Virginia Jumps on the SALT Workaround Bandwagon

April 14, 2022

Virginia has enacted legislation (Senate Bill 692) to implement an elective pass through entity (PTE) tax. The legislation also amends Virginia’s credit for taxes paid rule to permit residents of Virginia that are partners in a partnership to claim a credit for taxes paid for other states’ PTE taxes paid by a partnership in which the individual owns an interest. The broadening of Virginia’s credit for tax paid rule effectively overrules a ruling issued by the Department of Taxation where it was concluded that partners in a partnership were not permitted to claim a credit for taxes paid for other states’ PTE regimes. Both of the amendments are applicable to taxable years beginning on and after January 1, 2021, but before January 1, 2026.

Senate Bill 692 impacts individuals that own an interest in a PTE (i.e., a business treated as a partnership or S corporation for income tax purposes) in two significant ways. First, PTEs that are engaged in business in Virginia will be able to elect to pay income tax at the entity-level, which will create an entity level deduction that will flow through to the owners of the PTE and circumvent the federal $10,000 state tax deduction limitation imposed on individual taxpayers for federal income tax purposes. Similar entity-level elective taxes have been implemented in a number of states over the last three years, including California, Illinois, Maryland, Massachusetts, New Jersey, and New York. Second, as noted above, the legislation overrules the ruling issued in December of 2021 by the Virginia Department of Taxation that concluded only Virginia resident owners of S corporations are permitted to claim a credit for another state’s PTE tax. Additional details on each aspect of the bill are outlined below.

  • Virginia Elective Pass-through Entity Tax
    • “Qualifying pass-through entity” – a PTE that is permitted to elect to be taxed at the entity-level) is a PTE that is “100 percent owned” by individuals. Therefore, unlike other states that may permit a PTE to elect into the state’s entity-level tax even when the PTE is owned by other business entities, Virginia PTE election can only be made by PTEs that are owned by individuals.
    • Tax Rate – the elective PTE tax rate is 5.75%
    • Credit for Owners – individual owners of a PTE that have made the election and paid the PTE tax are permitted to claim a credit on their Virginia income tax return in an amount equal to their pro rata share of the tax paid by any qualifying pass-through entity of which they are an owner. For nonresident owners of an electing PTE, this is somewhat similar to the historical nonresident withholding requirements that PTEs are required to pay. However, for resident owners that have typically made estimated tax payments on income from a PTE from which they own an interest, an electing PTE will pay tax on the distributive share of income of both residents and nonresidents.
    • Making the election
      • For 2021, given the late enactment of Senate Bill 692, the legislation creates a retractive election for tax year 2021. The procedures for the retroactive election are to be established by the Virginia Department of Taxation. The only details provided in the legislation regarding the retroactive election process are that:
        • The due date to make the election must be no earlier than one year after the extended due date for filing the applicable return (i.e., October 15, 2023); and
        • No interest will accrue on underpayments attributable to the election.
      • For now, PTEs should file their 2021 Virginia income tax return under the non-resident withholding regime. As provided in the legislation, a PTE that wishes to make the election to be taxed at the entity-level for tax year 2021 to create a business deduction will be able to do so through the retroactive process to be implemented by the Department of Taxation.
      • For tax years 2022 through 2025, an electing PTE will be required to make an annual election on or before the due date for filing the applicable return, including any extensions that have been granted.
    • Apportionment – the legislation does not address whether the PTE tax is based only on Virginia source income of resident owners. Some states that have enacted an elective PTE tax have implemented a hybrid approach in that the portion of the PTE’s income attributable to resident owners is based on income from all sources (i.e., within and without the state), while the portion of the PTE’s income attributable to non-resident owners is based on income from Virginia sourcing only (i.e., apportioned income). The legislation does require the Department of Taxation to publish guidelines for the implementation of the elective PTE tax. Those guidelines, or possibly subsequently enacted legislation, will need to provide clarification to taxpayers on this seemingly unaddressed aspect of Virginia’s PTE tax.
  • Credit for Other States’ Pass-through Entity Tax
    • As noted above, Senate Bill 692 amends Virginia’s credit for taxes paid statute to allow Virginia residents that own an interest in either a partnership or a S corporation that is subject to an elective PTE tax in another state to claim a credit for their pro rata share of the other state’s PTE tax.
    • The credit for owners of a partnership is effective for tax years 2021. Therefore, a credit for another state’s PTE tax (e.g., Maryland’s PTE tax) claimed on a 2020 Virginia individual income tax return could potentially be challenged by the Department.
    • There is a timing issue for tax year 2021 for Virginia resident partners of partnerships with respect to when they are permitted to claim the credit. Technically, because Senate Bill 692 is not “emergency” legislation, it does not become effective until July 1, 2022. Therefore, the Department of Taxation could disallow a credit claimed for another state’s PTE tax on a resident individual income tax return filed prior to July 1, 2022. The Department is yet to indicate whether they intend take such action. It would seem useless for the Department to utilize resources to disallow credits that it would be required to allow a couple of months later. Still, Taxpayers that file a return claiming the credit prior to July 1, 2022 should be aware that the credit could initially be disallowed.
    • Senate Bill 692 does not alter 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 PTE are still not able to claim a credit for the District of Columbia’s corporate franchise or unincorporated business tax because these taxes are not “substantially similar” to Virginia’s PTE tax.

There are still a number of issues that need to be clarified with respect to Virginia’s new elective PTE tax. The process by which the retroactive election will be made for tax year 2021 is the obvious issue that Department of Taxation needs to address. However, equally important is whether the tax is on an apportioned or unapportioned distributive share for the PTE income attributable to resident owners.

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