A new election available to pass-through entities can help partners, members, and shareholders (collectively “owners”) reduce their federal taxes owed. In the spring of 2022, the Virginia General Assembly passed House Bill 1121 and Senate Bill 692, allowing certain pass-through entities (PTEs) to elect to pay Virginia income tax at the entity level.  

This election can provide PTE owners with a workaround for the $10,000 cap on state and local tax deductions instituted for individual tax returns. Virginia recently released draft guidelines, and understanding the basics of the Pass-Through Entity Tax (PTET) election can help you know whether this option can work to your advantage.  

Benefit to Taxpayers

This election can help taxpayers deduct a greater portion of state and local tax payments from their federal tax burden. Before this election was available, generally a PTE did not pay tax on the income it generated. Instead, it would pass the earnings through to the owners of the PTE. The owners would then pay the tax assessed on PTE income on their individual tax returns.  

While individuals can deduct state taxes paid from their federally taxable income, the Tax Cuts and Jobs Act (TCJA) limits the individual deduction for state taxes to $10,000. This cap meant that taxpayers who expended more than $10,000 in state taxes were out of luck. When owners make this election, they choose to pay PTET at the entity level. In other words, the PTE will pay Virginia income tax on the income it generates. After the PTE pays the Virginia income tax, the owner receives a state tax credit for the taxes paid by the PTE. The reclassification benefits owners in two ways.  

First, the state and local tax $10,000 cap will no longer limit the amount of tax PTE owners can use to reduce their federal tax burden. Removing this cap can allow taxpayers who pay more than $10,000 in state taxes to reduce their federal tax burden by a larger figure when the PTE pays the tax. 

Second, it will free up space within the $10,000 cap for state and local taxes unrelated to PTE income that owners pay. These combined benefits can significantly decrease a taxpayer’s federal income tax. 

Who Qualifies?

Note: The Virginia General Assembly recently presented a bill for the Govenor’s signature that will modify the eligibility requirements (see box “Potential New Legislation” for more information). If signed, the new law will take effect on July 1, 2023. The following provides the current eligibility requirements for the election. 

The most basic requirement for this election is that the entity qualify as a PTE. A PTE is an entity that is considered separate from its owner(s) for purposes of paying federal income tax. The second requirement is that the PTE be 100% owned by natural persons.  

Generally, an owner is a natural person if they are a human being (compared to an owner who is a corporation or another PTE.) However, certain non-human entities can still qualify as natural persons for purposes of qualifying for this election. Also, any qualifying S Corporation can make the election. A Hantzmon Wiebel team member can help you determine whether your PTE is eligible for this election. 

Notably, this election is made at the entity level and will, therefore, apply to all owners of the PTE. A PTE cannot make this election on an individual owner-by-owner basis. Virginia has not specified any steps that PTE owners must take to gain consensus for making this election, so owners are free to consult their own bylaws to make this decision. 

Timing

This election is available for tax years 2021 through 2025. Virginia has released draft guidelines that detail how to make the election for 2022 and onward. Virginia will release guidance on how to make this election for 2021 at a later date. Importantly, Virginia will not assess any penalties on PTE taxpayers who choose this election for 2022 but have not made Virginia estimated payments related to that tax year. 

Next Steps

The process for making this election and taking full advantage of its benefits can be complex. Additionally, the rules surrounding this election are subject to change as Virginia has only published draft guidelines. However, the Hantzmon Wiebel team is here to help. If you have any questions about whether to make this election, please feel free to contact a Hantzmon Wiebel team member. 

Disclaimer of Liability
Our firm provides the information in this article for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this blog are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.