My company operated a contracting business in Virginia and a farm in another state. When the farm passed to an heir under the owner's will, can I allocate that gain entirely to the other state instead of apportioning it under Virginia's standard formula?

Plain-English summary

A real property contractor doing business in Virginia also operated a farm in another state ("State A"). In 2014, the corporation's sole owner passed away, and under her will, the State A farm property passed directly to one of her children -- a distribution that produced a taxable gain for federal income tax purposes. The taxpayer argued the gain wasn't the result of a business sale but simply carried out the deceased owner's wishes, and asked the Department for permission to allocate the ENTIRE gain to State A rather than apportion it across states under Virginia's standard statutory formula.

Procedural failure. Virginia's process for requesting an alternative apportionment method is well-established and must be followed in a specific order: first file the return using the STANDARD statutory method and pay any tax due, THEN file a timely amended return proposing the alternative method, with an explanation of why the standard method is inapplicable or inequitable. The taxpayer here skipped this process and simply asked for the alternative method directly in a ruling request -- without ever demonstrating (through actual filed returns and records the Department could examine) that the standard method produced an unconstitutional or grossly distorted result.

Substantive failure -- not "nonbusiness income." Even setting the procedural problem aside, the taxpayer's argument depended on treating the farm gain as "nonbusiness income" (income unrelated to the taxpayer's regular business, which under U.S. Supreme Court precedent can sometimes be allocated to a single state rather than apportioned). But the facts as presented showed the taxpayer had been operating the farm as an actual going concern, not just passively holding it -- meaning the farm was part of a single UNITARY business (combining contracting and farming) right up until the distribution. Under that unitary-business framework, the gain doesn't qualify as separately allocable nonbusiness income at all.

The final irony -- it wouldn't have helped anyway. Under the legal standard the taxpayer was invoking, nonbusiness income is allocated to the taxpayer's STATE OF COMMERCIAL DOMICILE -- and since the taxpayer's ongoing, primary business activity was its Virginia contracting operations, its commercial domicile was Virginia itself. So even if the gain HAD qualified as nonbusiness income, it would have been allocated entirely to Virginia -- actually INCREASING the Virginia tax owed rather than reducing it. Virginia law expressly forbids granting an alternative apportionment method that would increase a taxpayer's tax liability, so the request would have failed on this ground too.

What this means for you

Businesses considering a request for an alternative apportionment method

Follow the required procedure exactly: file your return using the STANDARD statutory method first, pay any tax due, and THEN file a timely amended return proposing the alternative method with supporting documentation. Asking the Department directly for pre-approval, without going through your actual filed returns, is very unlikely to succeed.

Multi-state businesses that also hold investment or other seemingly passive assets in another state

Before assuming a gain qualifies as separately allocable "nonbusiness income," consider whether the asset was actually integrated into your ongoing, unitary business operations (functional integration, centralized management, economies of scale) -- an asset that's genuinely operated as part of the business, even if it seems collateral to your main line of work, likely won't qualify for separate treatment.

Anyone weighing whether an alternative apportionment request is worth pursuing

Check where the "nonbusiness income" allocation rule would actually land the income BEFORE requesting it -- since nonbusiness income allocates to your state of commercial domicile, a business primarily headquartered/operating in Virginia may find that classification increases (not decreases) its Virginia liability, which the law won't allow you to elect into anyway.

Common questions

Q: How do I properly request an alternative method of apportionment from Virginia?
A: File your return first using the standard statutory apportionment method and pay any tax due, then file a timely amended return (within the deadline for refund claims) proposing the alternative method, explaining why the standard method is inapplicable or inequitable.

Q: What makes a gain "nonbusiness income" eligible for allocation to a single state instead of apportionment?
A: Under the Allied-Signal/MeadWestvaco standard, the underlying asset must NOT be an operational asset involved in a unitary business -- courts look at functional integration, centralization of management, and economies of scale to determine whether an asset (and its resulting gain) is truly part of the ongoing business.

Q: If my company's out-of-state asset produces "nonbusiness income," where does that income get taxed?
A: It's allocated to the company's state of commercial domicile -- which could mean MORE Virginia tax, not less, if Virginia is where your primary ongoing business activity and management are located.

Citations and references

• Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978) (apportionment is inherently approximate; a state's method is constitutionally valid if rationally related to business transacted within the state, even with some overlap between states)
• Hans Rees' Sons, Inc. v. North Carolina, 283 U.S. 123, 135 (1931), and Norfolk & Western R. Co. v. Missouri State Tax Commission, 390 U.S. 317, 326 (1968) (an apportionment formula will only be disturbed with clear and cogent evidence of an out-of-proportion or grossly distorted result)
• Corp. Exec. Bd. Co. v. Va. Dep't of Taxation, 297 Va. 57, 822 S.E.2d 918 (2019) (Virginia's apportionment method doesn't violate Due Process/Commerce Clauses or create a distorted result merely because it rests on the labor of Virginia employees; double taxation alone isn't unconstitutional)
• Department of Taxation v. Lucky Stores, Inc., 217 Va. 121, 225 S.E.2d 870 (1976), and Public Documents 85-61, 86-88, 92-85, 06-13, 07-75, 11-138, and 13-86 (the Department disfavors separate accounting; a different result under separate accounting alone doesn't show the statutory method is inequitable)
• Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992), and MeadWestvaco Corp. v. Illinois Department of Revenue, 553 U.S. 16 (2008) (standards for whether an asset is a unitary, operational part of a business, versus separately allocable nonbusiness income)
• Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980), and F.W. Woolworth Co. v. Taxation and Revenue Dept. of N.M., 458 U.S. 352 (1982) (three objective factors for a unitary relationship: functional integration, centralization of management, and economies of scale)

Subject

Apportionment : Alternative Method - Nonbusiness Income

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 21-99

Original ruling text

July 27, 2021

Re: Ruling Request: Corporate Income Tax

Dear *:

This will reply to your letter in which you request an alternative method of allocation and apportionment on behalf of * (the “Taxpayer”).

FACTS

The Taxpayer, a real property contractor operating in Virginia, also operated a farm located in * (State A). In 2014, the Taxpayer’s sole owner passed away. Through the owner’s will, the State A property owned by the Taxpayer was passed directly to one of the owner’s children. For income tax purposes, the distribution of the property resulted in a gain.

The Taxpayer contends the gain was not the result of a business sale, but to fulfill the wishes of the owner. Under these circumstances, the Taxpayer requests permission to allocate the gain from the sale of the farm property to State A.

RULING

For Virginia income tax purposes, a corporate taxpayer’s entire federal taxable income, adjusted and modified as provided in Virginia Code §§ 58.1-402 and 58.1-403, less dividends allocable pursuant to Virginia Code § 58.1-407, is subject to apportionment in accordance with Virginia Code §§ 58.1­408 through 58.1-421.

Alternative Method of Apportionment

The United States Supreme Court has recognized that allocation and apportionment of income is an arbitrary process designed to approximate income from business transactions within a state. As long as each state’s method of allocation and apportionment is rationally related to the business transacted within a state, then each state's tax is constitutionally valid even though there may be some overlap. See Moorman Mfg. Co. v. Bair , 437 U.S. 267, 98 S. Ct. 2340 (1978). Thus, the Taxpayer must show that the statutory method of apportionment produces an unconstitutional result.

An apportionment formula used as an approximation of an entity’s income reasonably related to the activities conducted within a taxing state will only be disturbed when the taxpayer has proved by “clear and cogent evidence” that the income attributed to the state is in fact “out of all reasonable proportion to the business transacted . . . in that state,” Hans Rees' Sons, Inc. v. North Carolina , 283 U.S. 123, 135 (1931), or has “led to a grossly distorted result,” Norfolk & Western R. Co. v. Missouri State Tax Commission , 390 U.S. 317, 326 (1968).

Recently, the Virginia Supreme Court’s decision in Corp. Exec. Bd. Co. v. Va. Dep't of Taxation , 297 Va. 57, 822 S.E.2d 918 (2019) found that Virginia’s apportionment method did not violate the Due Process or Commerce clauses of the United States Constitution or Virginia Code § 58.1-421 and did not create a distorted result because the tax imposed on services rested upon the labor of employees in Virginia. Recognizing the United States Supreme Court’s decision in Moorman Mfg ., 437 U.S. at 274, Virginia’s highest court acknowledged that the existence of double taxation does not, by itself, violate the United States Constitution. Further, it conceded the inevitability of states devising different schemes of taxation and apportionment. Corp. Exec. Bd. , 297 Va. at 72, 822 S.E.2d at 925 Thus, states are granted wide latitude in adopting apportionment formulas. See Moorman Mfg. , 437 U.S. at 274.

Title 23 of the Virginia Administrative Code (VAC) 10-120-280 goes even further by permitting taxpayers an alternative method when the statutory method of allocation and apportionment is inequitable. Under the standards of the regulation, a statutory method can be found to be inequitable if: (1) it results in double taxation of the income, or a class of income, of the taxpayer; and (2) the inequity is attributable to Virginia, rather than to the fact that some other state has a unique method of allocation and apportionment.

The Department’s long-standing policy holds the use of separate accounting in disfavor. See Department of Taxation v. Lucky Stores , Inc., 217 Va. 121, 225 S.E.2d 870 (1976), ), Public Document (P.D.) 85-61 (3/18/1985), P.D. 86-88 (4/30/1986), P.D. 92-85 (6/1/1992), P.D. 06-13 (2/7/2006), P.D. 07-75 (5/18/2007), P.D. 11-138 (7/28/2011) and P.D. 13-86 (6/10/2013). The Taxpayer has not provided any evidence that demonstrates the statutory apportionment method is inequitable. The fact that separate accounting produces a different result from the statutory method is not sufficient to show the statutory apportionment method is inequitable.

In addition, the Taxpayer has not followed the established procedure for requesting an alternative apportionment method. The policies that apply to requests for an alternative method of allocation and apportionment under Virginia Code § 58.1-421 are well established. In order for a taxpayer to request an alternative method of allocation and apportionment, the taxpayer must file the return using the statutory method and pay any tax due. Next, the taxpayer is required to file an amended return proposing an alternative method within the time prescribed for filing amended returns claiming refunds. The amended return must include a statement of why the statutory method is inapplicable or inequitable and an explanation of the proposed method of allocation and apportionment. The Department will not grant an alternative method of allocation and apportionment unless it determines: (1) the statutory method produces an unconstitutional result under the particular facts and circumstances of the taxpayer's situation; or 2) the statutory method is inequitable because it results in double taxation and the inequity is attributable to Virginia, rather than another state’s method of apportionment. See Title 23 VAC 10-120-280.

In the context of a ruling request, when a taxpayer does not provide the Department with the opportunity to examine the records underlying the claim, the taxpayer cannot demonstrate that Virginia’s factor formula produces an unreasonable or distorted result. Further, because constitutional apportionment is designed to approximate income from business transactions within a state and not result in actual income from business transactions within a state, a taxpayer’s argument that Virginia's statutory method does not reflect actual income in Virginia cannot be accepted.

The use of an alternative method is allowed only in extraordinary circumstances where the need for relief has been demonstrated by clear and cogent evidence. Based on the facts presented, the Taxpayer has not demonstrated that the statutory method is unconstitutional or inapplicable as it would apply to the Taxpayer. Furthermore, the Taxpayer’s request is not in accordance with the procedure for requesting an alternative method of allocation and apportionment outlined in Title 23 VAC 10-120-280. Based on the foregoing, I must deny the Taxpayer’s request to use an alternative method of allocating and apportioning income.

Nonbusiness Income

Not withstanding the general rule, the Department will allow an alternative method of allocation and apportionment if a taxpayer can show that the imposition of Virginia’s statute is in violation of the standards enunciated by the United States Supreme Court in Allied-Signal, Inc. v. Director, Division of Taxation , 504 U.S. 768, 119 L.Ed.2d 533 (1992) and Meadwestvaco Corporation v. Illinois Department of Revenue , 553 U.S. 16, 128 S.Ct. 1498 (2008). In order to meet the standards set by the Supreme Court, a taxpayer must demonstrate that its investments are not operational assets involved in a unitary business.

In considering the existence of a unitary relationship, the Supreme Court has focused on three objective factors: (1) functional integration; (2) centralization of management; and (3) economies of scale. See Mobil Oil Corp. v Commissioner of Taxes , 445 U.S. 425 (1980); F. W. Woolworth Co. v. Taxation and Revenue Dept. of N.M. , 458 U.S. 352 (1982); and Allied-Signal.

The decision of the United States Supreme Court in Allied-Signal also made it clear that the payee and payor need not be engaged in the same unitary business as a prerequisite to apportionment in all cases. In Meadwestvaco supra at 29, 128 S.Ct. 1507, the Supreme Court clarified that the decision in Allied-Signal did not create “a new ground for the constitutional apportionment of extrastate values in the absence of a unitary business.” Still, it opined the operational function analysis in Allied-Signal could be influential to the finding that an asset was a unitary part of a business being conducted in the taxing jurisdiction. Accordingly, the form of an entity’s business and the purpose of its investments are both relevant in determining if an asset was a unitary part of the business conducted by such entity.

According to the Taxpayer, the farm was used strictly for farming purposes and the farming activity had slowly been diminishing prior to the distribution. The facts as stated, however, indicate the Taxpayer owned the farm assets and was operating the farm as a going concern. Thus, it appears the Taxpayer’s unitary business included both contracting and farming up until the distribution of the property.

Further, the Taxpayer argues that the gain only resulted from the execution of the owner’s will and was not the result of a business decision. Without clear documentation as of the intent of the owner, the Department cannot speculate as to the owner’s reasons for separating the businesses upon her death.

What the Department is able to surmise of the facts presented is that the Taxpayer conducted a unitary business that included farming in State A and contracting in Virginia and that the assets of the farm were being used in the operation of the Taxpayer’s farming business until the time of the distribution. Under these circumstances, the Department would not consider the gain to be nonbusiness income eligible for allocation to the Taxpayer’s state of commercial domicile.

In addition, under the standards of Allied-Signal, nonbusiness income is allocated to the entity’s state of commercial domicile. Because the primary ongoing activity was its contracting operations, it appears the Taxpayer was commercially domiciled in Virginia. As such, if the gain were treated as nonbusiness income, it would be allocated to Virginia. Virginia Code § 58.1-421, however, expressly prohibits allowing an alternative method of allocation and apportionment if the alternative method increases the tax liability of a taxpayer. In the case presented, allocating the gain to Virginia would likely increase the Taxpayer’s Virginia income tax liability. Accordingly, the gain from the distribution of the farm property could not be treated as allocable income.

The Code of Virginia sections, regulations, 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 Department’s Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/596o

Related Documents

85-61

86-88

92-85

06-13

07-75

11-138

13-86