On April 11, 2022, Virginia Gov. Glenn Youngkin signed into law Senate Bill 692, providing for a pass-through entity (PTE) tax election and adopting a credit for taxes paid for similar elections, effective July 1, 2022, but applicable to tax years beginning on or after Jan. 1, 2021.
The law establishes an annual PTE election for tax years beginning on and after Jan. 1, 2021, and before Jan. 1, 2026. The tax is imposed at a rate of 5.75% at the PTE level. A qualifying PTE includes entities owned by natural persons or, in the case of PTE that are S corporations, certain estates, and trusts that are permitted to own S corporation shares. The law allows a corresponding refundable individual or fiduciary income tax credit for any amount of income tax paid by a PTE having Virginia taxable income if the PTE makes the election and pays the elective income tax imposed at the entity level. The effect of such elective income tax and corresponding refundable credit would be to allow the PTE to pay Virginia income tax rather than its owners.
Electing for 2021
Due to the late adoption, it is not feasible for the Virginia Department of Taxation to implement the PTE election and refundable credit provisions while the filing season for the tax year 2021 is underway. However, for the 2021 tax year, the department is instructed to make procedures for PTEs to elect and pay the tax due at the entity level at least 12 months after the extended due date of the PTE’s 2021 Virginia income tax return. Interest will not accrue on under- or over-payments solely attributable to such an election.
Electing for 2022 and after
For tax years beginning on and after Jan. 1, 2022, and before Jan. 1, 2026, a PTE may make the annual PTE election on its timely filed return, including any extensions; i.e., by April 15, 2023, for calendar year filers.
Credit for taxes paid
The legislation provides that for taxable years beginning on and after Jan. 1, 2021, and before Jan 1, 2026, the amount of any state income tax paid by a pass-through entity under a substantially similar PTE workaround is deemed to have been paid by its individual owners in proportion to their ownership. This provision allows the credit for “substantially similar” taxes paid for PTE elections taken in other states. Recall that in late December, the department released a ruling specifically denying such a credit under state law, finding that a tax imposed at the entity level was not attributable to the members. However, the ruling found that shareholders of an S corporation may be able to qualify for the credit under certain circumstances.
The “substantially similar” language for purposes of the credit for taxes paid has been included in many of the state PTE workarounds, but it should be noted that most states have generally not defined or clarified how a substantially similar election is determined. New York is a notable exception. Additionally, the Virginia law does not permit Virginia resident owners a credit for their share of the District of Columbia Franchise Tax, which the department has historically denied.
For the tax year 2021, the electing PTE will need to wait for department guidance regarding how to make payments, whether a new form will be created for this tax and if payments can be transferred from resident owners’ estimated tax payments account to the electing PTE account. No interest will accrue on taxes later paid by electing PTEs in cases where such tax was timely paid by the partners. However, the accrual of refund interest would be eliminated for taxes originally paid by owners for the taxable year 2021 that would later be refunded once the election is made and the refundable credit claimed by such owners. Accordingly, taxpayers should extend their 2021 filings if they are considering the election for the 2021 tax year.
Additionally, there may have been instances where taxpayers did not make another state’s PTE election because the PTE had Virginia owners, who previously would not have been allowed a credit against Virginia income tax. Taxpayers may need to revisit other state elections now that such a credit for taxes paid is available.
In allowing the credit for taxes paid for similar taxes, Virginia joins the District of Columbia which recently issued guidance clarifying that taxpayers may also be able to claim such a credit. Maryland has provided the credit for similar taxes since its workaround was enacted in 2020.
Virginia is at least the 25th state to adopt a workaround tax. Several other states have similar proposals pending in state houses. New Mexico and Utah recently enacted workarounds effective beginning in 2022.
Please contact a qualifying state and local tax adviser for questions about Virginia’s PTE election or other state workarounds and consider that not all owners may benefit from such an election.