Virginia Disallows Credit for Pass-through Entity Taxes, While General Assembly Proposes SALT Cap Workaround 

The Virginia Department of Taxation has issued a ruling addressing whether resident individuals can claim a credit for taxes paid for their portion of a pass-through entity (PTE) tax paid by a PTE from which they receive a distributive share of income. Over the last three years, over 20 states have enacted PTE taxes that are aimed at circumventing the $10,000 state and local tax deduction limitation enacted Tax Cuts and Jobs Act (TCJA) of 2017. Therefore, this ruling has the potential to impact a significant number of Virginia taxpayers.

Pursuant to the ruling, a Virginia resident’s ability to claim a credit for a PTE tax largely hinges on whether the PTE, in which the individual owns an interest is a partnership or S corporation. Below is a summary of the key takeaways from the ruling:

• Shareholders of S Corporations – Virginia resident owners of S corporations can claim a credit for an entity-level PTE tax.
  • This ruling does not result in a change to Virginia’s disallowance of a credit for taxes paid for an unincorporated business or franchise tax based on net income. Notably, Virginia residents that own an interest in a S corporation are still not able to claim a credit for the District of Columbia’s corporate franchise tax.
  • This ruling does not result in a change to Virginia’s disallowance of a credit for taxes paid for an unincorporated business or franchise tax based on net income. Notably, Virginia residents that own an interest in a S corporation are still not able to claim a credit for the District of Columbia’s corporate franchise tax.
• Partners of a Partnership – Virginia resident owners of partnerships cannot claim a credit for an entity-level PTE tax.
  • The ruling specifically addresses Maryland’s PTE tax, but taxpayers should view the Department’s reasoning as generally applying to other recently-enacted elective PTE taxes by states that otherwise impose a broadly applicable income tax on nonresident individuals. Thus, the Department would likely similarly disallow a credit for taxes paid for the PTE taxes that have been implemented in California, New York, New Jersey, Massachusetts and Michigan.
  • The different treatment for S corporations vs. partnerships stems from a subsection of Virginia’s credit for taxes paid statute that allows a credit for taxes paid for entity-level S corporation income taxes. That subsection was added to Virginia law by the legislature in the 1980s in response to a Virginia Circuit Court case that disallowed a Virginia resident S corporation shareholder’s claim for a credit for taxes paid by an S corporation to a state that did not conform to the federal flow-through treatment of S corporation.

Like the legislature’s reaction in the 1980s, Aprio is aware of ongoing efforts to propose legislation that would result in this ruling being overturned. Such a change to Virginia law to allow partners in partnerships to claim a credit for taxes paid would seem to be inevitable considering that related legislation has been presented by Delegate Watts and Delegate McNamara that would see Virginia implement its own PTE tax (HB 401 and HB 1121). Permitting residents to benefit from a PTE tax imposed by Virginia, while not affording a similar benefit for PTE taxes imposed by other states, would undoubtedly be challenged by taxpayers. Aprio will continue to monitor developments on this important issue.

Contact Aprio’s State and Local Tax (SALT) team today to connect with an experienced advisor. 
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