-240

19-1

17-1