Virginia Pass-Through Entity Tax and Multitier Tax Partnerships

Virginia just enacted a pass-through entity tax (“PTET”), which applies in 2021 through 2025, inclusively. Many commentators have addressed the PTET, and I defer to them for the details. The PTET allows certain “qualified pass-through entities” to elect to pay Virginia taxes at the legal entity level. The objective is to avoid the federal income tax limit on deduction of Virginia taxes for the owners of the entity through converting the deduction into a credit.

Unfortunately, Virginia waited until the eleventh hour (and one year late) to enact this legislation. Now, the Department of Taxation (“VDOTax”) is seeking comments to determine how to make this legislation actually function. VDOTax has done an amazing job in similar circumstances, and I have no doubt their regulation of PTET will be a similar success. However, one area needs to be addressed: how to apply the PTET to tax partnerships that have tax partnerships as partners (“Multitier Tax Partnerships”). The common example would be an LLC operating in Virginia (the “Lower-Tier Partnership” or “LTP”), which has one or more LLCs as tax partners (each, an “Upper-Tier Partnership” or “UTP”). This example dictates that the LTP and each of the UTPs is classified as a tax partnership for federal and Virginia tax purposes, and thus, is not a single member entity and has not elected to be a corporation, for example.

The PTET only applies to a “qualifying pass-through entity,” which requires a pass-through entity (such as our LTP) to have only tax partners (members) that are natural persons or that would be eligible S corporation shareholders. Thus, on its face, the PTET regime would be unavailable to Multitier Tax Partnership (a tax partnership cannot be an S corporation shareholder). However, that result is illogical and ignores the reality of modern structures. Many, if not most, LTPs have UTPs. The PTET should apply to Multitier Partnerships of which all the indirect partners are natural persons or eligible to be S corporation shareholders (“Qualifying MTPs”).

The opposition might argue to VDOTax that the PTET grew out of rules related to S corporations and that the legislation is clear. However: (i) the federal tax law almost always collapses tiers (the tax partners in the UTP are deemed to own directly their proportional share of the LTP); (ii) most of the myriad of limitations that apply to S corporations (such as the restriction on allocations that differ from share ownership) do not apply to LLCs that only have natural persons as tax partners, so the legislation does not, and was not, limited to LLCs that could have elected S corporation status; and (iii) if the PTET Regulations contain the clarification that I suggest and limit it to Qualifying MTPs, VDOTax’s actions would be within its power and not violate the purpose of the PTET. To the contrary, without clarification, the benefit of the PTET in many modern structures is foreclosed. Therefore, not adding the clarification thwarts legislative intent.

The advocates of this clarification might argue that the PTET should also allow an LTP to have S corporations as tax partners and be a Qualifying MTP. I agree but will defer that lobbying to them. The clarification should apply to Qualifying MTPs that themselves have Qualifying MTPs and so on through collapsible chains. VDOTax will, however, need a manner for each Qualifying MTP to attest to its status, and of course, each Qualifying MTP needs to build into its governing document (in our case, its operating agreement) provisions, which require their tax partners to confirm their necessary status.

VDOTax has a difficult task. All pass-through entity lawyers, tax advisors, and clients also have a difficult task. While those of us that work with pass-through entities have the summer and a slight reprieve from tax filing season, we need to start work immediately to add PTET provisions in governing agreements. Those provisions must be flexible and work regardless of what the PTET Regulations provide.

Please note: an article with updates on this subject was posted in December 2022. You can read that article here.