I co-founded a tech startup, invested cash over several years (some before Virginia's subtraction window opened, some during it, with a distribution along the way), and sold my stake for a big gain -- how much of that gain actually qualifies for Virginia's long-term capital gain subtraction?

Plain-English summary

A husband and wife co-founded a Virginia LLC in 2007, which they later converted into a corporation in 2014, then sold their shares later that same year for a substantial long-term capital gain reported on their federal return. The company had been certified by the Virginia Secretary of Technology as a "qualified business" -- one of the requirements for Virginia's special subtraction that lets certain long-term capital gains from investing in Virginia tech businesses be excluded from state income tax. The couple claimed the full subtraction on their 2014 Virginia return; the Department denied it entirely on the theory that their investment wasn't a "qualified investment." On appeal, and after the couple provided a detailed capital contributions spreadsheet, balance sheets, profit-and-loss statements, and K-1s spanning 2007-2014, the Department didn't just reverse itself -- it walked through the correct methodology and RECOMPUTED the couple's subtraction to reflect only the portion of the gain actually eligible.

The subtraction has two hard boundaries. To qualify, the investment must be in a business certified as a "qualified business" (or approved technology business) with its principal facility in Virginia and under $3 million in prior-year revenue -- and the INVESTMENT ITSELF must have been made between April 1, 2010 and June 30, 2020. Investments made before that window (like this couple's original 2007 contributions) don't count toward the subtraction, no matter how large the eventual gain.

Only "investment"-type contributions count -- not sweat equity. The subtraction statute borrows its eligibility framework from a related tax-credit statute covering equity and subordinated-debt investments in technology businesses. That means only a direct transfer of CASH or other property with a determinable monetary value, in exchange for equity or subordinated debt, counts as an "investment" -- the couple's "sweat equity" (unpaid labor/services) contributed to the business doesn't count toward the eligible investment amount, even though it likely helped build the value that was eventually sold.

For LLCs, tracking "net investment" is genuinely complicated -- and that complexity is the real substance of this ruling. Unlike a stock certificate (which has a fixed value tied to a purchase date), an LLC member's capital account constantly fluctuates with the business's profits, losses, and distributions. The Department's methodology: your "net investment" isn't just your total cash contributions -- it's your contributions MINUS any distributions that exceeded your share of CURRENT AND RETAINED earnings (i.e., distributions that were effectively a return of your own capital, not a payout of profit). The ruling works through a full numeric example to illustrate: a member (H) contributes $100 in 2009 (before the window opens) and another $100 in 2011 (during the window), then takes a $20 distribution in 2012 before selling for a $910 gain. Because the 2012 distribution exceeded that year's income plus retained earnings, $50 of it is treated as a return of the 2011 investment -- shrinking the "in-window" net investment from $100 down to just $50. The couple's total net investment (in-window $50 plus pre-window $100) is $150, so the ELIGIBLE portion of the gain is calculated as $50/$150 (33.33%) times the $910 total gain -- just $303.33, not the full amount.

The result here. Applying this same methodology to the couple's actual documented contributions (which spanned both before and during the eligibility window), the Department recomputed their subtraction rather than denying it outright, and remanded the figure to compliance staff to issue a revised bill.

What this means for you

Founders or investors who contributed cash to a Virginia LLC or corporation both before and during April 1, 2010-June 30, 2020

Only the NET investment made during that window is eligible for the subtraction -- keep a running, dated ledger of every cash/property contribution (with amounts and dates) so you can prove exactly how much falls inside versus outside the eligibility window when you eventually sell.

LLC members who took distributions along the way before an eventual sale

Understand that a distribution exceeding your share of current-year profit and prior retained earnings is treated as a RETURN OF YOUR OWN CAPITAL for this calculation -- it reduces your "net investment" figure (and thus your eligible subtraction percentage), even though it might feel unrelated to your eventual capital gain.

Founders whose contribution to the business was mostly "sweat equity" rather than cash

Only cash or property contributions with a determinable monetary value count as "investment" for this subtraction -- unpaid labor/services you contributed, however valuable to the business's eventual worth, don't increase your eligible investment amount.

Anyone claiming this subtraction who receives an initial denial

A denial isn't necessarily final or all-or-nothing -- as this case shows, providing detailed contemporaneous documentation (contribution spreadsheets, balance sheets, K-1s) can lead the Department to recompute a PARTIAL subtraction rather than uphold a complete denial, if your investment timeline genuinely spans both inside and outside the statutory window.

Common questions

Q: My company was certified as a Virginia "qualified business," but I invested some money before April 1, 2010 and some after -- does my whole gain qualify for the subtraction?
A: No -- only the gain attributable to your NET investment made between April 1, 2010 and June 30, 2020 is eligible; any gain tied to earlier (or later) contributions doesn't qualify, even from the same overall investment in the same business.

Q: Does "sweat equity" (unpaid work) I put into my startup count as an investment for this subtraction?
A: No. Only direct cash or property contributions with a determinable monetary value, made in exchange for equity or subordinated debt, count as an "investment" for this purpose.

Q: I took a distribution from my LLC before selling my stake -- does that affect my eligible subtraction amount?
A: Potentially yes. If the distribution exceeded your share of that year's profit and prior retained earnings, it's treated as a return of your own capital contribution (rather than a profit payout), which reduces your "net investment" figure and can shrink the percentage of your gain that's eligible for the subtraction.

Q: How is the eligible portion of my gain actually calculated if my investments span both before and during the eligibility window?
A: Divide your NET investment made during the eligibility window by your TOTAL net investment (in-window plus outside-window), then multiply that percentage by your total gain included in federal taxable income.

Citations and references

• Public Document 16-83 (5/16/2016) and P.D. 16-181 (9/6/2016) -- the subtraction's "investment" requirement borrows the equity/subordinated-debt eligibility framework from the related Qualified Equity and Subordinated Debt Tax Credit statute
• Public Document 18-131 (6/27/2018) -- an investment need not meet ALL the requirements of a "qualified investment" under Va. Code § 58.1-339.4 to be eligible for the subtraction
• Public Document 17-108 (6/21/2017) -- the subtraction's statutory restrictions must be satisfied at the time the investment is MADE, not when the resulting income is later realized
• Howell's Motor Freight, Inc., et al. v. Virginia Dep't of Taxation, Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983) (statutes granting deductions/subtractions/credits are legislative grants and must be strictly construed against the taxpayer and in favor of the taxing authority)

Subject

Subtraction : Long-Term Capital Gain - Eligible Investment

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 21-84

Original ruling text

July 13, 2021

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, 2014. I apologize for the delay in the Department’s response.

FACTS

The Taxpayers, a husband and wife, co-founded * (VALLC) in 2007, then converted VALLC into *** (VACP) in 2014. The Taxpayers sold shares of VACP later in 2014, and reported the income from the sale as a long-term capital gain on their federal return. The Virginia Secretary of Technology issued VACP a Letter of Certification, verifying that it was a “qualified business” for purposes of Virginia’s long-term capital gain subtraction.

The Taxpayers filed a Virginia individual income tax return for the 2014 taxable year, claiming a long-term capital gain subtraction for the income they received from the sale of VACP stock. Under review, the Department denied the subtraction because the investment that created the capital gain was not a qualified investment. The Taxpayers appealed, contending that they met all the statutory requirements to claim the subtraction.

DETERMINATION

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 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 properly 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.

By reason of their character as legislative grants, statutes relating to deductions and subtractions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell’s Motor Freight, Inc., et al. v. Virginia Dep’t of Taxation , Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983).

For individual income tax purposes, Virginia Code § 58.1-322.02 24 provides for a subtraction for any income taxed as a long-term capital gain for federal income tax purposes. The following restrictions apply:

To qualify for a subtraction . . . , such income shall be attributable to an investment in a “qualified business,” as defined in 58.1- 339.4, or in any other technology business approved by the Secretary of Technology, provided that the business has its principal office or facility in the Commonwealth and less than $3 million in annual revenues in the fiscal year prior to the investment. To qualify for a subtraction . . . , the investment shall be made between the dates of April 1, 2010, and June 30, 2020. No taxpayer who has claimed a tax credit for an investment in a “qualified business” under 58.1-339.4 shall be eligible for the subtraction under this subdivision for an investment in the same business.

By using the term “investment” and referring to the eligibility criteria found in Virginia Code § 58.1-339.4, it appears that the General Assembly intended for only equity and subordinated debt investments to be eligible for the subtraction. That is because Virginia Code § 58.1-339.4 pertains to the Qualified Equity and Subordinated Debt Tax Credit, for which only equity and subordinated debt investments in technology businesses are eligible. Virginia Code § 58.1-322.02 24 provides that if a taxpayer has already claimed the credit, he is not eligible to claim the subtraction. Thus, the overall statutory scheme involves the same types of investments, either equity or subordinated debt. See Public Document (P.D.) 16-83 (5/16/2016) and P.D. 16-181 (9/6/2016). Based on the Department’s understanding of the General Assembly’s intent, investments must be a direct transfer of cash or other property with a determinable monetary value to a qualified business in exchange for equity or subordinated debt.

It is not necessary, however, for investments to meet all the requirements of a “qualified investment” under Virginia Code § 58.1-339.4. See P.D. 18-131 (6/27/2018). The Department has also reiterated that the statutory restrictions must be satisfied at the time the investment is made rather than when the income is realized. See P.D. 17-108 (6/21/2017).

Equity is defined as “common stock or preferred stock, regardless of class or series, of a corporation; a partnership interest in a limited partnership; or a membership interest in a limited liability company, which is not required or subject to an option on the part of the taxpayer to be redeemed by the issuer within three years from the date of issuance.” See Virginia Code § 58.1-339.4 A.

When an individual or entity invests in stock of a corporation, they receive a stock certificate equal to the value of the investment. Matching cash payments to stock certificate dates makes tracking the amount and time of investments for purposes of the subtractions reasonably straight forward.

For pass through entities such as LLCs and partnerships, the determination of contribution values and dates is much more complicated. When an LLC is formed, an owner (called a “member”) or owners make a capital contribution or an investment into the business to get it started. Member contributions can include payments of cash or assignments of non-cash resources (i.e. property, assumptions of liability or services). Non-cash capital is measured based on the fair market value of property. The value of services, however, is generally not recognized in an individual's capital account to avoid tax implications.

Under Virginia Code § 13.1-1002, a “membership interest” is defined as a member’s share of the profits and the losses of the limited liability company and the right to receive distributions of the limited liabilities company’s assets. A member’s capital or equity can be reflected as a percentage, certificates or units. The membership interest or capital account percentages or units are kept separate from profit and loss allocations and distributions based on terms of the company’s operating agreement. Thus, a membership interest or equity percentage will generally remained unchanged as the capital account is adjusted. Because the issuance of new certificates or units can be readily identified as new investments, the Department cannot discriminate against a contribution made by a member to a capital account even if their ownership percentage does not change.

Unlike stock, however, for which the value remains static at the date of purchase, an LLC members capital or equity account into which the initial investment was made will be impacted by subsequent profits and losses of the business and distributions paid out to such member. This places additional demands on both the accounting system of the business and the record keeping of the member in order to accurately track the actual value of amounts invested during periods for which the long-term capital gain subtraction is permitted.

At the end of each fiscal year, a member’s share of the LLC’s profit or loss is reflected in their capital account. When a member takes a distribution, or draws from the LLC, a corresponding decrease is reported in their capital account. If an additional capital contribution is made, the amount is recorded as another investment in the member’s capital account. Thus, the amount and timing of a member’s equity or capital is constantly fluctuating.

The issue of the timing of the investment is not an issue when all of the investments are made within the effective dates of the long-term gain subtraction. Under the current statute, the subtraction is limited to the gain on investments made in a qualified business between April 1, 2010, and June 30, 2020. See Virginia Code § 58.1-322.02 24. For a qualified business that was started prior to the effective date of the subtraction, however, the issue becomes determining the amount of the gain attributable to the investment made by a member during periods eligible for the subtraction. Any gain attributable to an investment made prior to April 1, 2010, would not be eligible for the subtraction.

For purposes of determining the amount of the gain included in taxable income, the proceeds from the sale of membership interests would generally be netted against a member’s balance in their capital account. For purposes of the subtraction however, not all of the amounts included in a members capital account would be considered to be investments. Because an investment would include only monetarily valued contributions by a member, adjustments resulting from the profits and losses from ongoing operations and distributions correlated to those profits and losses would not be included in the amount of a member’s investment for purposes of determining how much of a gain is eligible for the subtraction. Thus, for purposes of the long term gain subtraction, a member’s investment would be limited to the net of the fair market value of their investments (contributions to capital) and any distributions not attributable to the earnings of the business ( i.e . distributions in excess of current and retained earnings). It will be the member’s responsibility to maintain records of their net investments in a qualified business.

When a member has made investments in a qualified business on dates both prior to and during the eligibility period, a computation must be done to determine the portion of the gain eligible for the subtraction. The eligible portion of the gain would be the portion of the gain of attributable to net investments made during the eligibility period (currently April 1, 2010 through June 30, 2020). The statute is silent as to how to determine the amount of the eligible gain. If a taxpayer is able, they may provide evidence that clearly attributes gains to specific net investments. Absent such evidence, a taxpayer’s long-term gain eligible for the subtraction would be calculated by dividing their net investments made during the eligibility period by their total net investment and multiplying the resulting percentage with the total gain included in federal taxable income or FAGI.

It may be is easiest to understand the computation of net investments and the amount of eligible gain by considering an example. An individual (H) forms APP, LLC (APP) in 2009 and contributes $100 to help start the business. APP reports net losses of $50 in both 2009 and 2010. In 2011, H invests another $100 and APP reports $10 profit. In early 2012, H takes a $20 distribution and sells APP for $1,000. At the time of the sale, H’s capital account has a balance of $90 (See Table 1) resulting in a gain of $910.

Table 1 - H’s Capital in App, LLC

Year

Contributions (Investments)

Distributions

Profits and Losses

Net Capital

2009

$100

($50)

$50

2010

$0

($50)

$0

2011

$100

$10

$110

2012

$50

$90

While the gain is based on total net capital, the eligible subtraction is based only on the portion of the net investment made during the eligibility period. First, H must determine his net investment. H’s total investment in APP was $200. However, because the distribution in 2012 exceeded current and retained earnings, a computation is required in order to determine how much, if any, H’s investment must be reduced. The distribution in 2012 ($20) exceeded the most current income of $10 in 2011 and exceeded the total prior retained earnings. Consequently, H received a return of his capital investment equal to $50 because his retained loss exceeds net income. Thus his net investment at the time of the sale of APP was $150.

H made a $100 investment in APP in 2009 prior to the eligibility period for the subtraction. Thus any gain attributable to this portion of the investment would not be eligible for the subtraction. H also made $100 investment in 2011 during the eligibility period, but also took a distribution that resulted in a $50 reduction in his investment. As a result of the excess distribution, H’s net investment during the eligibility period was $50.

To determine the eligible portion of the gain, the total net gain would be multiplied by the percentage of the investment made investment during the eligibility period or $50 divided by $150 (33.33%). $910 multiplied by 33.33% would result in a subtraction of $303.33.

In this case, the Taxpayers earned income from the sale of VACP stock, and the income was taxed as a long-term capital gain for federal income tax purposes. In addition, VACP was certified by the Virginia Secretary of Technology as a “qualified business,” had its principle office or facility in Virginia, and earned less than $3 million in annual revenue in the fiscal year prior to investment.

The Taxpayers assert that a majority of their investment was “sweat equity,” but that they did invest cash through capital contributions. The Taxpayers provided a capital contributions spreadsheet showing cash deposits made from 2007 through 2014, as well as balance sheets, profit and loss statements, and federal schedules K-1 from 2007 through 2014. At issue, therefore, is what portion of the gain was attributable to an equity or subordinated debt investment made after April 1, 2010.

Based on the information provided by the Taxpayers, the Department has recomputed the Taxpayers’ long-term gain in accordance with this determination. The attached schedule shows the computation of the eligible subtraction. The assessment will be returned to compliance staff to be adjusted in accordance with this schedule and an updated bill with accrued interest to date will be sent to the Taxpayers. The Taxpayers should remit payment of the balance within 30 days from the bill date to avoid the accrual of additional interest.

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 ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1609-C

Related Documents

16-83

16-181

17-108

18-131