Virginia's Pass-Through Entity Tax: Significance, Structure Problems, Potential Solutions, and Happy Wishes
This post (“Final 2022 Post”) is the third in a series the author has written on Virginia’s pass-through equity tax (“PTET”). Click here to read the First Post (posted July 22, 2022) which dealt with the problems of the PTET in multitier partnership (“MTP”) structures and requested relief. Click here to read the Second Post, which acknowledged that VDOTax did not provide this relief in its Draft Guidelines. Capitalized terms not defined in this Final 2022 Post have the meanings provided in the first two posts.
As 2023 approaches, several issues need to be addressed: (i) what is the significance of the PTET; (ii) what are some problem structures and their potential solutions; and (iii) will the General Assembly provide relief?
Significance of the PTET
Federal tax law was changed to limit the aggregate deduction of various state and local taxes (including income taxes) to $10,000 ($5,000 for married filing separately) each tax year between 2018 and 2025, inclusively. The limitations for 2026 are different. Many states have tried techniques to “work around” this federal limitation. Many of these techniques have failed, or at least, the IRS says they have failed.
One technique that the IRS appears to have blessed (at least for tax partnerships and S corporation paying state income taxes) is a PTET like Virginia’s. In a PTET, the entity pays the state income tax and passes through a state credit to its tax partners or S shareholders. Virginia enacted a PTET effective for taxable years 2021 through 2025, inclusively. Unfortunately, Virginia requires all the tax partners to be natural persons (or deemed natural persons under federal tax law). An example of a deemed natural person is an LLC, which has a natural person as its sole member and which has not elected to be taxed as a C or S corporation.
The PTET could be significant. Without delving into the minutiae of income sources and residency, assume a tax partnership has $10 million in taxable income each year, has four equal tax partners, and each of the tax partners already has state income taxes more than $10,000 (thus, each has consumed his limitation). If the tax partnership could make a PTET election for 2022 through 2025, inclusively, that would create an aggregate federal deduction of $575,000 or $143,750 per tax partner each year. At the highest federal tax rate, this would have a value of $212,750 aggregate and about $53,200 per tax partner each year.
Problem Structures and Potential Solutions
An S corporation qualifies to elect PTET by definition without any reorganizations or transfers. Thus, if the S corporation is the entity seeking the PTET Election, no disqualifying issues should exist. However, many practical issues exist for S corporations (especially those with trusts as shareholders), which the author intends to address in a future post or article.
As further discussed below, the determination whether a tax partnership (including an LLC taxable as a partnership) qualifies is made each taxable year (undoubtedly the calendar year), a tax partnership with other than natural persons cannot elect PTET for 2022. However, if it can take, and does take, the necessary steps to qualify before the end of the year, it could elect PTET in 2023.
A. LLC has One or Multiple S corporations as Members. To reiterate, the Draft Guidelines state that a tax partnership must be wholly owned by tax partners treated as natural person to qualify for the PTET Election. Assuming that the value of the LLC interest in the S corporation (“Relevant Interest”) is significant and is substantially higher than its tax basis (the author refers to this excess as the “Delta”), a practical solution may be unobtainable. The most obvious candidates for restructuring would either be taxed as a taxable redemption or a taxable liquidation of the S corporation. Thus, transferring the Relevant Interest to ownership of the S corporation shareholder(s) is ill-advised. Yes, that redemption or liquidation would vest ownership in a qualifying S shareholder (and, thus, qualify the LLC for PTET Election by definition under the Draft Guidelines) (unless the S shareholders included ESBTs, QSSTs, or other specific categories). However, the IRS may review and argue that the value of the Relevant Interest was understated, that the Delta was greater, and that the gain is higher. The parties probably have no definitive valuation to defend against the argument. Furthermore, PTET is great, but it is generally not worth those gyrations.
The best option seems to be electing PTET at the S corporation-level, but that leaves the individual LLC members out of PTET relief. If nothing can be done with the S corporation (because, for example, the Delta is too high or the valuation is too murky), nothing can be done, or need be done, this year. The S corporation has several ways to make the PTET Election for 2022 at the S corporation-level even into 2023 and relief from estimated tax payments in 2022 in the Draft Guidelines is just and fair. Please note that for 2023 and thereafter estimated tax payments for PTET are scheduled to be required.
B. Lower-Tier Partnership with Upper-Tier Partnership(s) as Members.
Only Individual Indirect Members of the LTP: Assume that a tax partnership (“LTP”) has all natural persons as its tax partners except one LLC (“UTP”) owned by natural persons A and B. If that LLC distributes the tax partnership interest to A and B this month, the tax partnership could qualify in 2023 and beyond. No PTET Election can be made in 2022. However, make sure that you have a problem before you seek a solution. If the UTP is owned by a natural person, it should be deemed a natural person as a disregarded entity (unless a contrary federal tax election has been made). In addition, most grantor trusts would be deemed natural persons.
S corporations of the Upper-Tier Partnership: A tax partnership has the ability in most instances to redeem a tax partner in-kind on a tax-free basis or to split-up, spin-off, or otherwise separate the tax partners’ ownership of the UTP’s portfolio of investments. What is the scenario? How significant does the proportionate value of the LTP Interest compare to the natural person’s share of the UTP? Is the PTET Election worth the effort to gain agreement?
Referring back to the issue of during what period the PTE is tested, the law and the Draft Guidelines seem clear it has to be the entire tax year. Opinions may vary. Tax partnerships do not “terminate for tax purposes” on mere transfers of interests anymore. Esoteric rules do exist on tax partnership continuations in unique scenarios, which rarely arise. C corporations would generally be unable to elect S corporation status during mid-year. An S corporation could lose its status and become a C corporation, but the qualification for PTET should be based on the S period,
The General Assembly apparently intended to enact the PTET to restore the federal deduction of Virginia taxes. The legislation failed in many real-world structures. Please review the relief that the author requested in my First Post. One must empathize, however, with VDOTax. The legislation was enacted retroactively. Having to administer the filing of PTET returns for MTP is a daunting task. VDOTax has numerous regulatory projects that are much older than the PTET, and at least, produced their best thoughts on October 31, 2022 on PTET in the Draft Guidelines. Please review the Second Post for how the Draft Guidelines are not law or regulations but have significant importance.
The author’s efforts to convince VDOTax to provide relief were in vain and fears that this issue will not be addressed again before the provision sunsets or its impetus to exist does (the federal deduction work-around). The General Assembly could, of course, enact a simple provision making these regulations a priority and directing VDOTax to fix the issues outlined in my three posts to the extent of VDOTax capability to handle administration of such a fix.
Happy New Year.
Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.