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In Virginia, Arm's-Length Still Leads to Overreach

By Timothy Gustafson and Prentiss Willson

The Virginia Tax Commissioner overturned the Department of Taxation’s adjustments to a taxpayer’s nonresident Virginia income tax return based on a determination that certain transactions between related entities were indeed conducted at arm’s-length, contrary to the Department’s prior findings. The nonresident taxpayer was the majority owner of both an out-of-state LLC as well as a Virginia-based S Corporation. The LLC’s only client was the Virginia S Corp. The S Corp., a financial and retirement services provider, paid the LLC fees for investment and asset management services performed on behalf of the S Corp.’s clients. On the nonresident tax return filed by the taxpayer, the loss passed through from the S Corp. was attributed to Virginia while the income passed through from the LLC was attributed to the taxpayer’s state of residency. The Department determined that the fees paid from the S Corp. to the LLC were not at an arm’s-length rate and attributed all of the taxpayer’s share of the LLC’s income to Virginia, exercising its authority under Virginia Code section 58.1-446 to “equitably adjust the tax” where two commonly owned corporations structure an arrangement to improperly reflect the business done in Virginia. On appeal, the Commissioner disagreed with the Department’s adjustments, determining that the LLC, which incurred reasonable operating costs in light of its business activities, had economic substance and that the fees paid by the S Corp. to the LLC were comparable to the fees paid to an unrelated third-party provider, i.e., were at arm’s length. However, the Commissioner returned the case to the Department for a reassessment upon finding that portions of both the LLC’s income (received from its only client – the S Corp.), and the taxpayer’s salary as one of the LLC’s two employees, were attributable to the 74 days that the taxpayer performed work on behalf of the LLC in Virginia. Rulings of the Tax Commissioner, No. 12-219 (December 21, 2012).

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