The PTE Election Rush—Retroactivity Is Not the Same in Every State

In the rush to make pass-through entity (PTE) tax elections, taxpayers should be on the lookout for traps that may catch the unwary if they file in more than one state. Retroactivity is one of the potential traps. The retro time period for one state may not be the same as another. And while some of the issues applying retroactivity may be the same, the longer the retroactivity period, the larger the headache.

Virginia and Colorado are the first two states to enact a retroactive PTE election. Virginia’s election is retroactive to 2021, and Colorado’s is retroactive to 2018. Mking the election should be relatively straightforward on a forward basis, but the opportunity to make a retroactive election leaves several unanswered questions.

Virginia Pass-Through Entity Tax

On April 11, 2022, Virginia joined the others states enacting a PTE workaround to the $10,000 limitation on individuals for deducting state and local taxes on their federal income tax returns. Virginia’s PTE election is effective for tax years 2021 through 2025 and allows a qualifying PTE to make an election to pay tax at the rate of 5.75% at the entity level. Owners will be entitled to a credit equal to their pro rata share of the PTE tax. If the credit exceeds the owner’s tax liability, the excess will be treated as an overpayment and will be refunded to the owner.

Under Va. Code § 58.1-309.3, a qualifying PTE is one that is “100 percent owned by natural persons or, in the case of a Subchapter S corporation, 100 percent owned by natural persons or other persons eligible to be shareholders in an S corporation.” The statute makes no provision for PTEs owned by other PTEs, including tiered LLCs.

The legislation does allow a credit for state income taxes paid by a PTE in another state for taxable years 2021 through 2025. This overrides Public Document 21-156 (Dec. 29, 2021), which generally denied a credit for a tax paid to Maryland under that state’s elective pass-through entity tax. The PTE credit will not be allowed for any other entity-level taxes, such as any franchise, privilege, business, license, or occupation taxes described in Va. Code § 58.1-332.2.

Colorado Pass-Through Entity Tax

In 2022, Colorado amended its PTE election to make it retroactive to tax year 2018. Colorado’s PTE election allows the owners to claim a credit against their individual income tax equal to the pro rata share of the tax paid by the electing PTE. The PTE tax will be the same as the corporate rate. Unlike Virginia, Colorado’s PTE is available to all partnerships and S corporations without any apparent restrictions on tiered structures.

Retroactive Election in Virginia for Tax Year 2021

The biggest issue with Virginia’s PTE election is that the Department of Taxation has not issued guidance for making the election. Under Va. Code § 58.1-609.3, the election must be made “in a format and according to such requirements and procedures to be established by the Department of Taxation.” The election for 2021 cannot be made “no earlier than one year after the extended due date for filing the applicable return,” which is Oct. 15, 2023.

In the meantime, Virginia Tax Bulletin 22-6 instructs PTEs and their owners to file their returns for 2021 by the original or extended due dates for filing the return without making the election or claiming the credit. Once the Department of Taxation releases the procedures in 2023, qualifying PTEs making the election and their owners will need to file amended federal and Virginia returns and pay the PTE taxes for 2021.

Retroactive Election in Colorado for Tax Years 2018–2021

Colorado provides more detail about making a retroactive election for tax years beginning on or after Jan. 1, 2018, but before Jan. 1, 2022. Colo. Rev. Stat. § 39-22-343 provides that the PTE must make the election by filing an amended composite return on or after Sept. 1, 2023, but before July 1, 2024.

The election to file retroactively in Colorado is binding and cannot be reversed. Colorado has one year to make any adjustments. It will not assess any late filing assessment or penalties for late filing. Taxpayers should be aware that a retroactive election may extend the statute of limitations for Colorado to audit and assess a PTE.

Observations About the Retroactive Elections

Many PTEs sold some or all of their assets in a prior year. Such PTEs may need to hold enough cash in reserves or put cash back into the entity in order to make the election. If the PTE has been liquidated and dissolved, it’s uncertain how the PTE will be able to make the election when the forms become available.

Individuals must pay a certain percentage of their estimated tax liability by certain deadlines. It’s uncertain if PTEs making the election will need to pay their PTE taxes before the individual owners are refunded. If the owners put cash back into the PTE to pay the entity-level tax, the tax distributions made in a prior year may need to be reclassified as regular distributions.

Before making the PTE election, the tax matters manager or partner will need to consider the impact on any non-resident owners. Not all states will give a credit to a taxpayer for any PTE taxes paid to another state.

The tax matters manager or partner may need to consider whether the tax distribution language in the operating/shareholder agreement will treat any PTE tax as a tax to be netted under the tax distribution section.

Conclusion

The retroactive nature of both Virginia’s and Colorado’s PTE elections leaves many unanswered questions. It also creates unique challenges for PTEs concerning future years. We expect that both states will issue additional guidance and solicit comments, thus presenting an opportunity for it to consider and answer these questions before finalizing its guidance.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Stephanie Lipinski Galland is a partner at Williams Mullen with extensive legal experience in state and local taxation with an emphasis on representation before state and local taxing authorities in income, franchise, sales, use, and unclaimed property controversies.

Kyle Wingfield is also a partner at Williams Mullen whose practice focuses on resolving tax disputes with state and local taxing authorities and the IRS. He has significant experience in managing audits, handling administrative appeals, and filing petitions in federal and state courts to obtain relief for his clients.