On April 11, 2022, Virginia Gov. Glenn Youngkin approved legislation that adopts an elective pass-through entity (PTE) tax regime, retroactively applicable to tax years beginning on or after Jan. 1, 2021.1 In addition, Virginia recently enacted several important corporate income tax legislative changes that: (i) advances the state’s Internal Revenue Code (IRC) conformity date from Dec. 31, 2020, to Dec. 31, 2021;2 decreases the waiting period required to elect a different filing method for affiliated corporations;3 (iii) permits a consolidated filing election for certain banks;4 and (iv) increases the state-specific business interest deduction beginning with the 2022 tax year.5 Finally, recently enacted legislation expands several existing exemptions and exclusions for Virginia sales and use tax purposes.
Elective PTE tax regime
For tax years beginning in 2021 through 2025, qualifying PTEs may elect to pay income tax at the entity level on an annual basis.6 Electing PTEs will be taxed at a rate of 5.75%, Virginia’s current individual income tax rate.7 PTE owners are entitled to a refundable income tax credit against their personal income tax liability based on the pro rata share of tax paid by the PTE.8 If the amount of the credit attributable to the owner exceeds their personal tax liability, the credit is refundable to the PTE owner.9
A “qualifying pass-through entity” is defined as a PTE that is 100% owned by natural persons or, in the case of an S corporation, 100% owned by natural persons or other persons eligible to be shareholders in an S corporation.10 Accordingly, PTE owners in tiered ownership structures are not eligible to make the election at the lower-tier level.
In computing the PTE tax base, taxable income is determined under Virginia law, under which the taxpayer is eligible to take all deductions, credits, and other adjustments that would be otherwise computed at the PTE level. However, the PTE’s taxable income is adjusted to eliminate any federal deduction for state and local income taxes to prevent PTE owners from receiving the benefit of both a credit and deduction for state income taxes paid by the PTE.11
Significant authority is delegated to the Virginia Department of Taxation to develop the format and procedures for making the PTE tax election for the 2021 tax year.12 While the specific timing for making the election is to be determined by the Department, the legislation specifies that the due date may be no earlier than one year after the extended due date for filing the applicable return.13 For calendar year taxpayers, this means the due date of the first election will be no earlier than October 15, 2023. During this time, no overpayment or underpayment interest will accrue that is solely attributable to the late election.14 For the 2022 through 2025 tax years, the election will be made on a timely filed PTE return, including any applicable extensions.15
In addition, the legislation modifies Virginia’s resident credit provision for taxes paid to other states to allow all resident PTE owners to claim a credit where the PTE pays an entity-level tax that is substantially similar to Virginia’s PTE tax. Under the amended credit provision, the PTE owner is deemed to have paid tax at the owner level in proportion to their ownership in the PTE.16 Prior to this legislation, the law had provided, and the Department had confirmed, that only S corporation shareholders were entitled to claim a credit for taxes paid to other states by the S corporation.17 A Virginia PTE tax election is not required in order to claim the credit for taxes paid to other states.
As the Department is required to issue guidance under which the PTE tax will be implemented, formal published guidelines are expected in the coming months. The Department already has issued a bulletin that addresses certain mechanics of the new PTE tax law:
- PTEs should not attempt to pay the elective PTE taxes with their 2021 tax return. Qualifying PTE taxpayers are not yet able to make an election or pay PTE tax on their 2021 income tax returns, regardless of whether the return is filed by the original or extended due date.
- Likewise, individual PTE owners may not claim credits for any elective PTE tax paid by the PTE for the 2021 tax year on their 2021 tax returns. Claiming the credit will result in the denial of credit and the potential assessment of interest and penalties. PTE owners should compute their personal income tax liability and make payments without regard to the PTE credit, and will have the ability to claim the credit once the election is made in 2023.
- Individual taxpayers may claim credit for taxes paid by the PTE to other states on their 2021 tax returns, as long as the tax is substantially similar to Virginia’s elective PTE tax.18
Corporate income tax legislative changes
Decrease in period required to change filing method
As a separate company filing state, Virginia allows corporate taxpayers that are members of an affiliated group of corporations the ability to file combined or consolidated returns. Historically, once the election was made, an affiliated group was required to file on the same basis for at least 20 years prior to requesting a change in filing status.19 While the Department has allowed for changes between separate and combined return filing methods, it has often denied discretionary requests for changes to or from a consolidated filing method.
House Bill 348 reduces the period required to request a filing status change from 20 years to 12 years, either from separate company or combined to consolidated filing status, or from consolidated to separate company filing status.20 The bill leaves unchanged the Department’s authority to grant permission to change filing methods where there is no decrease in tax liability computed under the proposed election as compared with the group’s former filing method in the immediately preceding tax year.21 Further, the group must file returns under both the previous filing method and the desired filing method, and to remit the higher tax liability between the two tax filing methods for the initial and immediately succeeding tax year.22 Given that this change applies on a prospective basis, the Department is under no obligation to grant a filing method change in the current year, based upon qualification to change in prior years.
Consolidated filing election for certain state or national banks
For tax years 2023 and 2024, Senate Bill 386 permits certain affiliates of state or national banks to elect to change from a combined to consolidated filing status.23 In order to make a valid change in filing status, the affiliated group must have filed on the same basis for at least the last preceding 20 years, and at least one member of the affiliated group must be a related entity to a state or national bank that is exempt from filing a Virginia corporate income tax return under Va. Code Ann. Sec. 58.1-302.24
Generally, in order to elect a consolidated filing status in Virginia, an affiliated taxpayer must be subject to the corporate income tax. This legislation provides a limited window whereby affiliated taxpayers that are owned by a corporation subject to the bank franchise tax will have the option to file as a consolidated group. Effectively, this bill temporarily removes the requirement that the common parent must be subject to corporate income tax, and further eliminates the need for taxpayers meeting the criteria to apply for such filing change. The requirement to file returns under both the previous filing method and the desired filing method, and to remit the higher tax liability between the two tax filing methods for the initial and immediately succeeding tax year, also applies in this instance.25
General IRC conformity date advanced to Dec. 31, 2021
On Feb. 23, 2022, the governor approved emergency legislation advancing Virginia’s IRC conformity date from Dec. 31, 2020, to Dec. 31, 2021.26 Identical legislation was enacted on March 9, 2022.27 This legislation generally allows Virginia to conform to the American Rescue Plan Act of 2021 (ARPA).
In prior IRC conformity legislation, Virginia decoupled from the deductibility of expenses funded by Paycheck Protection Program (PPP) loans but provided for a deduction of up to $100,000 of PPP-related expenses for the 2020 tax year.28 The 2022 conformity legislation extends the availability of this Virginia-specific $100,000 deduction to PPP-related expenses incurred in the 2019 tax year as well. This retroactive deduction may be taken to the extent these amounts were not deductible on prior federal tax returns.29 For PPP expenses incurred in 2021 and forward, the legislation fully conforms to the federal deductibility of expenses related to forgiven PPP loans.
Notably, Virginia continues to decouple from several significant aspects of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. These modifications include the decoupling from bonus depreciation on certain assets, the five-year net operating loss (NOL) carrybacks and the business interest limitation.30 Specifically, taxpayers must continue to compute their business interest limitation under IRC Sec. 163(j) based upon 30% of adjusted taxable income (ATI) rather than the 50% limitation adopted by the CARES Act. Despite this limitation, Virginia has historically allowed for a measure of relief through an additional state-specific deduction for 20% of business interest expense disallowed under Sec. 163(j).31 For tax years beginning on or after Jan. 1, 2022, the 20% state-specific deduction of disallowed interest expense has been increased to 30%.32 The amount of disallowed business interest expense upon which the additional deduction is based still must be computed on a pro forma basis, based upon the disallowed business interest as computed without regard to the CARES Act limitation.
Sales and use tax changes
Recently enacted legislation expands existing exemptions or exclusions to the Virginia sales and use tax:
- Taxable accommodations exclusion for use of meeting space: The definition of “accommodations” has been updated to specifically exclude “rooms or space offered by a person in the business of providing conference rooms, meeting space, or event space if the person does not also offer rooms available for overnight sleeping.”33 This definition is retroactive to September 1, 2021, though the state does not provide for a refund for taxes paid prior to July 1, 2022.34
- Aircraft component exemption: The sunset period for a sales tax exemption related to “parts, engines, and supplies used for maintaining, repairing, or reconditioning aircraft or any aircraft’s avionics system, engine, or component parts” has been extended from July 1, 2022, through July 1, 2025.35 This exemption applies to both manned aircrafts with maximum takeoff weight of at least 2,400 pounds, and unmanned aircrafts.36
- Internet service equipment exemption: The sales and use tax exemption related to implication, transmission, and distribution equipment used to provide Internet service has been expanded to include network equipment, defined as “modems, fiber optic cables, coaxial cables, radio equipment, routing equipment, switching equipment, a cable modem termination system, associated software, transmitters, power equipment, storage devices, servers, multiplexers, and antennas.”37 The definition of Internet service providers is also expanded to include telecommunication service providers.38
- Veterinarian prescription medicines and drugs: Effective July 1, 2022 and for a period of three years, purchases of prescription medicines and drugs by veterinarians that are distributed to their patients and clients will be exempt from the sales tax.39 Historically, veterinarian medicines and drugs were subject to tax, while other medicines, drugs, and similar goods were exempt.40
- Printing materials exemption: The sunset date of the sales tax exemption for advertising businesses that purchase printed materials from Virginia-based printers has been extended from July 1, 2022 through July 1, 2025.41
Commentary
With the PTE tax legislation, Virginia joins a growing number of states that have enacted entity-level tax regimes as a workaround to the federal $10,000 state and local tax (SALT) deduction limitation adopted under the Tax Cuts and Jobs Act (TCJA) of 2017. However, it is important to note that the election is available to a smaller subset of qualifying entities than many other states have permitted. The narrow definition of a qualifying PTE to include only natural persons or persons eligible to participate as an S corporation shareholder will require PTEs and their owners to scrutinize forthcoming guidance to determine whether they are eligible to make a Virginia PTE tax election.
The ability to make a PTE tax election to apply retroactively to the 2021 tax year also warrants additional consideration for PTEs and their owners that may be considering whether to make an election and for which tax years. While taxpayers have a considerable amount of time to analyze the implications of making the election, the delay in implementation creates significant uncertainty for the current year tax compliance process. The current inability to pay tax at the entity level and take a corresponding credit at the owner level may result in taxpayers effectively having to pay tax twice and seek a refund if the election is made at a future time. Further, an anticipated PTE election may not alleviate the need for withholding at the entity level on originally filed returns for the 2021 tax year. Therefore, taxpayers should consider whether an election for the 2021 tax year is practical, due to the uncertain timing and administration of the PTE election. Furthermore, the timing of the election and payment may additionally have implications beyond Virginia, such as the federal deducibility of state taxes, as well as other states’ allowance of a resident owner credit for PTE tax paid to Virginia.
The PTE tax legislation provides further clarity regarding the credit available to resident owners of PTEs paying entity-level taxes to other states. The legislation supersedes the Department’s prior interpretation that the resident credit was only available to S corporation shareholders by allowing other PTE owners to claim credit for taxes paid to another state beginning in 2021, provided the tax is substantially similar to Virginia’s PTE tax. While this expanded eligibility for the resident credit is helpful to taxpayers, further guidance providing the Department’s interpretation of a “substantially similar” entity-level tax is welcome.
Virginia’s change in the waiting period to request a change to a consolidated filing method from 20 years to 12 years presents an opportunity for a large group of previously ineligible corporate taxpayers to reevaluate their Virginia filing method. While corporate taxpayers often find it more beneficial to file on a consolidated basis, the Department has strictly adhered to the 20-year requirement and has declined to offer discretionary relief to taxpayers who have requested such change.
Taxpayers who may benefit from a consolidated election should conduct an analysis to determine whether this change in filing method is now available. Taxpayers who initially missed the opportunity to elect a consolidated filing method, or who may have inadvertently elected a less preferential filing method in their first year of eligibility, may now find an opportunity to obtain relief and tax savings from an election that has been historically prohibitive. Further, the reduced waiting period may represent an opportunity to reconsider whether a consolidated filing election would benefit taxpayers whose business operations have changed since making their initial election.
Despite the change in waiting period, the legislature has left in place several restrictive conditions to effect the change in filing methods, including the requirement that the change may not reduce tax in the immediately preceding year, and that the taxpayer pays the greater tax of the current and immediately succeeding tax year. Companies impacted by recent economic downturns may wish to evaluate whether this requirement would be satisfied in 2020, and/or whether the company could mitigate potential liability by changing methods in 2021. In determining whether to change filing methods, taxpayers should consider numerous other factors including when the initial election was made, the nexus attributes of group members, the affiliated group composition, and the impact on attributes such as NOL carryforwards and excess business interest expense carryforwards.
Virginia’s advancement of its IRC conformity date to Dec. 31, 2021, additionally allows the Commonwealth to conform to the federal treatment of several ARPA provisions, including: (i) conformity to the federal income tax treatment of expenses related to the forgiven PPP loan proceeds for the 2021 tax year; and (ii) the retroactive allowance of up to $100,000 of expenses related to the forgiven PPP loans for 2019. Even though Virginia continues to decouple from other significant aspects of the CARES Act, corporate taxpayers may receive additional tax benefits for the 2021 tax year and forward due to the increased additional state-specific deduction for disallowed business interest expense under Sec. 163(j).
1 Ch. 690 (S.B. 692/H.B. 1121), Laws 2022, adding VA. CODE ANN. § 58.1-390.3.
2 Ch. 19 (S.B. 94), Ch. 3 (H.B. 971), Laws 2022, amending VA. CODE ANN. § 58.1-301.
3 Ch. 274 (H.B. 348), Laws 2022, amending VA. CODE ANN. § 58.1-442.
4 Ch. 417 (S.B. 386/H.B. 224), Laws 2022, amending VA. CODE ANN. § 58.1-442.
5 Ch. 648 (S.B. 288/H.B. 1006), Laws 2022, amending VA. CODE ANN. §§ 58.1-322.03; 58.1-402.
6 Ch. 690, adding VA. CODE ANN. § 58.1-390.3.A.1, .2.
7 Ch. 690, adding VA. CODE ANN. § 58.1-390.3.B.
8 Ch. 690, adding VA. CODE ANN. § 58.1-390.3.D.
9 Id.
10 Ch. 690, amending VA. CODE ANN. § 58.1-390.1.
11 Ch. 690, adding VA. CODE ANN. § 58.1-390.3.C.
12 Ch. 690, adding VA. CODE ANN. § 58.1-390.3.A.1.
13 Id.
14 Id.
15 Ch. 690, adding VA. CODE ANN. § 58.1-390.3.A.2.
16 VA. CODE ANN. § 58.1-332.C.2.
17 VA. CODE ANN. § 58.1-332.C.1; Ruling of the Commissioner, P.D. 21-156, Virginia Department of Taxation, Dec. 29, 2021.
18 Tax Bulletin 22-6, Virginia’s New Elective Pass-Through Entity Tax, Virginia Department of Taxation, Apr. 15, 2022.
19 VA. CODE ANN. § 58.1-442.C.
20 Ch. 274, amending VA. CODE ANN. § 58.1-442.C.
21 VA. CODE ANN. § 58.1-442.C.1.
22 VA. CODE ANN. § 58.1-442.C.2.
23 Ch. 417, adding VA. CODE ANN. § 58.1-442.D.
24 Id.
25 Id.
26 Ch. 3 (H.B. 971), amending VA. CODE ANN. § 58.1-301.B.
27 Ch. 19 (S.B. 94), amending VA. CODE ANN. § 58.1-301.B.
28 VA. CODE ANN. § 58.1-322.03.17; 58.1-402.H. For further discussion, see GT SALT Alert: Virginia advances IRC conformity date one year.
29 Ch. 19, amending VA. CODE ANN. § 58.1-322.03.17.
30 VA. CODE ANN. § 58.1-301.B.7, .8.
31 VA. CODE ANN. §§ 58.1-322.03.15; 58.1-402.G.
32 Ch. 648 (S.B. 288/H.B. 1006), Laws 2022, amending VA. CODE ANN. §§ 58.1-322.03.15; 58.1-402.G.
33 Ch. 154 (S.B. 432), Laws 2022, amending VA. CODE ANN. § 58.1-602.
34 Ch. 154, adding VA. CODE ANN. § 58.1-602.3, .4.
35 Ch. 228 (S.B. 701/H.B. 462), Laws 2022, amending VA. CODE ANN. § 58.1-609.10.20.
36 Id.
37 Ch. 435 (S.B. 683/H.B. 1155), Laws 2022, amending VA. CODE ANN. §§ 58.1-602; 58.1-609.6.
38 Ch. 435, amending VA. CODE ANN. § 58.1-602.
39 Ch. 552, (S.B. 517/H.B. 551), Laws 2022, adding VA. CODE ANN. § 58.1-609.10.22.
40 VA. CODE ANN. § 58.1-609.10.9.
41 Ch. 481 (S.B. 101), Laws 2022, amending VA. CODE ANN. § 58.1-609.6.4.
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