Virginia Residents: You May Pay Double State Tax on Pass-Through Entity Income

By: Jeff Glickman, SALT Partner

At a glance

• The main takeaway: The decision of making a Pass-Through Entity Tax election is not straightforward, and the tax consequences to each owner will vary depending on each state’s rules.
• Assess the impact: Pass-Through Entities that operate in multiple states and have individual owners that reside in multiple states may have their federal income tax benefit reduced or may even end up paying more tax.
• Take the next step: Aprio’s State and Local Tax (SALT) team can help you determine the potential federal and state tax consequences for Pass-Through Entity Tax elections at the entity and owner level.

The full story:

At the time this article was published, there were 22 states that enacted Pass-Through Entity Taxes (PTE Taxes) as a workaround to the federal $10,000 limit on itemized deductions for state and local taxes paid. What has become clear regarding PTE Taxes is for pass-through entities (PTE) that operate and have owners residing in multiple states, the decision to make these elections is not straight forward. While making the PTE Tax election will likely provide PTE owners with a federal income tax benefit, that benefit may be reduced or eliminated for some or all PTE owners depending on each state’s rules.

However, it is possible that a PTE owner may be harmed under the PTE Tax election if a state does not provide a resident income tax credit for PTE Taxes paid to other states. For example, assume a PTE owner who is a resident of state A had $1,000,000 of income that was subject to a PTE Tax in state B at a 10% tax rate (i.e., $100,000 of PTE Tax paid). The federal tax benefit to that owner for the $100,000 PTE Tax payment at a 37% tax rate is $37,000. However, if State A does not provide the owner with a credit for the PTE Tax paid to State B, then the owner will pay tax to State A on that $1,000,000 of income. If State A’s individual tax rate is greater than 3.7%, then the resident will pay more combined federal and state tax as a result of making the PTE Tax election.[1]

Why would credit for the owner not be available in State A?

In most states, resident state credits for taxes paid to other states apply to income taxes paid by the individual to the other state. Since a PTE Tax is a liability of and paid by the PTE, it does not technically meet the requirements for the credit. Many, but not all, states that have enacted PTE Taxes have amended their rules to allow resident credit for these taxes, but in states that have not enacted a PTE Tax, that is not likely the case.

Recently, the Virginia Society of CPAs received a letter ruling from the Virginia Department of Taxation (Department) addressing whether Virginia provides its residents a tax credit for PTE Taxes paid to other states (the letter specifically addressed Maryland’s PTE Tax).[2]

Under Virginia law, residents are entitled to a tax credit for income taxes paid to another state on income derived from sources outside the state and subject to Virginia income tax.[3] However, if a state income tax is paid by an S-corporation, the amount of tax paid is deemed by the individual shareholders in proportion to their ownership.[4] Otherwise, the regulation makes clear that “[a] credit may not be claimed by an individual for tax imposed by another state on a distributing entity (e.g., an estate, regulated investment company, a partnership or a trust in which the individual is a beneficiary or shareholder).”[5]

Based on this language, the Department ruled that a resident shareholder of an S-corporation may be eligible for a credit for PTE Taxes paid to another state by the S-corporation (assuming any other requirements for the credit are met). However, for resident owners of other types of PTEs, a credit is not available.

Virginia is not the only state to take this position, as we recently wrote an article in our October 2021 SALT Newsletter about a Maine Board of Tax Appeals decision denying its resident taxpayers a credit for Connecticut PTE Tax.

The bottom line

PTEs that operate in multiple states and have individual owners that reside in multiple states should reach out to a tax advisor to model the financial impact of making a PTE election.

Aprio’s SALT team has experience with these new PTE Taxes and how to determine the potential federal and state tax consequences at the entity and owner level. We can work with your company to determine how these elections will impact your entity and your owners so that you can make an informed decision. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the January 2022 SALT Newsletter.

[1] If the PTE election is not made, then the owner would have paid tax to state B directly, and State A would have provided the credit.

[2] Letter from Virginia Department of Taxation to Virginia Society of CPAs, dated December 28, 2021.  To see the Society’s letter to the Virginia Department of Taxation requesting the ruling, click here.

[3] Va. Code Ann. § 58.1-332(A).

[4] Va. Code Ann. § 58.1-332(C).

[5] 23 Va. Admin. Code 10-110-221(C).

Disclosure

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.