Just Passin’ Through: A Primer on Virginia’s Pass-Through Entity Withholding Rules

November 1, 2009

By Jay Bethard, CPA, J.D., LL.M.

During the 2007 General Assembly session, Virginia enacted a withholding requirement for nonresident owners of pass-through entities who conduct business in Virginia. This adds a wrinkle to the taxation of the owners of partnerships, LLCs and S corporations who earn income from Virginia sources.

Get ready, because these rules take effect for taxable years beginning in 2008 and thereafter. Read below for a closer look at this requirement and how it affects pass-through entity owners residing outside Virginia.

Who does this new rule affect?

The term “pass-through entity” is generally used to refer to a business entity or organization that does not pay federal income tax. Instead, the income from pass-through entities is taxed to their owners. Pass-through entities include general partnerships, limited partnerships, LLCs and S corporations. Most states, including Virginia, follow the federal treatment and do not impose income taxes on these entities.

Owners of pass-through entities include LLC members, partners in partnerships and S corporation shareholders. These owners are generally individuals, but they can also be trusts or corporations. Nonresident owners are owners who are not treated as Virginia residents for income tax purposes. This article does not cover the Virginia requirements for determining if a taxpayer is a resident, but this determination is usually based on the state in which the owner files a resident income tax return. If this state is not Virginia, then the owner in question is a nonresident owner for purposes of the withholding rules.

Pass-through entities will often have one or more resident owners and one or more nonresident owners. In these situations, the rules only apply to the nonresident owners. For example, suppose that Company A, a Virginia limited partnership with $1,000 of income from Virginia sources, is owned 50 percent by Company B, a Maryland limited partnership, and 50 percent by Individual X, a Virginia resident. In this case, withholding is only required on the portion of the income from Virginia sources taxable to the nonresident.

Income from Virginia sources

To be subject to withholding, pass-through entities must have income from Virginia sources. Income from the conduct of a business, trade, occupation or profession in Virginia is considered income from Virginia sources. Also, income generated from the buying and selling or leasing of property located in Virginia is considered income from Virginia sources.

Many times, business entities conduct business and generate income in many states. In this case, the rules for apportioning and allocating income that apply to corporations in Virginia also apply to pass-through entities. These rules are beyond the scope of this article. 

In determining “income from Virginia sources,” all items of income, gain, loss and deduction from Virginia sources are taken into account. Thus, it is not uncommon for a pass-through entity to have a net loss for a particular tax year. The rules only require that withholding occur if there is a net taxable income that will be allocated to nonresident owners. Therefore, no withholding is required in the case of pass-through entities with a net loss.

To summarize, pass-through entities with net taxable income from Virginia sources, all or part of which is taxable to nonresident owners, are subject to these withholding rules for tax years beginning on or after January 1, 2008. 

Payment of withholding amount

The withholding rate is a flat 5 percent, determined by multiplying the net taxable income from Virginia sources allocable to nonresident owners by 5 percent. This amount may only be reduced by Virginia tax credits of the pass-through entity that are used by the nonresident owners to offset the tax imposed by Virginia on their income. 

Withholding payments are due on the original due date of the pass-through entity return (Form 502), which is the 15th day of the fourth month after the close of the entity’s tax year (April 15 for calendar year entities). If the pass-through entity return is being filed by the original due date, this payment must be made using Form 502V, which may be attached to the return when filed.

Virginia grants pass-through entities an automatic six-month extension to file their returns. This, however, does not apply to payment of the withholding for nonresident owners. To avoid penalties for underpayment, the pass-through entity must pay the lesser of 90 percent of the current year’s withholding based on actual income for the taxable year, or 100 percent of the prior year’s payment (if a payment was required in the prior year and the tax period was a full 12 months) by the original return due date. This is a helpful safe harbor for entities that do not know the exact amount of withholding that will be due until their returns are completed.

Form 502W is used to make nonresident owner withholding payments prior to the actual filing of the pass-through entity’s return (e.g. in the case of an extended return). The remaining amount of withholding, if any, is paid using Form 502V attached to the return when filed. If there is an overpayment, it may either be applied to the required withholding payments for the next year or refunded to the pass-through entity. This election is made on the return.

Exceptions to the withholding rules

What if a pass-though entity with Virginia source income has a nonresident owner that is also a pass-through entity? This is the fact pattern set forth earlier involving Company A owned 50 percent by Company B. The statute provides an exception for pass-through entity owners. The responsibility for making the withholding payments shifts to the upper-tier pass-through entity to the extent it has nonresident owners who must pay tax on its income from Virginia sources.

This exception is available for multiple tiers of ownership that are composed of pass-through entities. It makes no difference if the lower-tier pass-through entity is treated as a resident of Virginia. Returning to our earlier example, suppose that Company B is owned 10 percent by Corporation V, a Virginia S corporation, and 45 percent each by Companies C and D, both Delaware partnerships. Company A would not be required to make withholding payments on behalf of Company B, because B is also a pass-through entity. Company B could also avail itself of this exception, because all of its owners are also pass-through entities.

The statute contains other exceptions as well. The withholding rules do not apply to nonresident owners that are tax-exempt entities, such as charitable organizations. Banks, insurance companies and public utilities that are not subject to Virginia income taxes likewise do not require withholding payments to be made on their behalf. Other nonresident owners subject to exceptions to the withholding rules include those with diplomatic immunity, publicly traded partnerships and those that file unified (composite) returns. Finally, a pass-through entity may petition the tax commissioner for an exemption for undue hardship. 

Single-member LLCs are not required to make withholding payments because these entities are disregarded for Virginia income tax purpose. Any income from Virginia sources is treated as though it is earned by their owners. If a single-member LLC is an owner of a pass-through entity with income from Virginia sources, the owner of this LLC is treated as the owner of the pass-through entity for purposes of determining if withholding payments are required.

Treatment of owners

The withholding rules are designed to cover the tax payments the nonresident owners would otherwise make themselves. Thus, nonresident owners generally do not need to make estimated payments to Virginia on this income from Virginia sources.

The pass-through entity will issue each of its owners a statement VK-1 that will show, among other information, the amount of nonresident withholding made on their behalf. When the nonresident owner files its Virginia income tax return (Form 763 in the case of individuals), it reports this amount of the withholding as taxes paid.

These withholding payments are not a tax assessed to the pass-through entity. The proper accounting treatment for these payments is to treat them as distributions to or receivables from the nonresident owners rather than expenses of the entity. Therefore, they do not affect the taxable income of the entity that is allocated to the owners. However, they may be taken as itemized deductions by the nonresident owners on their federal tax returns, because these are state income tax payments.

The itemized deduction on the nonresident owner’s individual federal return is only available in the year in which the payments are made. The payments are treated as made by the individual in the year in which the pass-through entity makes the payments to the Virginia Department of Taxation (TAX). Therefore, it may be worth considering making the withholding payments in December rather than waiting until they are due, as it may be more advantageous to individual nonresident owners. Form 502W should be used to make these early payments.

Another consideration for nonresident owners is the amount of required withholding. Virginia imposes a tax on individuals, corporations and trusts at a rate of 5.75 percent, but the required withholding is only 5 percent. In some cases, nonresident owners will have additional tax due upon filing their Virginia returns, especially if this is the only income from Virginia sources they have. It appears that the withholding was set at a lower rate in order to allow the nonresident owners to take advantage of Virginia’s graduated tax rates and the portion of federal itemized deductions allowed to nonresident individuals on Form 763.

The interplay of these rules and forms can create a practical problem for the nonresident owner in this case. As discussed earlier, the statute either allows any excess withholding to be refunded to the pass-through entity or carried forward to the next taxable year. This does not allow for the entity to withhold at greater than 5 percent to cover any potential shortfall of its nonresident owners. Unless there is a change to this part of the statute or regulations are issued that will allow differing treatment, it appears that the appropriate solution to this problem is to have the nonresident owner make its own Virginia estimated payments to supplement the withholding.

What if the nonresident owner has other income from Virginia sources? If this other income does not come from a pass-through entity, these owners may already be making their own Virginia estimated payments. The shortfall created by the 5 percent withholding rate can be factored into these other Virginia estimates.

What if the nonresident owner has a net loss from other Virginia sources that is equal to or greater than its share of Virginia source income from a particular pass-through entity? Are withholding payments required to be made by this entity on behalf of such an owner? The answer is not entirely clear, but there appears to be an authority that suggests not.

TAX issued Ruling No. 07-150, dated September 21, 2007, to provide guidance on this new withholding requirement. The ruling states an exception from pass-through entity withholding for individuals “who are exempt from Virginia income taxes.” It cites as examples those individuals “who did not have any liability for Virginia income tax in the previous year and who do not expect to have any liability in the current year.” Thus, if an individual filed a Virginia nonresident income tax return showing no tax liability in the prior year, and expects that to be the case in the current year, then no withholding is necessary.

Necessary forms and statements

Pass-through entities and their nonresident owners (i.e. other pass-through entities) are required to complete and file forms and statements related to these withholding requirements. Entities are required to provide information statements to their nonresident owners and file these statements with TAX.

Also, to utilize the exception, pass-through entity nonresident owners must provide a statement to the entities they own stating that they are treated as pass-through entities. TAX had not released any of these forms as press time.

Looking forward

TAX has said it plans to supplement the guidance it has issued thus far with permanent regulations. Until these regulations are available, practitioners should rely on the statute, rulings and instructions provided by TAX for applicable forms.

Jay Bethard, CPA, J.D., LL.M., is a tax manager with Grant Thornton’s Private Wealth Services Group in McLean, where he focuses primarily on tax planning and compliance for individuals, closely held businesses and trusts. Contact him at Jay.Bethard@qt.com.

Disclaimer: The statements contained herein do not necessarily represent the viewpoints or official positions of Grant Thornton, LLP.