Virginia Pass-Through Entity Tax Updates

CATHIE SHAW: Hello and welcome to Cherry Bekaert's Tax Services Podcast, where we will be talking about the Virginia pass-through entity tax election today.

CATHIE SHAW: I'm Cathie Shaw, a partner with Cherry Bekaert's National Tax Practice specializing in state and local tax, and I'm joined today by Tony Konkol, an attorney in our SALT Advisory Practice.

CATHIE SHAW: Hi, Tony. How are you today?


TONY KONKOL: Great, Cathie. How are you?


CATHIE SHAW: I'm good. How's the weather where you are?


TONY KONKOL: It's a beautiful, sunny day. I need to get out and do some yard work.


CATHIE SHAW: I'm sure you'd much rather do a podcast than yard work, so we'll go ahead and get started.

CATHIE SHAW: We want to talk about Virginia's pass-through entity tax, but before that, let me provide a brief summary for those who might not be familiar with pass-through entity tax elections.

CATHIE SHAW: The majority of states have adopted pass-through entity tax elections. Tony, I bet you know off the top of your head how many states have not enacted these.


TONY KONKOL: We're only at five states with an individual income tax that have not enacted something. Two of those have not even proposed legislation.


CATHIE SHAW: So only two haven't proposed it, and three at least tried something that didn't go anywhere. That's the majority of states by far.

CATHIE SHAW: The Tax Cuts and Jobs Act (TCJA) of 2017 placed a $10,000 limit on the state and local tax deduction for individuals. That created a disparity between C corporations and pass-through entities because a C corporation could deduct state tax at the entity level, while an owner of a pass-through entity could not fully deduct state tax on their individual return.

CATHIE SHAW: States with higher tax rates, like New York and California, saw this as a significant issue and sought ways to preserve the federal-tax benefit for their residents. Various approaches were considered, and the pass-through entity tax election emerged as a workable solution, with IRS guidance effectively validating the approach.

CATHIE SHAW: Under the election, an S corporation or a partnership or an LLC treated as a partnership for federal tax purposes can elect to have the tax imposed on the pass-through entity itself rather than on the individual owners. That allows the entity to deduct the tax on its return, and the individual owners receive a credit for the tax paid at the entity level to avoid double taxation.

CATHIE SHAW: States vary in how they implement the election. For example, California allows separate owners to opt in, while Arizona generally enrolls everyone by default with an option to opt out. In most other states, if the entity makes the election, it applies to all owners who are subject to the state's personal income tax.

CATHIE SHAW: Early on, it was important to determine where owners resided because the owner might not have gotten a credit in their resident state if that state had not adopted similar legislation. Now that the majority of states have adopted the election, owners generally receive a credit or deduction on their resident state return.

CATHIE SHAW: Most taxpayers familiar with pass-through entities are making these elections where it makes sense, but Virginia has recent activity that is particularly impactful.


TONY KONKOL: Virginia passed legislation in 2022 to allow a retroactive pass-through entity tax election for the 2021 tax year. The statute delegated authority to the Department of Taxation to implement the election, but we had to wait for guidance on how to carry it out.

TONY KONKOL: By statute, the earliest date to make the election was tied to the extended filing deadline for 2021 returns, which meant October 15, 2023, was the earliest the election could be made. However, we did not receive guidelines until February 2024.


CATHIE SHAW: I kept asking if those guidelines were out yet, and there was no information for a while.


TONY KONKOL: The guidelines were finally issued in February. Anyone who wants to take advantage of the retroactive 2021 election has until September 16, 2024, to do so.

TONY KONKOL: Virginia requires that pass-through entity tax payments and returns be filed electronically. Virginia created an online platform for taxpayers to file this electing pass-through entity return for taxpayers who may not have access to tax software with the necessary forms.

TONY KONKOL: The online platform is for a special electing pass-through entity return, the Form 502 PTE return, which is different from the regular Virginia Form 502 pass-through entity return. For the retroactive 2021 election, taxpayers must use this online platform and enter the information for 2021 directly into the system.

TONY KONKOL: Most taxpayers have already filed their regular Virginia Form 502 for 2021. To make the retroactive election, they will need to take the information from that Form 502 and input it into the online electing PTE return for 2021.


CATHIE SHAW: Virginia's election is beneficial for Virginia owners of pass-through entities because the tax base can be the owner's entire federal K-1 income, adjusted for state modifications. A Virginia resident owner could include their entire K-1 income, even if the entity files in many states, and calculate the tax on that full amount.

CATHIE SHAW: However, the entity must come up with the cash to pay the tax at the entity level for 2021. How does the individual owner get credited for that, given the tax was already paid at the individual level in 2021?


TONY KONKOL: Under the guidelines, the entity will issue a Virginia K-1 showing the owner's amount of the pass-through entity tax credit for 2021. As an administrative convenience, the guidelines state that the taxpayer should not amend the 2021 individual return to claim the credit.

TONY KONKOL: Instead, the 2023 individual return is the exclusive vehicle for claiming the retroactive credit and any refund or application against the taxpayer's Virginia tax liability. The 2023 return will be the only return on which the owner claims the 2021 PTE credit.

TONY KONKOL: If you have already filed your 2023 return, you will need to file an amended 2023 return to claim the 2021 credit. If you have not yet filed the 2023 return, you should consider extending it rather than filing, so you can input the PTE credit once you receive the entity-issued Virginia K-1.


CATHIE SHAW: I like that administrative convenience because it helps with cash flow: the pass-through entity pays the tax, and the individual can claim the credit on the 2023 return to recover the cash.

CATHIE SHAW: From my experience, when Virginia issues a number of refunds, the Department of Taxation may scrutinize large refunds and request additional documentation. If you expect a large refund, you may need to provide extra information, which could slow the refund process.

CATHIE SHAW: This retroactive election is an opportunity, but you should evaluate whether it makes sense for each owner. Look at the Virginia income per owner, the tax that would be attributable to the owner if a resident, or the apportioned Virginia income if a nonresident, and calculate the Virginia tax.

CATHIE SHAW: Your federal tax benefit is essentially your federal effective tax rate multiplied by the Virginia tax paid by the entity. That calculation helps determine whether the election is worthwhile.


TONY KONKOL: Because the entity will be paying the tax in 2024, the individual's federal deduction for that state tax will generally be on their 2024 federal return. This results in cash outflow in 2024 for the entity and an associated federal deduction on the owner's 2024 federal return.

TONY KONKOL: There has been discussion about whether a refund would offset the deduction, but the taxpayer paying the tax, the entity, and the taxpayer claiming the deduction, the individual, are different taxpayers. The states enacting the election are taking the position that the individual will get the deduction.


CATHIE SHAW: The pass-through entity tax credit is refundable in Virginia, so you should be able to receive a refund, although the timing may vary depending on processing.


TONY KONKOL: Virginia allows taxpayers discretion in the ordering of credits. Structural credits, such as credits for tax paid to other states, are generally required to be claimed first. After structural credits, you can elect the ordering of other credits, and the PTE credit would typically be applied last.

TONY KONKOL: Because the PTE credit is refundable, it should not interfere with other nonrefundable credits and carryovers in most situations.


CATHIE SHAW: If you have not talked to your preparer, speak with them if you had any significant Virginia tax for the 2021 tax year. The September 16, 2024, deadline is final; there are no extensions.


TONY KONKOL: If you are going to enter information on Virginia's website yourself, start early. Expect there to be significant data entry for multiple owners, and allow time for any glitches.


CATHIE SHAW: We also want to note other Virginia updates that may have been overshadowed by this retroactive PTE guidance.


TONY KONKOL: In January, Virginia issued final pass-through entity guidelines, following draft guidelines from October 2022. The January guidance provided clarifications and examples, including an optional election for S corporations.

TONY KONKOL: For S corporations, Virginia allows an optional computation where residents can elect to compute tax on the Virginia-sourced income of the entity rather than the resident's entire share of K-1 income. This option is not required but is available to all shareholders of an S corporation.

TONY KONKOL: Virginia likely included this option to address second-class-of-stock concerns and to provide a safe-harbor approach for S corporations with unequal distributions.


CATHIE SHAW: Other states, such as Indiana, New York, and Minnesota, have different approaches regarding whether residents include their entire share or only apportioned income. Virginia's approach is at least permissive for S corporations.


TONY KONKOL: The January guidelines also clarified that owners must add back to Virginia taxable income the state income taxes deducted on the federal return to keep the state calculation neutral. The addition is limited to the amount that would be deductible on the federal return in that year.

TONY KONKOL: That clarification is relevant to the retroactive election, especially where payments were split between 2023 and 2024. The owner may be limited to the addition based on what was deducted on the federal return in 2023, and timing issues may affect deductibility.


CATHIE SHAW: You should consult your tax preparer about the appropriate year to take the federal deduction, as facts and circumstances vary and recurring item exceptions may apply.

CATHIE SHAW: That concludes our time. The September 16 deadline for the retroactive 2021 election is final and cannot be extended.


TONY KONKOL: Because filings must be entered on the state's website, do not wait until the last minute. Allow sufficient time for data entry and potential system issues, especially if there are multiple owners.


CATHIE SHAW: Please reach out to Cherry Bekaert, your Cherry Bekaert contact, Tony, or me if you have questions about the Virginia pass-through entity tax election or other state pass-through entity tax elections or SALT matters.

CATHIE SHAW: Thank you for joining us on our podcast today.