Virginia Releases Draft Guidelines for Pass-through Entity Tax Elections

On October 31, 2022, the Virginia Department of Taxation (the “Department”) released draft guidance (the “Draft Guidelines”) on Virginia’s elective pass-through entity (PTE) tax, addressing how to make a PTE tax election for 2022 and thereafter. The Draft Guidelines follow an April tax bulletin (Tax Bulletin 22-6). Further guidance on a retroactive election for tax year 2021 will be published before October 15, 2023.

Virginia’s PTE tax law, enacted earlier this year, allows a qualifying PTE to make an annual election for tax years 2021 through 2025 to pay income tax at a rate of 5.75 percent at the entity level. A PTE that qualifies to make the election (a “qualifying PTE”) is one that is 100 percent owned by natural persons, or, in the case of a subchapter S corporation, 100 percent owned by natural persons or other persons eligible to be shareholders in an S corporation. An entity that is disregarded as separate from its owner for federal income tax purposes, such as a single-member limited liability company or a qualified subchapter S subsidiary, is not a qualifying PTE. However, if a disregarded entity is an owner of a PTE, the disregarded entity is ignored in determining whether the PTE is owned 100 percent by natural persons. If a PTE (the “upper-tier entity”) owns another PTE (the “lower-tier entity”), only the upper-tier entity can make an election if it qualifies. Any lower-tier entities cannot make an election. The law provides a corresponding refundable income tax credit for tax years 2021 through 2025 for any amount of income tax paid by a qualifying PTE having Virginia taxable income if the PTE makes the election and pays the elective income tax imposed at the entity level. The law allows the qualifying PTE to shift the income tax burden from the PTE owners to the PTE itself.

Note that the Draft Guidelines are only the Department’s interpretation of the new law and are not formal rulemaking. Therefore, the Draft Guidelines lack the force and effect of law or regulation. If a court of law makes a final determination that the Draft Guidelines are erroneous, then a taxpayer who relied on the Draft Guidelines will be treated as having relied on erroneous written advice for purposes of waiving penalties and interest.

Insight – Trusts owning interests in PTEs will pose particular difficulties. If a nongrantor trust is an owner of a federal tax partnership, that partnership will not be a qualifying PTE because the nongrantor trust is not an individual. However, if a nongrantor trust that makes an electing small business trust (ESBT) election is a shareholder of an S corporation, the S corporation will be a qualifying PTE. A grantor trust is a disregarded entity for federal income tax purposes, so partnerships and S corporations owned by grantor trusts will still be qualifying PTEs.

Making the Election

There are four ways for a qualifying PTE to elect to pay the PTE tax (PTET) for the tax year, including:

(1) During tax year 2022, filing Form 502V and submitting a payment of PTET;

(2) During tax year 2023 and thereafter, making an estimated payment of PTET for the tax year;

(3) Making an extension payment of PTET for the tax year; or

(4) Filing a PTET return (“Form 502PTET”) on or before the extended due date for the tax year.

If a Form 502PTET has not been filed for the tax year, the PTET election can be revoked by filing Form 502. However, filing Form 502PTET is a binding election of the PTET for the tax year.

Virginia does not require any specific method for an electing PTE to obtain consent from its owners, so such consent should be obtained pursuant to the PTE’s governing documents. Note, however, that once the election is made for a given year, it is binding on all owners. An owner of a PTE does not have the ability to “opt-out” if the PTE makes the PTET election.

Insight - Given that a PTET election is not final until filing the required return, and as there are no estimated tax payments required before the due date of the return for tax year 2022, the Draft Guidelines effectively allow a calendar year PTE to defer the 2022 PTET election and payment of PTET until the original tax return due date of April 17, 2023.

Determining PTE Taxable Income and Tax Liability

The Draft Guidelines provide four steps for a PTE to determine its taxable income and tax amount.

(1) First, a PTE should determine the allocation and apportionment of the PTE’s income using the existing Form 502 instructions.

(2) Second, the PTE should determine if its owners are resident or nonresidents of Virginia. 

• For individuals, the determination is made based on Virginia’s definition of “resident” in Va. Code § 58.1-302. For purposes of the PTET computation, any individual owner should be treated as a resident if he or she is a resident of Virginia for Virginia individual income tax purposes for at least half of the year. An individual owner cannot be a part-year resident.
• Estate or trust owners are residents if they meet the “resident estate or trust” definition in Va. Code § 58.1-302 for the tax year.
• A disregarded entity will be classified based on its owner’s residency status.

(3) Third, the electing PTE will add:

• Each resident owner's share of the electing PTE’s income or loss, as modified by Virginia additions and subtractions; and
• Each nonresident owner's share of the PTE’s income or loss that is attributable to Virginia. This includes both apportionable and allocable income.

Separately stated items are generally included when calculating an owner’s share of an electing PTE’s income, however, a separately stated deduction subject to a federal limitation (such as charitable contributions) will be limited to what is allowed under federal law for C corporations.

(4) Finally, the electing PTE’s Virginia income tax liability may be calculated by multiplying the PTE’s taxable income by 5.75 percent. The tax due may be reduced by payments made during the year and any entity-level tax credits.

Filing the PTET Return

The PTET return (Form 502PTET) is due on the 15^th day of the fourth month following the close of the tax year. A calendar year filer’s return is due by April 15, however, such returns may be automatically extended six months to October 15. PTET returns must be filed electronically and signed by an owner, officer or employee of the PTE who is authorized to sign on behalf of the PTE in tax matters. Further guidance is forthcoming for how to file and make payments.

Although returns may be automatically extended, taxes are due at the original filing date. An electing PTE must pay at least 90 percent of its PTET due by the original due date of its return or be subject to an extension penalty. The extension penalty is 2 percent per month, up to a maximum of 12 percent of the tax due.

The electing PTE must notify its owners that the election has been made and provide each owner a completed Schedule VK-1 so the owners can complete their Virginia tax returns.

Estimated Tax Payments

For tax year 2022, estimated tax payments for an electing PTE are optional. If an electing PTE chooses to do so, it may make payments electronically using Form 502V. Otherwise the electing PTE may wait to make payments until the original due date of the return.

Insight – Cash basis PTEs may wish to make 2022 estimated payments before December 31, 2022.

For tax years 2023 and beyond, estimated payments are required if the PTE’s tax liability is expected to exceed $1,000. Calendar year taxpayers are required to make quarterly estimated payments by April 15, June 15, September 15, and December 15.

Nonresident Withholding Payments and Composite Payments

For a PTE with nonresident owners, any payments made by a PTE before it made the PTET election during the year should be claimed on Form 502PTET. The PTE should request a refund for any composite payments made before it made the PTET election.

Filing Requirements for Nonresident Owners of an Electing PTE

Unlike a non-electing PTE, an electing PTE may not file a composite return on behalf of its nonresident owners. Instead, a nonresident owner whose only Virginia-source income is from a PTE may file a Virginia nonresident return.

Penalties and Interest

Electing PTE penalties are based on Virginia’s corporate tax penalties. As previously mentioned, failure by a PTE to pay its PTET liability by the original due date of its return results in an extension penalty of 2 percent per month of the tax due, up to 12 percent of the tax due, if payment is not made by the extended due date of the return. If the full amount of tax due is not paid when the return is timely filed, a late payment penalty of 6 percent per month up to a maximum of 30 percent of the tax due will be assessed.

If a PTET return is filed late or not filed, a late filing penalty equal to the greater of $100 or 30 percent of the tax due is assessed. The late payment penalty does not apply to the extent that the PTET is already subject to the late filing penalty. A $100 late filing penalty applies even if no PTET is due.

Additional civil and criminal penalties may be imposed for filing a fraudulent return. Interest on the unpaid balance of any tax and penalty is charged at the underpayment rate established by Internal Revenue Code § 6621, plus 2 percent, from the due date until paid.

Filing a Return by an Owner

An owner of an electing PTE may claim a refundable PTET credit against the owner’s Virginia individual income tax or fiduciary income tax. A trust, other than a trust that is disregarded for income tax purposes, that is an owner of an electing Subchapter S corporation may claim the full PTET credit that it receives on its fiduciary income tax return, but may not distribute any portion of the credit to its beneficiaries. Owners claiming a PTET credit on their individual or fiduciary income tax return must make an addition equal to the amount of PTET credit claimed.

Owners may not claim a PTET credit until they have received Schedule VK-1 from the electing PTET. If an electing PTE does not issue Schedule VK-1 before the due date of an owner’s return, the owner may file the owner’s return on extension or file a return without claiming the credit and file an amended return after receiving Schedule VK-1.

Credit for Taxes Paid to Other States

Taxpayers may claim Virginia’s nonrefundable credit for taxes paid to other states (“out-of-state credit”) on their individual income tax return for certain taxes paid by a PTE under another state’s substantially similar PTE tax structure, subject to limitations. The out-of-state credit may also be claimed on fiduciary income tax returns. The out-of-state credit is limited to Virginia resident returns only, except for states with reciprocity with Virginia as discussed below (currently Arizona, California, and Oregon).

Reverse Credit States

Certain states practice tax reciprocity with Virginia. Such states are termed “reverse credit states” because reciprocity reverses the typical rule that out-of-state credits are claimed only on resident returns.

A Virginia resident receiving income from a reverse credit state typically may claim an out-of-state credit on that state’s nonresident income tax return and is prohibited from claiming a credit on the Virginia resident income tax return. Similarly, a reciprocal state resident with Virginia income may claim an out-of-state credit on the nonresident’s Virginia nonresident income tax return but not the reciprocal state’s resident income tax return. 

At present, the three reverse credit states with a substantially similar PTET are Arizona, California and Oregon. If the reverse credit state disallows an out-of-state PTET paid to Virginia, a Virginia resident may claim the credit on the resident’s Virginia return with required documentation verifying the other state’s disallowance of the out-of-state credit to Virginia residents. Likewise, a resident of a reverse credit state may claim an out-of-state credit for PTET paid to such state on the nonresident’s Virginia return if no out-of-state credit is claimed on their resident return in the reverse credit state.

Credits are limited for nonresidents based on the ratio that the nonresident’s Virginia taxable income bears to the total income reported to the resident state. If another state uses a subtraction or deduction based PTET instead of a credit based PTET, an equivalent amount of taxable income is added back. The total income base for the other state will include the sum of (1) taxable income on the resident return, and (2) the amount of taxable income on which the PTE paid PTET to the other state.

Takeaways

• Although the Draft Guidelines provide additional clarity for the process of electing PTET for 2022 and future years, finalized guidance and additional guidance for 2021 remain outstanding. 
• PTEs should consider both their potential eligibility for the PTET and the economic impact of the PTET election to their owners—particularly nonresidents—as tax filing season approaches. 
• An entity electing the PTET for 2022 must pay 90% of its PTET liability by April 17, 2023 to avoid an extension penalty.

Open Questions

The Draft Guidelines do not clarify when the qualifying PTE determination is made. It is unclear what impact structural changes during the year have for both the election of the PTET and the calculation of the PTET. For example, an otherwise ineligible entity may become eligible during the tax year through either the addition of eligible members or the removal of ineligible members. Similarly, a lower-tier entity may become an upper-tier entity during the year and become a qualifying PTE as a result. It is unclear if these entities would be eligible for the PTET for the full year or only a portion of the year. Additionally, questions arise for reporting obligations and whether an entity may need to file multiple tax returns, for example, both a pass-through and PTET return (Form 502 and Form 502PTET) to account for the changes midyear.

Williams Mullen will continue to monitor developments relating to the Virginia PTE election. Should you have any questions regarding the Draft Guidelines or Virginia’s PTE election, please do not hesitate to reach out to any member of the firm’s Tax Section.