Update on Potential Tax Savings Opportunity: Virginia’s Pass-through Entity Tax and SALT Cap Deduction Workaround

For individual owners of pass-through entities, such as partnerships, limited liability companies (“LLCs”), business trusts, and S Corporations, Virginia’s elective Pass-through Entity Tax (“PTET”) offers potential federal income tax savings as a workaround to the $10,000 state and local tax (“SALT”) federal income tax deduction limitation. Individuals owning a pass-through entity through a disregarded entity, such as grantor trust or single member LLC, and certain owners of S Corporations can also make use of the PTET. The PTET regime is effective for Taxable Years 2021 through 2025.

The Virginia Department of Taxation (“Department”) recently released Draft Guidelines and Frequently Asked Questions on the PTET for Taxable Years 2022 through 2025. This article provides a brief summary of the updates. We previously discussed the Pass-through Entity Tax here.

The updates do not address the procedures for the PTET for Taxable Year 2021. The Department advises taxpayers to continue to follow the instructions in Tax Bulletin 22-6 regarding Taxable Year 2021 until additional guidance is provided.

Key Takeaways

• The PTET election is made at the entity level. PTEs and their owners should consider whether the PTE qualifies, the economic effects of the election, and who is in control of making such an election.
• PTEs should consider whether to restructure to qualify for the PTET election. For some disregarded entities, such as sole proprietorships or single member LLCs, or closely held businesses it may be beneficial to restructure the business to be a qualifying PTE.
• As a PTE’s ownership changes, it should reassess whether it qualifies for the PTET election.
• The Draft Guidelines and Frequently Asked Questions provide additional guidance on the procedures related to the PTET for Taxable Years 2022 through 2025. Guidance on Taxable Year 2021 remains outstanding.
• An electing PTE for Taxable Year 2022 should plan to pay at least 90% of its PTET by April 17, 2023 to avoid late payment penalties.

Who Qualifies?

Only a “Pass-through entity” or “PTE” that is 100% owned by natural persons (as described below) can qualify for the Pass-through Entity Tax. In the case of an S Corporation, the S Corporation can qualify if it is 100% owned by natural persons or other persons eligible to be shareholders of an S Corporation (e.g., certain trusts). Natural person means a human being, but also includes entities disregarded for federal tax purposes such as grantor trusts and single member LLCs, so long as that disregarded entity is 100% owned by a human being. A PTE is any entity, including a partnership, a limited liability company, a business trust, or an S Corporation, that is recognized as a separate entity for federal income tax purposes, in which the entity’s tax items flowthrough to the partners, members, or shareholders for federal income tax purposes. For tiered PTEs, only the upper tier PTE, if it qualifies, can make the election.

In the Frequently Asked Questions, the Department clarified that a PTE qualifies to make the PTET election for a taxable year so long as it meets the qualification requirements at any time during such taxable year and the PTE only flows through refundable PTET credits to direct natural person owners, or persons eligible to be shareholders in an S Corporation, in the case of an S Corporation PTE.

What Are the Potential Benefits?

A qualifying PTE that elects into the PTET for a taxable year calculates the PTET and then allocates the refundable PTET credits. The sum of credits cannot exceed the total PTET paid by the electing PTE. The credits are distributed in proportion to the owners’ distributive or pro rata shares of income. The effect of this elective income tax for the PTE and the corresponding refundable credits is to allow the PTE to pay income tax rather than its owners and, thereby, to provide a Virginia workaround for the $10,000 cap on the federal deduction for SALT paid.

If the electing PTE’s total PTE taxable income is zero or less, its owners are not entitled to any credits. Instead, the electing PTE may file Form 502PTET to request a refund of any PTET estimated tax payments it made.

How to Make the Election?

Virginia’s PTET is elective. The election is made by the PTE at the entity level in accordance with the PTE’s management and organizational documents. Owners of the PTE do not have the option to opt out of the PTE’s election.

A qualifying PTE has the option to make the election to pay PTET for the taxable year. According to the Draft Guidelines, such election can be made by one of four methods:

1. During Taxable Year 2022, filing Form 502V and submitting a payment of PTET with such form;
2. During Taxable Years 2023 and after, making an estimated payment of PTET for the taxable year;
3. Making an extension payment of PTET for the taxable year;
4. Filing a PTET return (“Form 502PTET”) on or before the extended due date for the taxable year.

If a Form 502PTET has not been filed for the taxable year, the PTET election can be revoked by filing the Form 502. Once Form 502PTET is filed, the election is binding for that taxable year.

In the Frequently Asked Questions, the Department clarified that the filing of a paper Form 502V with a check would not be a valid PTET election because electronic payment and filing are required. The Department stated that Online Form PTET-PMT (preferred) and online Form 502V can be used to make a valid election. Additionally, the Department will accept an ACH Credit payment using return payment code 00032 as a valid election.

What Are the Annual Filing Requirements?

Similar to the annual filing of the Form 502, Pass-Through Entity Return of Income and Return of Nonresident Withholding Tax, the deadline for the Form 502PTET is 15^th day of the 4^th month following the close of the taxable year (e.g., April 15^th for calendar year entities). Virginia allows an automatic 6-month filing extension for PTEs (e.g., October 15^th for calendar year entities). The filing extension is not a payment extension. According to the Draft Guidelines, an electing PTE must pay at least 90% of its PTET due by the original due date for filing the return. The Department requires that PTEs file their returns and make any tax payments electronically.

An electing PTE must notify its owners that the election has been made and provide a Schedule VK-1 to each of its owners with information regarding the income and related deductions and credits passed through to each owner so that the owners can complete their own Virginia tax returns. The Draft Guidelines provide the steps for the calculation of the PTE’s Virginia taxable income and the resulting PTET based on the owner’s residency status with Virginia. Electing PTEs make an addition for any state and local income taxes to the extent that the electing PTE deducted such taxes in determining its federal taxable income.

An owner may claim refundable PTET credits against their Virginia individual income tax or fiduciary income tax, but according to the Draft Guidelines, must wait until the electing PTE issues the Schedule VK-1. A trust, other than a trust that is disregarded for income tax purposes, that is an owner of an electing S Corporation is allowed to claim the full credit that it receives on its fiduciary income tax return, but it is not permitted to distribute any portion of the credit to its beneficiaries.

An electing PTE may not file a composite return on behalf of its nonresident owners. If a nonresident owner’s only Virginia-source income is through an electing PTE that fully pays the PTET, such nonresident owner is permitted, but not required, to file a Virginia nonresident return.

The Draft Guidelines provide the penalties for an electing PTE for the failure to file the annual return timely and the failure to pay timely.

Are Estimated Payments Required?

According to the Draft Guidelines, for Taxable Year 2022, an electing PTE is not required to make estimated payments of PTET and will not be subject to an addition to tax charge for not making estimated payments. The Department states that taxpayers may wait to make payments until the original due date of the Form 502PTET, when they should either make a return payment or, if filing on extension, an extension payment.

For taxable years after the Taxable Year 2022, an electing PTE is required to make estimated payments if its PTET for the taxable year can reasonably be expected to exceed $1,000. The estimated payments are due in four quarterly installments by the 15^th day of the 4^th month and then the 15^th day of the 6^th, 9^th, and 12^th months of the electing PTE’s taxable year (e.g., for a calendar year filer: 25% by April 15, 25% by June 15, 25% by September 15, and 25% by December 15).

According to the Draft Guidelines, electing PTEs should not make nonresident withholding payments or payments associated with composite returns. Electing PTEs can claim the withholding payments on the Form 502PTET. The Draft Guidelines provide the procedures for the reallocation of payments associated with composite returns, which are the same as the reallocation of estimated payments made by owners for Virginia individual income taxes provided in the Frequently Asked Questions. These requests should be made to the Department as far in advance of filing the Form 502PTET and individual returns as possible.

Are Credits Available for Taxes Paid by a PTE in Another State?

Yes, for Taxable Years 2021 through 2025, taxpayers may claim Virginia’s nonrefundable credits for taxes paid to other states on their individual income tax return for certain taxes paid by a PTE under another state’s substantially similar PTE tax structure. The tax must be substantially similar to Virginia’s PTET. Thus, the credit does not apply to any other entity taxes, such as any non-elective franchise, privilege, business, license, occupation, excise, or unincorporated business taxes. The credit can be claimed on the taxpayer’s Virginia resident income tax return unless the state is a reverse credit state.

Reverse credit states are states that practice reciprocity with Virginia in that a Virginia resident receiving income from that state may typically claim an out-of-state credit on that state's nonresident income tax return and is generally prohibited from claiming a credit on his or her Virginia resident income tax return. According to the Draft Guidelines, there are currently three reverse credit states with a substantially similar pass-through entity tax: Arizona, California, and Oregon.

Note on Draft Guidelines and Frequently Asked Questions

The Draft Guidelines and Frequently Asked Questions are the Department’s interpretation of the new PTET law. They do not constitute formal rulemaking and hence do not have the force and effect of law or regulation. In the event that the final determination of any court holds that any provision of them is contrary to law, taxpayers who follow them would likely be treated as relying on erroneous written advice of the Department for purposes of waiving penalty and interest.

Disclaimer: The information contained herein is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax, legal, and financial advisers. This summary is not intended, and should not be construed, as accounting, business, financial, investment, legal, tax, or other professional advice, services, or opinion provided by Sands Anderson PC. Sands Anderson PC shall not be responsible for any loss incurred by any person who relies on this summary.