Virginia Updates Pass-through Entity Tax Guidelines

By: Michael Colavito, SALT Director

At a glance

• The main takeaway: Virginia released updated guidelines on its pass-through entity tax to address legislation enacted last year as well as for S corporations with resident and nonresident owners.
• Assess the impact: The new guidelines are intended to provide pass-through entities with a workaround to the $10,000 limit on the federal deduction for state and local taxes enacted in the Tax Cuts and Jobs Act and clarify several complicated issues that can arise when considering a pass-through entity tax election.    
• Take the next step: Aprio’s State and Local Tax (SALT) team can assist your business in addressing the benefits and costs of making a PTET election. 

Schedule a free consultation today to learn more!

The full story:

On January 4, 2024, after an extensive public comment period, the Virginia Department of Taxation (the Department) finally released its updated Guidelines for the Pass-through Entity Tax (PTET Guidelines). The PTET Guidelines were initially released in draft form in October of 2022. Since then, legislation was enacted (HB 1456) that made an important change to Virginia’s PTET — namely that the election to be subject to the PTET can now be made by any pass-through entity (PTE) that have owners other than just individuals. Additional information on that change to Virginia’s PTET is addressed in a prior SALT Newsletter article. The updated PTET Guidelines incorporate this legislative amendment and include a handful of other notable procedural and filing related changes. 

A closer look at the guidelines:

Virginia’s PTET, which is similar to those enacted by other states, is intended to provide a workaround to the $10,000 limit on the federal deduction for state and local taxes as enacted by the Tax Cuts and Jobs Act (TCJA) of 2017. This is accomplished by allowing a PTE to elect to pay income tax at the entity level.  The PTE is entitled to deduct the PTET paid on its federal return, which then lowers the net income of the PTE that flows-through to owners of the PTE.  

Virginia’s PTET Guidelines help to clarify several of the more complicated issues that arise when considering a PTET election, such as how to make the election and associated payment as well as the required compliance obligations of both the PTE and its owners. To make the PTET election in Virginia, a PTE can either:

• Make an estimated payment of PTET for the taxable year, 
• Make an extension payment of PTET for the taxable year, or 
• File a PTET return (Form 502PTET) on or before the extended due date for the taxable year.

However, unlike some other states, a PTE may revoke the election prior to filing Form 502PTET by instead filing Form 502.  

The PTET Guidelines incorporate the changes made by House Bill 1456 (referenced above) by explaining that all PTEs can now make the election, but that the PTET is only imposed on the pro rata or distributive share of income attributable to “eligible owners.” An “eligible owner” means a direct owner of a PTE who is a natural person or an estate or trust, including entities that are disregarded for federal tax (e.g., grantor trusts and single member limited liability companies) provided that they are 100% owned by a natural person. 

Regarding the apportionment of the PTET tax base, the PTET Guidelines allow for a “Special Option for Certain S Corporations.” Generally, when determining the net income subject to Virginia’s PTET, the pro rata or distributive share of income attributable to resident owners is not subject to apportionment, and the pro rata or distributive share of income attributable to nonresident owners is subject to apportionment. The “Special Option for Certain S Corporations,” permitted by the PTET Guidelines, allow an S corporation making the PTET election to calculate the PTET by apportioning the pro rata or distributive share of income of both residents and nonresidents.¹  

The PTET Guidelines also provided additional guidance to taxpayers regarding estimated PTET payments.  The updated PTET Guidelines clarify that, for taxable years after 2022, a PTE may avoid underpayment penalties under the prior year tax exception (i.e., no penalty imposed so long as the estimates paid are equal to or more than the PTET shown on the prior year return) only if the PTET made the PTET election for the preceding taxable year. Thus, a PTE making the election for the first time either needs to make the decision early enough in the taxable year to make timely estimated payments or make “catchup payments” to reduce the underpayment penalty.

Finally, the PTET Guidelines provide Virginia-resident owners of an electing PTET information regarding claiming credits for taxes paid to other states. Importantly, the Department addresses the nuances of how this tax credit may apply in the context of “reverse credit states” (i.e., Arizona, California, and Oregon) that also have their own PTET regimes. Generally, a Virginia resident earning income from one of these states is not permitted to claim the other state’s PTET credit on the Virginia resident income tax return and instead claims that credit on the nonresident income tax return filed in that state. However, when the other state does not permit a Virginia resident to claim a credit for the Virginia PTET, the Virginia resident may claim the other state tax credit on a Virginia resident return with appropriate documentation regarding such disallowance. This is consistent with the Department’s prior guidance on reverse credit states for a resident that is included in a reverse credit state’s composite return.  

The bottom line

The PTET Guidelines incorporate the 2023 legislative change that removes the criteria that limited the election to PTEs that only had owners that are natural persons. Further, the special option for S corporations to apportion the entire tax base alleviates the potential issue of disproportionate distributions. However, two issues have not been resolved by the PTET Guidelines. 

• First, although the PTET Guidelines do state that electing PTEs must make nonresident withholding payments on behalf of its nonresident ineligible owners, there is no guidance in the guidelines on how that is done. However, Form 502PTET instructions provide that an electing PTET that has ineligible owners for which nonresident withholding is required must also file a Form 502 to report those payments. 
• Second, the Department has not fully addressed the filing requirements for making the retroactive election for tax year 2021. Instead, the Department has only stated on its website that a PTET can make a 2021 PTET payment. According to information provided to Aprio, the Department plans on issuing additional guidelines addressing the 2021 retroactive election.  

Aprio’s SALT team continues to assist businesses in addressing the benefits and costs of making a PTET election. We constantly monitoring these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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¹ Presumably, this was added to ensure that S corporations do not violate the “one class of stock” requirement under the Internal Revenue Code.