Rev. Rul. 89-16

1989-1 C.B. 76, 1989-6 I.R.B. 5.

                       Internal Revenue Service

                                 Revenue Ruling

                 STATE INCOME TAXES; MANDATORY WAGE ASSESSMENTS

                          Published: February 6, 1989

Section 164. - Taxes, 26 CFR 1.164-1: Deduction for taxes.

  State income taxes; mandatory wage assessments. Amount withheld from the wages of employees for contribution to the West Virginia Unemployment Compensation Trust Fund qualify as state "income taxes" and, therefore, are deductible by the employees under section 164(a)(3) of the Code.

  The State of West Virginia's Unemployment Compensation Trust Fund was depleted. In response to worsening conditions, the Federal government advanced to West Virginia funds under section 1201 of the Social Security Act, 42 U.S.C. section 1321, as amended in

1981, to help pay unemployment compensation benefits.

  In 1987, West Virginia enacted a statute designed to raise money to repay the Federal government. Under state law, employers are required to withhold a percentage of gross wages paid to each employee and remit the withheld amounts to the state. In addition, employers are required to remit a percentage of employee wages. The statute reserves the authority to impose an additional 'stabilization' assessment on employers and employees if it determines that benefits paid out of the Unemployment Compensation Trust Fund will exceed the contributions received during any calendar quarter.

  ISSUES. At issue is whether the amounts withheld from employees wages constitute state income taxes deductible under section 164(a)(3). Also at issue is whether employers may deduct their contributions as state taxes paid or accrued in carrying on a trade or business.

  HOLDINGS. The Service has held that employees may deduct the amounts withheld, provided that the employee itemizes his or her deductions. The Service also ruled that West Virginia employers subject to the statute may deduct their contributions under section 164.

  ANALYSIS. The Service relied primarily on Rev. Rul. 81-191, 1981-2 C.B. 49, in which withholding under the Rhode Island Temporary Disability Insurance Act was held deductible. The key to determining that the withholding constitutes a tax, the Service noted, is that the amounts 'are exacted pursuant to legislative authority in the exercise of the taxing power of the state, and they are imposed and collected by the state for the purpose of raising revenue to be used for a governmental function that serves public purposes.'

  For further information, contact Geoffrey Channing Horton of the Office of Assistant Chief Counsel (Income Tax and Accounting) at (202) 566-3627.

ISSUE

  Are contributions made by employees and employers pursuant to the West Virginia Unemployment Compensation Law taxes which are allowed as a deduction under section 164(a) of the Internal Revenue Code for the taxable year in which paid or accrued?

FACTS

  The State of West Virginia pays unemployment compensation benefits, based upon average weekly wages, from the state's Unemployment Compensation Trust Fund (the Fund). Because the state's Fund was depleted, the West Virginia Department of Employment Security (the Department), a state agency, was advanced funds by the federal government under the provisions of section 1201 of the Social Security Act, 42 U.S.C.A. section 1321, as amended in 1981, to help pay the unemployment compensation benefits.

  In order for West Virginia to repay the debt the state owed to the federal government, the state in 1987 amended its Unemployment Compensation Law (Law), Chap. 21A of the West Virginia Code, to authorize the Department to borrow money by the issuance of revenue bonds or notes. To repay the notes and bonds, the Law requires all employers as defined therein to withhold a percentage of the gross wages paid to each employee and remit the withheld amounts to the Department. W. Va. Code ch. 21A-8A-8(a) (Michie 1985 & Supp. 1987). All employers for which employee withholding is required are also subject to, and must remit to the Department, a compulsory contribution based on a percentage of each employee's gross wages. W. Va. Code. Ch. 21A-8A-8(b).

  The Law further empowers the state to impose an additional 'stabilization' assessment on employees and employers for any calendar quarter for which the Department determines that benefits paid out of the Fund will exceed the contributions received. W. Va. Code ch. 21A-5-10a(a). This optional stabilization assessment is computed similarly to the mandatory one described above. W. Va. Code ch. 21A-5-10a(b).

LAW AND ANALYSIS

  Section 164(a)(3) of the Code provides, in part, that state income taxes shall be allowed as a deduction for the taxable year in which they are paid or accrued. Section 164(a) also allows as a deduction state taxes not otherwise specifically described therein that are paid or accrued within the taxable year in carrying on a trade or business.

  In Rev. Rul. 81-191, 1981-2 C.B. 49, employees were required to contribute to the Rhode Island temporary disability insurance benefit fund pursuant to the Rhode Island Temporary Disability Insurance Act (Act). The employer was required to withhold the amount of such contributions from the employees' wages at the time the wages were paid. If the employer failed to withhold the contributions of any employee within the time provided by the Act, the employer became solely liable for such contributions under the Act.

  Rev. Rul. 81-191 holds (1) that the contributions withheld from the wages of an employee are state 'income taxes' that are deductible by the employee under section 164(a)(3) of the Code, provided that the employee itemizes deductions in computing taxable income, and (2) that amounts paid or accrued by an employer are 'excise taxes' that are deductible by the employer under section 164(a). Rev. Rul. 81-191 reasons that the employee and employer contributions to the fund are 'taxes' because they are exacted pursuant to legislative authority in the exercise of the taxing power of the state, and they are imposed and collected by the state for the purpose of raising revenue to be used for a governmental function that serves public purposes. The ruling further reasons that the employee contributions to the fund are 'income taxes' because they are measured by wages paid during the calendar year, and that the employer contributions to the fund are state taxes paid or accrued in carrying on a trade or business. For similar results and rationale, see Rev. Rul. 81- 192, 1981-2 C.B. 50 (New York); Rev. Rul. 81-193, 1981-2 C.B. 52 (New Jersey); and Rev. Rul. 81-194, 1981-2 C.B. 54 (California).

  In West Virginia, the contributions under its Unemployment Compensation Law by both employees and employers are taxes. The law requires employers to withhold a portion of each employee's wages at the time the wages are paid, and subjects employers to compulsory contributions based on a percentage of each employee's gross wages. In addition, the Law provides for a similarly computed stabilization assessment on employees and employers if needed. These withheld and contributed amounts are exacted pursuant to legislative authority in the exercise of the taxing power of the State of West Virginia, and are imposed and collected by the State for the purpose of raising revenue to be used for a governmental function that serves public purposes, namely, to repay a State public debt that was incurred to provide unemployment compensation benefits to qualified recipients.

  Moreover, the amounts withheld from the employees' wages are 'income taxes' because they are measured by wages paid during the calendar year, and the amounts contributed by employers are paid or accrued 'in carrying on a trade or business.' See Rev. Rul. 81-191, and Trujillo v. Commissioner, 68 T.C. 670 (1977).

HOLDING

  Amounts withheld from the wages of an employee for contribution under the West Virginia Unemployment Compensation Law are state income taxes and, therefore, shall be deductible by the employee under section 164(a)(3) of the Code for the taxable year in which paid or accrued. However, such amounts are deductible by an employee only if the employee's deductions are itemized in computing taxable income under section 63 of the Code.

  Amounts contributed by an employer under the Law are state taxes paid or accrued by the employer in carrying on a trade or business and, therefore, shall be deductible by the employer under section 164(a) of the Code for the taxable year in which paid or accrued.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Geoffrey Channing Horton of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling contact Mr. Horton on (202) 566-3627 (not a toll-free call).

Rev. Rul. 89-16, 1989-1 C.B. 76, 1989-6 I.R.B. 5.