I bought into an LLC from a previous owner who took a Virginia bonus-depreciation addition in an earlier year -- can I still claim the offsetting Virginia subtraction in a later year, even though I wasn't the original owner?

Plain-English summary

A husband and wife filed a joint 2016 Virginia individual income tax return claiming a fixed date conformity (FDC) subtraction. The Department requested more information, then disallowed the subtraction and issued an assessment because it had no record of the couple ever reporting the matching FDC ADDITION in a prior year -- normally the trigger that would later justify a subtraction. The couple appealed, and won.

Why Virginia has FDC additions and subtractions at all. Virginia's income tax generally starts from federal adjusted gross income (or federal taxable income for corporations), but Virginia's conformity to the Internal Revenue Code is "fixed" to a specific date each year rather than automatic and ongoing -- and even as that date has been repeatedly advanced (to Dec. 31, 2015 for 2015 tax years per VTB 16-1, then to Dec. 31, 2016 for 2016 tax years per VTB 17-1), Virginia has consistently refused to conform to federal bonus depreciation (IRC § 168(k)). That mismatch means a business that claims bonus depreciation federally must ADD BACK the extra depreciation for Virginia purposes in the year it's taken federally -- but then, in later years, as the SMALLER Virginia depreciation continues while the larger federal depreciation has already been used up, the business (or its owners) can SUBTRACT that catch-up difference. Over an asset's life, total FDC additions generally equal or exceed total FDC subtractions.

How this flows through a pass-through entity. When an LLC (or partnership, S-corp, etc.) takes bonus depreciation, the resulting FDC additions and subtractions typically pass through to individual owners in proportion to their ownership share, the same way other income, gain, loss, deduction, and credit items pass through. Owners are generally taxed only on their own passed-through share, and the statutory scheme presumes that if an owner accurately reports the amounts the pass-through entity provided them, those amounts are correct -- any error should be corrected first at the ENTITY level, then passed through to owners, rather than second-guessed owner-by-owner.

Why the couple won. The couple weren't the ORIGINAL owners of the LLC -- they'd acquired their interest from a prior owner who had taken the FDC addition in an earlier year. But their Virginia Schedule VK-1 forms from the LLC showed the FDC subtraction being passed through to them for depreciation on assets placed in service before their ownership began, where bonus depreciation had been claimed federally but not for Virginia. The Tax Commissioner found that the couple's lack of a PERSONAL prior-year addition didn't matter: the original owner's earlier addition had already affected that owner's own federal adjusted gross income and basis in the LLC, and when ownership transferred, the NEW owner simply reports whatever FDC adjustments the entity itself passes through -- consistent with federal partnership-audit principles (which generally determine tax treatment at the partnership level, not the individual partner level). Because the couple accurately reported what their LLC's own forms showed, the subtraction was valid and the assessment was abated.

A caveat that remains open. The ruling notes that if the Department later determines there actually WAS a reporting error in an earlier year's FDC addition, the fix must happen through a correction to the return for the year the addition was required (within the applicable statute of limitations) -- and if the error originated at the pass-through entity's own level, the Department must audit and adjust the ENTITY's return, which can also trigger a separate 6% penalty against the entity for failing to timely file a required return.

What this means for you

New owners of an LLC, partnership, or S-corp interest

You don't need your OWN personal record of a prior-year FDC addition to validly claim a later FDC subtraction -- what matters is that the pass-through entity's own tax reporting (e.g., your Schedule VK-1) correctly shows the subtraction passing through to you as the current owner, tracing back to bonus depreciation the entity claimed before you acquired your interest.

Accountants preparing returns for new pass-through owners

When a client acquires an interest from a prior owner, verify FDC subtraction eligibility against the ENTITY's own historical bonus-depreciation reporting, not against whether your client personally reported a matching addition -- ownership transfers don't reset or forfeit an asset's FDC subtraction trail.

Pass-through entities themselves

If the Department later finds a reporting error in how your entity handled bonus depreciation, expect the correction (and any associated late-filing penalty) to be made at the ENTITY level first, with the effects then flowing through to current owners -- not assessed against individual owners for the entity's own reporting mistakes.

Common questions

Q: Do I need to have personally reported a prior FDC addition to claim an FDC subtraction now?
A: No -- if you acquired your pass-through interest from a previous owner, what matters is that the entity's own tax forms (like your Schedule VK-1) show the subtraction passing through to you, tracing back to bonus depreciation the entity claimed before your ownership began.

Q: Why doesn't Virginia allow bonus depreciation in the first place?
A: Virginia's conformity to the Internal Revenue Code is fixed to a specific date each year rather than automatic, and the General Assembly has consistently excluded IRC § 168(k) bonus depreciation from that conformity, requiring an addition when it's claimed federally and offsetting subtractions in later years.

Q: What if the Department later finds an actual reporting error in the entity's bonus-depreciation history?
A: The correction must be made to the return for the year the addition was originally required (within the statute of limitations), and if the error is at the pass-through entity's level, the Department audits and adjusts the ENTITY's return -- which can also trigger a 6% late-filing penalty against the entity.

Subject

Pass-through Entity : FDC Subtractions - Bonus Deprecation

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 21-48

Original ruling text

April 6, 2021

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 “Taxpayer”) for the taxable year ended December 31, 2016.

FACTS

The Taxpayers, a husband and wife, filed joint Virginia individual income tax returns for the 2016 taxable year, claiming a fixed date conformity (FDC) subtraction. Under review, the Department requested additional information to determine if the Taxpayers qualified for the subtraction. After reviewing the information provided, the Department disallowed the subtraction because the Taxpayers had not previously reported an FDC addition and issued an assessment. The Taxpayers appeal, contending the FDC subtraction on their return is correct.

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 was specifically exempt as a Virginia modification pursuant to pursuant to Chapter 3 of Title 58.1 of the Code of Virginia .

In 2003, Virginia began conforming to the IRC as of a specific or fixed date. Since then, the General Assembly has enacted legislation to move the date of conformity forward each year. Effective for taxable years beginning on and after January 1, 2015, Virginia’s conformity date was advanced from December 31, 2014 to December 31, 2015, with limited exceptions. See Virginia Tax Bulletin (VTB) 16-1 (2/5/2016). Effective for taxable years beginning on and after January 1, 2016, Virginia’s conformity date was advanced from December 31, 2015 to December 31, 2016 with limited exceptions. See VTB 17-1 (2/6/2017). For both taxable years Virginia continued to prohibit bonus depreciation allowed for certain assets under IRC § 168 (k).

Because Virginia does not fully conform to the IRC, any bonus depreciation must be adjusted to determine the depreciation amount for Virginia income tax purposes. FDC additions and subtractions, therefore, are not considered to be a Virginia modification. Rather, any exceptions identified in Virginia Code § 58.1-301 are added or subtracted from FAGI as computed under the IRC in order to determine an individual taxpayer’s FAGI for Virginia income tax purposes.

For example, if a taxpayer computed their FAGI using bonus depreciation for one or more assets, then the FAGI for Virginia purposes must be recomputed as if those assets had not received bonus depreciation, resulting in a Virginia addition. In a later tax year, when the Virginia depreciation amounts are less than the federal depreciation amounts, the taxpayer would recognize the difference by taking a Virginia subtraction. Although, FDC subtractions can be taken in the immediate taxable years following the return on which an FDC addition was reported, required FDC additions will generally be equal to or greater than the total of FDC subtractions claimed in subsequent years.

FDC additions and subtractions are often taken on an individual’s return pursuant to an ownership interest in a pass through entity (PTE). A PTE is “any entity… that is recognized as a separate entity for federal income tax purposes, in which the partners, members or shareholders report their share of the income, gains, losses, deductions and credits from the entity on their federal income tax returns.” See Virginia Code § 58.1-390.1. In determining Virginia taxable income of an owner of a PTE, each item of income, gain, loss, deduction or credit shall be in the same proportion as the owner’s distributive share, for federal income tax purposes, and have the same character and be incurred in the same manner for an owner as if realized directly from the source from which it was realized by the PTE. See Virginia Code § 58.1-391. Owners of a PTE usually are liable for tax in their individual capacities only on income that is passed through to them, while the PTE is liable for taxes imposed on the PTE itself. See Virginia Code § 58.1-390.2.

This statutory regime implies that when a PTE provides tax information to an individual owner and they accurately report the amounts on their Virginia return, the information is presumed to be correct. If it is determined that an error was made by a PTE, a change or correct would happen first to the PTE, then the change or correction would pass through to the individual owners.

In this case, the Department denied the Taxpayers’ FDC subtraction because there is no record of the Taxpayers taking an FDC addition in a prior taxable year. The Taxpayers explain that they acquired ownership of the PTE from a prior owner, who had taken the FDC addition. They provided Virginia VK-1 forms, showing that the FDC subtractions were taken for depreciation of assets that were placed in service prior to the taxable years at issue for which bonus depreciation was calculated for at the federal level but not for Virginia. They assert that, because bonus depreciation was claimed in prior taxable years on the federal level but not for Virginia, they are now entitled to recognize that difference by taking a Virginia subtraction.

Virginia’s conformity to federal law is limited. See Public Document (P.D.) 98-158 (10/20/1998) and P.D. 07-195 (11/27/2007). Further guidance can be instructive in determine how the Department could approach the administration of Virginia’s income tax structure. Under Treas. Reg. § 301.6221-1(a)(a), the tax treatment of income, loss, deductions, and credits are determined at the partnership level. This means that the IRS, in general, cannot change a partner’s treatment of partnership items of the partner’s return. In P.D. 20-31 (3/4/2020), the Department opined that IRS procedures should be considered when making adjustments to amounts reported on a federal return. Because FDC additions and subtractions are essentially a modification to federal income tax laws, the Department must, likewise, consider the implications of IRS procedures. Examining FDC additions and subtractions reported by a PTE on the PTE’s return provides a more complete audit trail and record keeping consistency.

When the original owner reported the FDC addition, it would have affected their FAGI and basis in the PTE. When they sold the interest in the PTE, the new owner reports whatever FDC adjustments are passed through from the PTE. The fact that the Taxpayers were not the original owners who reported the FDC addition does not affect the Taxpayers ability to claim the FDC subtraction. Because the Taxpayers properly reported their FDC subtraction as indicated on their federal and Virginia PTE tax forms, they are entitled to claim the subtraction on their 2016 Virginia joint individual income tax return. Accordingly, the assessment at issue has been abated.

If the Department determined that there has been an error in reporting an FDC addition in prior taxable years, then the Department must correct the Taxpayers’ return for the taxable year in which an addition was required but not taken. As such, correction must be made within the applicable statute of limitations. Further, if the Department ascertains there has been a reporting error on the returns provided by the Taxpayers’ PTE, then the Department must audit and make adjustments at the PTE level. Pursuant to Virginia Code § 58.1-394.1, the Department is authorized to impose a penalty equal to 6% of the PTE’s Virginia taxable income when such PTE fails to file a required return within the time required.

The Code of Virginia sections, Virginia Tax Bulletins 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/3484.A

Related Documents

16-1

17-1

98-158

07-195

20-31