When a pass-through entity files a unified (composite) return for its nonresident partners, must the tax be computed at the highest individual rate instead of each partner's own bracket, and does that income include guaranteed payments for services performed outside Virginia?

Subject

Pass-through Entity (PTE) : Unified Filing - Appealable Rate, Virginia Source Income

Plain-English summary

A pass-through entity (a partnership) filed a Form 765, Unified Nonresident Individual Income Tax Return (Composite Return), on behalf of its Virginia nonresident partners for the 2018 tax year. On review, the Department adjusted the tax rate used on the return and assessed additional individual income tax. The Taxpayer appealed, arguing the assessment was wrong for two reasons: first, that the Department should have let each partner pay tax at that partner's own (lower) rate and bracket based on that partner's pro-rata share of Virginia-source income; and second, that the Virginia taxable income figure itself was too high because it included guaranteed payments to partners for services performed outside Virginia.

The Tax Commissioner rejected the first argument but agreed there was a real problem with the second. On rates, Va. Code § 58.1-395 lets the Department permit unified filing only on terms it sets, and the Department's published Guidelines for Pass-Through Entity Withholding (P.D. 15-240) require that tax on a unified/composite return be computed at the single highest individual income tax rate under Va. Code § 58.1-320 -- with no itemized deductions, standard deduction, personal exemptions, resident-state tax credits, credit carryovers, or other credits not attributable to the entity. A unified return is a convenience the Department extends to taxpayers at their election, not a right to compute tax partner-by-partner at each partner's own bracket, so the Department's adjustment to the highest rate was correct based on the return as filed.

On the guaranteed-payments issue, the Commissioner agreed with the Taxpayer's underlying legal point: guaranteed payments are ordinary income to the individual partner and are sourced to where the services were actually performed. If those services were not performed in Virginia, the payments are not Virginia-source income (citing P.D. 05-48). But because the original assessment was based on the return exactly as the Taxpayer filed it, the fix for an overstated income figure is not a ruling reversing the assessment -- it is for the Taxpayer to file an amended return within the statute of limitations under Va. Code § 58.1-1823, submitted within 60 days of the ruling letter, so the Department could review it and adjust the assessment as appropriate.

What this means for you

Pass-through entities filing unified/composite nonresident returns

If you elect to file a Form 765 unified return for your nonresident partners or shareholders, expect the entire return to be taxed at the single highest Virginia individual income tax rate under Va. Code § 58.1-320, with no itemized or standard deductions, personal exemptions, other-state tax credits, or credit carryovers. You cannot compute each partner's share at that partner's own lower bracket -- the trade-off for the administrative convenience of one composite filing is the flat top rate, as spelled out in the Department's Guidelines (P.D. 15-240).

Partnerships and other pass-through entities with guaranteed payments to nonresident partners

Guaranteed payments are ordinary income to the receiving partner and are sourced based on where the underlying services were physically performed, not where the entity operates. If a nonresident partner's guaranteed payment compensates services performed entirely outside Virginia, that payment should not be included in the partner's Virginia-source income reported on the composite return.

Taxpayers who believe their reported income was wrong

An assessment based on a return exactly as filed will generally be upheld as "correct" in an administrative appeal, even if the underlying reported numbers were wrong. If you discover after filing that you overstated Virginia taxable income, the remedy is to file a timely amended return under the statute of limitations in Va. Code § 58.1-1823, not to seek reversal of an assessment that accurately reflects what was originally reported.

Common questions

Q: Can a pass-through entity compute Virginia composite-return tax for each nonresident partner using that partner's own individual tax bracket?
A: No. Under the Department's Guidelines for Pass-Through Entity Withholding (P.D. 15-240) and Va. Code § 58.1-395, a unified/composite return must be taxed at the single highest rate under Va. Code § 58.1-320, without deductions, exemptions, or most credits.

Q: Are guaranteed payments to a nonresident partner always Virginia-source income?
A: No. Guaranteed payments are ordinary income attributed to where the partner performed the underlying services. If those services were performed outside Virginia, the payments are not Virginia-source income and should not be taxed by Virginia.

Q: If a return overstated Virginia taxable income, does the Tax Commissioner correct the assessment as part of an appeal?
A: Not directly in this ruling. Because the assessment matched the return as filed, the Commissioner said the Taxpayer must file an amended return within the statute of limitations under Va. Code § 58.1-1823; the Department would then review it and adjust the assessment as appropriate.

Q: Is filing a unified/composite return mandatory for a pass-through entity with nonresident owners?
A: No. The ruling describes it as a privilege and administrative convenience the Department extends to taxpayers at their election, which eliminates the need for each nonresident partner to file a separate Virginia return, in exchange for tax being computed at the highest rate.

Q: Does this ruling mean every pass-through entity gets the same result?
A: No. This is a fact-specific determination for one taxpayer's 2018 unified return; it is not binding precedent for other taxpayers, though it reflects how the Department applies its published Guidelines and sourcing rules for guaranteed payments.

Citations and references

Statutes:

• Va. Code § 58.1-395 (discretionary authority to permit unified/composite filing)
• Va. Code § 58.1-320 (individual income tax rate brackets; unified returns taxed at the highest rate)
• Va. Code § 58.1-1821 (application for correction of assessment)
• Va. Code § 58.1-1823 (statute of limitations for filing an amended return)

Related public documents:

• P.D. 15-240 (12/22/2015) -- Guidelines for Pass-Through Entity Withholding
• P.D. 05-48 (4/7/2005) -- sourcing of guaranteed payments to nonresident partners

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 21-28

Original ruling text

March 2, 2021

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will respond to your letter in which you seek correction of the assessment of individual income tax issued to * (the “Taxpayer”) for the taxable year ended December 31, 2018.

FACTS

The Taxpayer filed a Form 765, Unified Nonresident Individual Income Tax Return (Composite Return), on behalf of its Virginia nonresident partners for the 2018 taxable year. Under review, the Department adjusted the rate of tax that was applied and issued an assessment. The Taxpayer appeals, contending the assessment is incorrect because its Virginia taxable income included guaranteed payments made to partners for services performed outside Virginia.

DETERMINATION

Virginia Code § 58.1-395 grants discretionary authority to the Department to permit unified filing under terms acceptable to the Department. The Virginia income tax on the unified return must be computed at the highest rate under Virginia Code § 58.1-320 without the benefit of itemized deductions, standard deductions, personal exemptions, credits for income taxes paid to states of residence, any tax credit carryover amounts, or any other tax credits that are not attributable to the pass-through entity. See Guidelines for Pass-Through Entity Withholding, published as Public Document (P.D.) 15-240 (12/22/2015) (the “Guidelines”). The pass-through entity is required to obtain the qualified nonresident owner’s consent to be included on the unified return and be subject to the same restrictions as described above. See id .

A unified return is an administrative convenience that allows nonresident partners to pay their respective Virginia tax at the entity level. The need for filing a separate Virginia return for each partner is eliminated. It is a privilege extended by the Department to taxpayers at the taxpayers’ election. The convenience to the nonresident partners usually outweighs any benefits that may be lost.

The Taxpayer explains that Virginia income tax due was calculated separately for each partner by taking each partner’s pro-rate share of Virginia source income and affording each partner the benefit of the lower income tax rates and brackets. This method is not permitted by the Guidelines, which state that the tax must be computed at the highest rate under Virginia Code § 58.1-320. In making the adjustment, the Department computed the tax due based on such rate. The Department’s adjustment, therefore, was correct based on the return as filed by the Taxpayer.

The Taxpayer now claims that the participants’ Virginia taxable income amount reported on the return was incorrect because the computation included guaranteed payment amounts to partners for services rendered outside Virginia. The Department has recognized that guaranteed payments are ordinary income to the individual partner and are attributed to the place where the services are performed. If those services are not performed in Virginia, then they are not Virginia source income. See P.D. 05-48 (4/7/2005).

Because the assessment was based on the return as filed by the Taxpayer, if the Taxpayer believes it incorrectly reported its Virginia taxable income, it should file an amended return. The amended return should be submitted within the statute of limitations provided under Virginia Code § 58.1-1823. If the return is filed within 60 days of 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: *, the return will be reviewed and the assessment will be adjusted, as appropriate. If the return is not received within the 60 day time period, the assessment will be considered to be correct and collection action may resume.

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/3554.M

Related Documents

05-48

15-240