How the Virginia Pass-Through Entity Tax Election can Benefit Business Owners
On April 11, 2022, Virginia Gov. Glenn Youngkin signed into law House Bill 1121. The enacted House Bill created a new tax election for pass-through entities (PTEs) doing business in Virginia, opening up a tax planning opportunity for business owners. The new tax election offers eligible S corporations, partnerships, and LLCs taxed as S corporations or partnerships an option to pay the state income tax due on the business income at the entity level on behalf of its individual owners. The elective pass-through entity tax was created for the benefit of business owners who face the $10,000 federal deduction limitation on state and local taxes (SALT) on their individual tax returns. For tax years beginning on or after January 1, 2021, but before January 1, 2026, qualifying PTEs may elect to pay tax at the entity level at a rate of 5.75%.
Additional guidance is still required from the Virginia Department of Taxation regarding how eligible PTEs will be able to make a retroactive pass-through entity tax election for their 2021 tax year. This guidance is expected to be released by October 15, 2023. For tax years beginning on or after January 1, 2022, but before January 1, 2026, the tax election must be made by a qualifying pass-through entity on its timely filed return, including any extensions.
Under the new law, owners of qualifying PTEs that make the pass-through entity tax election will receive a refundable state tax credit for their pro-rata share of the tax paid on their behalf by the entity. In addition, the individual owners of qualifying PTEs will be able to receive a state tax credit for income tax paid to another state that is substantially similar to the newly enacted Virginia pass-through entity tax.
Example
The following is an example to illustrate how the pass-through entity tax works. ABC Inc. is an S corporation owned 100% by Robert and operating solely in Virginia. In 2022, ABC Inc. has taxable income of $300,000, which gets passed through to Robert on his individual income tax return. Ordinarily, Robert would personally pay state income taxes of 5.75% on the $300,000 of business income. At 5.75%, the state income tax on the business income is $17,250, which exceeds the $10,000 SALT limitation on Robert’s federal individual tax return. Therefore, Robert loses out on the full federal tax deduction for state income taxes paid.
If ABC Inc. elects into the pass-through entity tax instead, the business would pay the $17,250 in state income tax and deduct it as an ordinary business expense. As a result, only $282,750 of business income is passed through to Robert on his federal individual tax return. If Robert owed $10,000 in state income taxes on his wages as an employee of ABC Inc., he just received an additional $17,250 in tax deductions. Since Robert is in the 32% federal tax bracket, the federal tax savings from making the pass-through entity tax election is $5,520. On Robert’s Virginia individual tax return, he will receive a refundable tax credit equal to the $17,250 of state income tax that was paid on his behalf by ABC Inc.
Key Takeaways
Guidance is still required from the Virginia Department of Taxation on how to make the new election and how to apply it retroactively to 2021. Since the guidance on retroactive application is not expected until late into 2023, PTEs should file their 2021 federal and state returns in accordance with the existing due dates and without consideration of the pass-through entity tax election.
Finally, talk with your tax advisor to analyze the federal and state income tax implications of electing into the pass-through entity tax.
