BEFORE THE IOWA DEPARTMENT OF REVENUE
HOOVER STATE OFFICE BLDG
DES MOINES, IOWA
IN THE MATTER OF THE PETITION OF
MICHAEL J. HUMES
DECLARATORY ORDER REGARDING
IOWA CODE § 422.5(1)(j)(2),
§ 422.8(2)(b) AND DEPARTMENT RULE
DOCKET NO: 03-20-6-0082
Pursuant to a "Petition for Declaratory Order" submitted to the Iowa Department of Revenue (hereinafter referred to as "Department") by Michael J. Humes (hereinafter referred to as "Petitioner") on June 12, 2003, and in accordance with Iowa Code Section 17A.9 and Department rule 701 IAC 7.56(8)(17A) Declaratory order-in general, the Department hereby issues its Declaratory Order.
The facts as presented by the Petitioner are as follows:
Petitioner is an individual taxpayer who is a resident of Iowa and who, along with his wife, files Iowa individual income tax returns under the status of "married filing separately on a combined return." Petitioner is a shareholder in Mutual Med, Inc. ("Mutual Med"), which is a corporation formed under the law of the state of Iowa and involved in insurance administration.
On April 11, 1986, Mutual Med made a valid election under Section 1362 of the Internal Revenue Code to be treated as a subchapter S corporation, whereby the income is taxed directly to its shareholders. For each of the tax years ending on or after December 31, 2000, Petitioner had made the election to calculate Iowa income tax by taking advantage of the provisions available under Iowa Code § 422.5(1)(j)(2), whereby an Iowa resident that is a shareholder in an S corporation that does business within and without Iowa may elect to take a credit against their Iowa individual income tax liability. Mutual Med will continue to be an S corporation for the period ending December 31, 2003, and will have approximately 65% of its sales attributable to Iowa.
Mutual Med expects to have positive taxable income for the period ending December 31, 2003, and Petitioner is planning to take distributions from Mutual Med prior to December 31, 2003. Such distributions would at least exceed the amount necessary for Petitioner to pay federal and state income taxes related to the pro rata share of Mutual Med's taxable income, and could potentially be as much as Petitioner's entire share of such income. After all distributions are made, it is anticipated that Petitioner will have a positive basis in his Mutual Med stock, Mutual Med will have a positive balance in its accumulated adjustment account as defined in Section 1368 of the Internal Revenue Code, and Mutual Med will have no accumulated earnings and profits.
The function of a declaratory order is to provide "reliable advice from an agency as to the applicability of unclear law." Bonfield, The Iowa Administrative Procedure Act: Background, Construction, Applicability, Public Access to Agency Law, The Rulemaking Process, 60 Iowa Law Rev. 731, 805 (1975). Iowa Code § 17A.9 (2003) contemplates declaratory orders by administrative agencies on a disclosed set of facts. City of Des Moines v. P.E.R.B., 275 N.W.2d 753, 758 (Iowa 1979). A declaratory order enables the public to secure definitive binding advice as to the applicability of agency-enforced law to a particular set of facts. Bonfield, at 822-823.
It is not the function of a declaratory order to resolve issues involving factual analysis "too complicated to handle outside of an actual adjudication." Bonfield, at 807. A declaratory order is not a "contested case" as defined in Iowa Code § 17A.2(5) (2003); namely, it is not an evidentiary hearing which is also an administrative remedy set forth in Iowa Code ch. 17A (2003) and in the Department's rules; see 701 IAC 7.50. Consequently, for purposes of this declaratory order, the Director views the issues raised in the petition for declaratory order as questions of law applicable to the factual situation disclosed by the Petitioner in the petition. This view is consistent with department rule 701 IAC 7.56 concerning the issuance of declaratory orders.
Petitioner requests a declaratory ruling on the following individual income tax question:
Under Iowa Code § 422.5(1)(j)(2) and § 422.8(2)(b), if the total distributions made by Mutual Med during 2003 reduce the corporation's accumulated adjustment account, and if the distributions by Mutual Med to the Petitioner do not exceed his stock basis and thus are excluded from the Petitioner's gross income, should such distributions be treated as a "return of capital" that are excluded from "distributions from income not previously taxed by Iowa" under Department subrule 701-50.3(4) and thus not be included in the calculation of Petitioner's net income allocated to Iowa?
For purposes of this declaratory order, it is assumed that the question dealing with this distribution not being included in the calculation of Petitioner's net income allocated to Iowa is solely for the purposes of computing the credit set forth in Iowa Code section 422.5(1)(j)(2).
Iowa Code section 422.5(1)(j)(2) provides for a credit for an Iowa resident that is a shareholder in an S corporation that does business within and without Iowa. The credit is calculated using a percentage, the numerator of which is the "resident's net income allocable to Iowa" and the denominator of which is the resident's total net income. Iowa Code section 422.8(2)(b) states that the resident shareholder's net income allocable to Iowa must include the greater of the following:
(1) The net income or loss of the corporation which is fairly and equitably attributable to this state under section 422.33, subsections 2 and 3.
(2) Any cash or the value of property distributions which are made only to the extent that they are paid from income upon which Iowa income tax has not been paid, as determined under rules of the director, reduced by the amount of any of these distributions that are made to enable the shareholder to pay federal income tax on items of income, loss, and expenses from the corporation.
Iowa Rule 701-50.3 further defines the value of property distributions set forth in section 422.8(2)(b). Subrule 701-50.3(4) states that distributions treated as a return of capital for federal income tax purposes should not be included as property distributions from income not previously taxed by Iowa. Therefore, if these distributions are considered a return of capital for federal tax purposes, it will also be considered a return of capital for Iowa tax purposes, and will not be included in Petitioner's income allocated to Iowa for purposes of calculating the credit under section 422.5(1)(j)(2).
The Director has reviewed the portions of the Internal Revenue Code and regulations cited in the Petition. Based on Section 1368 of the Internal Revenue Code and Regulation 1.1368-3, the Director believes that distributions which are excluded from Petitioner's gross income that subsequently reduce Petitioner's stock basis and the S corporation's accumulated adjustment account are considered a return of capital for federal tax purposes.
The Director finds that if the distributions that are excluded from Petitioner's federal taxable income and that subsequently reduced Medical Med's accumulated adjustment account and Petitioner's basis in Mutual Med stock are considered a return of capital for federal income tax purposes, then it is also considered a return of capital for Iowa tax purposes. These distributions are excluded from the definition of "distributions from income not previously taxed by Iowa," in accordance with Iowa subrule 701-50.3(4), and are excluded from the calculation of Petitioner's "net income allocable to Iowa" in accordance with section 422.8(2)(b). Accordingly, the Director finds that these distributions will not reduce the credit available to Petitioner under section 422.5(1)(j)(2).
Done at Des Moines, Iowa, this _____ day of July, 2003.
IOWA DEPARTMENT OF REVENUE
Michael D. Ralston, Director
POLICY SECTION ASSIGNMENT/SUMMARY REPORT
TTS: Jim McNulty From: Michael J. Humes
Control #: DOCKET NO: 03-20-6-0082 Date: 6/12/2003 Due Date: 7/11/2003
Subject Matter: Declaratory Order
Summary of Position Statement or Correspondence:
An S corporation distribution that is excluded from the shareholder's gross income and subsequently reduces the shareholder's stock basis and the S corporation's accumulated adjustments account is considered a return of capital for federal tax purposes. Therefore, it can be excluded from the petitioner's income allocated to Iowa for computing the S corporation apportionment credit for Iowa individual income tax purposes.
The ruling has not yet become final. The Petitioner has 60 days from the date of its issuance to appeal the order if it chooses.