                                 T.C. Memo. 2015-73



                           UNITED STATES TAX COURT



     MATTHEW L. CUTLER AND SHANNON W. CUTLER, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 17814-12.                           Filed April 9, 2015.



      Carl M. Markus, for petitioners.

      Teri L. Jackson and Reid Michael Huey, for respondent.



                             MEMORANDUM OPINION


      THORNTON, Chief Judge: Respondent determined deficiencies of

$15,234, $18,443, and $15,185 in petitioners’ 2007, 2008, and 2009 income tax,

respectively.1



      1
          All monetary amounts are rounded to the nearest dollar.
                                        -2-

[*2] After the parties’ concessions, the remaining issue for decision is whether

pursuant to section 62(a)(1) petitioners may deduct from their gross income

nonresident State taxes paid on petitioner husband’s (petitioner’s) share of

partnership income from his law firm.2 For the reasons explained below, we hold

that petitioners may deduct these State taxes only as itemized deductions pursuant

to section 164(a)(3).

                                    Background

      The parties submitted this case fully stipulated pursuant to Rule 122.

      Petitioner, a lawyer, is a principal in the law firm Harness, Dickey & Pierce,

PLC (HDP). HDP is organized in Michigan as a professional limited liability

company and is treated as a partnership for Federal income tax purposes. HDP has

offices in Michigan, Missouri, and Virginia. During the years at issue petitioner

worked in HDP’s Missouri office. He had the authority, along with other

principals of HDP, to direct its operations.

      During the years at issue HDP earned income sourced in Missouri,

Michigan, Virginia, Illinois, and Oregon. Petitioner did not perform services in

Michigan, Virginia, Illinois, or Oregon or work for clients based in those States.

      2
      Unless otherwise indicated, all section references are to the Internal
Revenue Code as in effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
                                        -3-

[*3] Petitioner nevertheless paid State nonresident income taxes on HDP’s income

sourced in these States.

      On Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., of

Forms 1065, U.S. Return of Partnership Income, for the years at issue, HDP

reported petitioner’s share of ordinary business income as self-employment

earnings. On their Federal income tax returns for the years at issue, petitioners

reported this income and claimed deductions for State nonresident income taxes as

unreimbursed partnership expenses on Schedules E, Supplemental Income and

Loss, as follows:3

          State              2007                 2008                  2009
     Michigan               $9,594               $10,822              $10,223
     Virginia                2,254                 4,200                 4,541
     Illinois                   95                       82                 43
     Oregon                   -0-                  -0-                      25
          Total             11,943                15,104               14,832

      Respondent determined that petitioners were not entitled to deduct the State

nonresident income taxes on their Schedules E but instead must deduct them as

itemized deductions on their Schedules A. This determination increased


      3
       Petitioners deducted Missouri resident income taxes on their Schedules A,
Itemized Deductions. Those deductions are not at issue.
                                           -4-

[*4] petitioners’ adjusted gross income with associated increases in self-

employment tax and alternative minimum tax. Petitioners, while residing in

Missouri, timely petitioned this Court.4

                                     Discussion

I. Burden of Proof

      Generally, the Commissioner’s determinations in a notice of deficiency are

presumed correct, and the taxpayer has the burden of proving that the

determinations are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933). Although the parties submitted this case fully stipulated under Rule 122,

this circumstance does not affect the placement of the burden of proof. See Rule

122(b); Borchers v. Commissioner, 95 T.C. 82, 91 (1990), aff’d, 943 F.2d 22 (8th

Cir. 1991). Because petitioners have not argued or shown that the burden of proof

with respect to any factual issue should shift to respondent, see sec. 7491, they

retain the burden of proof.


      4
        Petitioners filed a motion for leave to file out of time an amended petition
(motion for leave) and lodged an amended petition. Before the Court had acted on
the motion for leave, the parties filed a joint motion to submit this case under Rule
122, stating that the parties “agreed that the case may be submitted on the basis of
the pleadings and the facts recited in the attached stipulation”. The parties’ briefs
addressed all the issues that remained for decision in this case, including the points
that petitioners had sought to raise in their amended petition. Accordingly, we
will deny the motion for leave as moot.
                                        -5-

[*5] II. Deductions From Gross Income vs. Itemized Deductions

      Gross income includes all income from whatever source derived. Sec. 61.

Adjusted gross income (AGI) is gross income less certain deductions. Sec. 62(a).

These deductions are sometimes called “above the line”. Certain other deductions

may be subtracted from AGI in computing taxable income. Secs. 63(a), (b), (d),

164(a)(3). These itemized deductions are sometimes called “below the line”.

      The distinction between above-the-line and below-the-line deductions can

be significant. Above-the-line deductions generally may be claimed in addition to

itemized deductions or the standard deduction and offer the added benefit of

reducing AGI, which in turn is used as a measure to limit other tax benefits. See,

e.g., Calvao v. Commissioner, T.C. Memo. 2007-57. Below-the-line deductions,

unlike above-the-line deductions, are subject to income limitations and in some

instances can be deducted only to the extent they exceed a specified floor amount.

See Chu v. Commissioner, T.C. Memo. 2005-110.

      Deductions are allowed above the line if they are “attributable to a trade or

business carried on by the taxpayer, if such trade or business does not consist of

the performance of services by the taxpayer as an employee.” Sec. 62(a)(1). The

regulations interpret this statutory provision to mean that expenses are deductible

above the line when they are “directly, and not * * * merely remotely, connected
                                       -6-

[*6] with the conduct of a trade or business.” Sec. 1.62-1T(d), Temporary Income

Tax Regs., 53 Fed. Reg. 9874 (Mar. 28, 1988).

      For example, taxes are deductible in arriving at adjusted gross income
      only if they constitute expenditures directly attributable to a trade or
      business or to property from which rents or royalties are derived.
      Thus, property taxes paid or incurred on real property used in a trade
      or business are deductible, but state taxes on net income are not
      deductible even though the taxpayer’s income is derived from the
      conduct of a trade or business. [Id.]

      Substantially identical regulations have been in place since 1945, have been

deemed to have received congressional approval, and have been held to be a

proper interpretation of the statute. See Tanner v. Commissioner, 45 T.C. 145,

147-148 (1965) (rejecting a West Virginia taxpayer’s attempt to take above-the-

line deductions for West Virginia income tax he paid on his share of net income

earned by an accounting firm of which he was a partner), aff’d, 363 F.2d 36 (4th

Cir. 1966); see also Strange v. Commissioner, 114 T.C. 206 (2000) (disallowing

above-the-line deductions for State nonresident income taxes paid on net royalty

income derived from oil and gas wells), aff’d, 270 F.3d 786 (9th Cir. 2001).

      Petitioners seek to distinguish Tanner and Strange on grounds that the

nonresident income taxes in question are entity-level taxes that were imposed on

and therefore immediately connected with the conduct of petitioner’s trade or

business. Petitioners further contend that some of the Virginia nonresident taxes
                                         -7-

[*7] in question, unlike the State taxes in Tanner and Strange, were imposed on

their gross income rather than on their net income.

      A. Whether the Nonresident Taxes Were Entity-Level Taxes

      Petitioners argue that all the State taxes in question were entity-level taxes.

They argue that the 2008 and 2009 Virginia nonresident taxes were entity-level

taxes because they were imposed on HDP directly. More generally, they argue

that all the State taxes in question (including all the Virginia taxes) were entity-

level taxes because they were imposed on HDP constructively. We consider these

arguments in turn.

             1. Whether the Virginia Taxes Were Imposed Directly on HDP

      Petitioners argue that the 2008 and 2009 Virginia taxes were entity-level

taxes that were imposed directly on HDP rather than on petitioner.5 For the reasons

described below, we disagree.

      Virginia generally taxes the net income of a nonresident individual, partner,

or beneficiary receiving Virginia-source income. See Va. Code Ann. sec. 58.1-

325(A) (2013). A nonresident owner of a passthrough entity is liable for Virginia


      5
       Petitioners concede that the 2007 Virginia nonresident income taxes were
not imposed directly on HDP. Petitioners’ arguments about the 2008 and 2009
Virginia nonresident income taxes are predicated on certain amendments to the
Virginia income tax laws that became effective January 1, 2008.
                                         -8-

[*8] tax on income that passes through the entity only in the owner’s separate or

individual capacity. See id. sec. 58.1-390.2.

      A nonresident partner must first calculate the partner’s Virginia taxable

income as if the partner were a Virginia resident. Id. sec. 58.1-325(A). The partner

must then determine the ratio that its net amount of income, gains, losses, and

deductions from Virginia sources bears to the same items from all sources. Id. The

nonresident partner must then apply this ratio to the amount of Virginia taxable

income calculated as if the partner were a Virginia resident. Id. The product is the

nonresident partner’s Virginia taxable income. Id.

      Virginia requires a passthrough entity to withhold tax if it derives taxable

income from or connected with Virginia sources and allocates any portion of that

taxable income to a nonresident owner. Id. sec. 58.1-486.2(A). A passthrough

entity required to withhold tax is liable for the payment of the tax due. Id. sec.

58.1-486.2(G). If an entity fails to withhold the required tax and the nonresident

owner pays the tax, the entity is not liable for the withholding tax. Id. sec. 58.1-

486.2(H). A nonresident owner is allowed a credit against the owner’s Virginia

income tax for the owner’s share of the withheld tax. Id. sec. 58.1-486.2(E).

      Petitioners argue that Virginia expressly imposes a withholding tax on HDP

that is separate from the income tax that Virginia imposes on HDP’s nonresident
                                         -9-

[*9] principals. The Virginia withholding tax statute provides that a partnership

must pay a withholding tax for the privilege of doing business in Virginia. See id.

sec. 58.1-486.2(A). Petitioners contend that a separate Virginia statute regarding

the taxation of partnerships makes clear that the withholding tax is imposed on the

partnership itself. See id. sec. 58.1-390.2. Reading these statutes together,

petitioners argue, makes clear that the 2008 and 2009 Virginia taxes are entity-level

taxes imposed directly on HDP. We are not convinced.

      The Virginia withholding requirement in question is substantially similar to

the Federal withholding requirement that applies to wages.6 Under both the

      6
          Va. Code Ann. sec. 58.1-486.2(H) (2013) provides:

      If any pass-through entity fails to deduct and withhold tax as required
      by this section, and thereafter the tax against which such tax may be
      credited is paid, the tax so required to be deducted and withheld
      under this section shall not be collected from the pass-through entity,
      but the pass-through entity shall not be relieved from liability for any
      penalties or interest or additions to tax otherwise applicable in respect
      of such failure to withhold.

      Sec. 3402(d) provides as to wages:

      If the employer, in violation of the provisions of this chapter, fails to
      deduct and withhold the tax under this chapter, and thereafter the tax
      against which such tax may be credited is paid, the tax so required to
      be deducted and withheld shall not be collected from the employer;
      but this subsection shall in no case relieve the employer from liability
      for any penalties or additions to tax otherwise applicable in respect of
                                                                          (continued...)
                                        - 10 -

[*10] Virginia and Federal statutes, withholding agents are liable for the tax

required to be deducted and withheld. Compare Va. Code Ann. sec. 58.1-390.2

with sec. 3403. Under both the Virginia and Federal statutes, the withheld tax is

allowed as a credit against the tax imposed. Compare Va. Code Ann. sec. 58.1-

486.2(E) with sec. 31.

      We have often observed that there is only one Federal income tax but there

are two separate collection mechanisms: (1) from the employer pursuant to section

3402 or section 3403 and (2) from the employee, generally pursuant to sections 1,

61(a)(1), 6151(a), and 6155. See, e.g., McLaine v. Commissioner, 138 T.C. 228,

253 n.4 (2012); Whalen v. Commissioner, T.C. Memo. 2009-37; Roscoe v.

Commissioner, T.C. Memo. 1984-484. This observation also applies to the

Virginia taxes in question, given that the Virginia withholding mechanism mirrors

the Federal withholding mechanism.

      In sum, we conclude that the 2008 and 2009 Virginia taxes are not entity-

level taxes that were imposed directly on HDP.




      6
       (...continued)
      such failure to deduct and withhold.
                                          - 11 -

[*11]         2. Whether the Nonresident Taxes Were Constructively Imposed
                 on HDP

        Petitioners argue that all the nonresident taxes in question, including all the

Virginia taxes, were constructively imposed on HDP rather than on petitioner.

Petitioners maintain that this is necessarily so because petitioner performed no

services in any of the States generating the nonresident income taxes in question.

Petitioners contend that any other construction of the various States’ tax statutes

raises significant doubts about the constitutionality of the States’ taxing powers

because petitioner lacked a sufficient nexus to those States to be taxed by any of

them. Again, we are not convinced.

        In support of their argument, petitioners rely on an unpublished Virginia trial

court decision, DiBelardino v. Commonwealth, No. CL06-5696, 2007 Va. Cir.

LEXIS 330 (Va. Cir. Ct. June 22, 2007) (Richmond City). We are not bound by

this unpublished lower court State decision. See Commissioner v. Estate of Bosch,

387 U.S. 456, 465 (1967). In any event, we find it inapposite. DiBelardino held, in

part, that a member of a Delaware limited liability company, which was qualified to

do business in Virginia and which received settlement proceeds from a lawsuit

against a competitor, was not subject to Virginia income tax on these proceeds

because the member lacked any minimum contacts with the State of Virginia
                                        - 12 -

[*12] through ownership, management, or control of property there. By contrast,

the record in this fully stipulated case, in which petitioners bear the burden of

proof, does not establish that petitioners lack any nexus with Virginia or any of the

other States in question. To the contrary, the record convinces us that petitioner, as

an HDP principal, had the authority to manage HDP’s business, including its

business in Michigan, Virginia, Illinois, and Oregon.7

      In sum, petitioners have failed to establish that the nonresident taxes in

question were either expressly or constructively imposed on HDP. 8




      7
        A Michigan professional limited liability company (PLC) and its members
are subject to the Michigan Limited Liability Company Act (LLC Act). Mich.
Comp. Laws Serv. sec. 450.4901(2) (LexisNexis 2014). According to the LLC
Act, the members of a PLC are to manage the PLC’s business unless the PLC’s
articles of organization state otherwise. Id. sec. 450.4401. Petitioners failed to
place the HDP operating agreement into the record or otherwise to establish that
the HDP principals managed HDP differently than would be the case under the
default rules of the LLC Act. See id. sec. 450.4901(2). Accordingly, we have
found that petitioner had the authority along with other HDP principals to direct
its operations.
      8
       Having rejected the premises of petitioners’ argument, we need not and do
not decide whether, as they suggest, a State tax expressly or constructively
imposed on a business entity is necessarily directly attributable to a trade or
business so as to be deductible from gross income pursuant to sec. 61(a)(2).
                                       - 13 -

[*13] B. Whether the Virginia Taxes Were Imposed on Petitioners’ Gross Income

      Petitioners alternatively argue that the 2008 and 2009 Virginia taxes are

deductible from gross income because they were imposed on petitioner’s gross

income rather than his net business income. In support of this argument,

petitioners point to regulations under section 62 which provide that State taxes on

net income are not deductible in determining AGI. Sec. 1.62-1T(d), Temporary

Income Tax Regs., supra. From these regulations petitioners deduce that State

taxes on gross income are deductible in determining AGI.

      Petitioners’ argument fails because, if for no other reason, the Virginia taxes

in question were imposed on net income rather than gross income. See Va. Code

Ann. sec. 58.1-325(A) (providing for calculation of the Virginia “taxable income”

of a nonresident individual, partner or beneficiary as determined by comparing the

“net amount” of income, gain, or loss from Virginia sources and the “net amount”

of such items from all sources).9

      Petitioners also rely on Rev. Rul. 81-288, 1981-2 C.B. 17, in arguing that the

2008 and 2009 Virginia taxes were imposed on petitioner’s gross business income,

      9
       Terms in the Virginia Income Tax chapter generally have the same
meaning as in the Internal Revenue Code unless a different meaning is clearly
required. Va. Code Ann. sec. 58.1-301. Under the Internal Revenue Code,
“taxable income” means gross income less deductions allowed, sec. 63, as
distinguished from “gross income”, sec. 61.
                                        - 14 -

[*14] not his net income, and should be properly treated as an above-the-line

deduction. This revenue ruling concluded that the New Hampshire Business

Profits Tax (NHBPT) was deductible above the line. The revenue ruling describes

the NHBPT as a tax on the privilege of entering into a business in New Hampshire

and as measured by net profits reduced by a deduction for the reasonable value of

the proprietor’s services. By contrast, as previously discussed, the 2008 and 2009

Virginia taxes were taxes of general application applying to all of petitioner’s

Virginia-source income and calculated by reference to the net amount of income,

gain, loss, and deductions from HDP. Consequently, whatever weight might be

accorded the revenue ruling, petitioners’ reliance on it is misplaced.

       We sustain respondent’s determination that the State nonresident taxes in

question are not deductible from petitioners’ gross income in determining their

AGI but instead are deductible only as itemized deductions pursuant to section

164(a)(3).

      To reflect the foregoing and the parties’ concessions,


                                                 An appropriate order will be issued,

                                       and decision will be entered under Rule 155.
