Just
Passin’
Through:
A Primer on Virginia’s Pass-Through Entity Withholding Rules
By Jay Bethard, CPA, J.D., LL.M.
The term “pass-
D uring the 2007 General Assembly
session, Virginia enacted a with-
holding requirement for nonresi-
dent owners of pass-through entities who
conduct business in Virginia. This adds a
through entity” is wrinkle to the taxation of the owners of
partnerships, LLCs and S corporations who
generally used to earn income from Virginia sources.
Get ready, because these rules take ef-
refer to a business fect for taxable years beginning in 2008
and thereafter. Read below for a closer
entity or organization look at this requirement and how it affects
pass-through entity owners residing outside
that does not pay Virginia.
federal income tax. Who does this
Instead, the income new rule affect?
The term “pass-through entity” is general-
from pass-through ly used to refer to a business entity or organi-
zation that does not pay federal income tax.
entities is taxed Instead, the income from pass-through enti-
ties is taxed to their owners. Pass-through
to their owners. entities include general partnerships, limited
partnerships, LLCs and S corporations. Most
states, including Virginia, follow the federal
20 Taxation • Disclosures • November/December
treat-
ment
and
d o
n o t
impose
income
taxes on
these entities.
Owners of
pass-through entities
include LLC members,
partners in partnerships
and S corporation sharehold-
ers. 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 purpos-
es. This article does not cover the Virginia
requirements for determining if a taxpayer
is a resident, but this determination is usu-
ally based on the state in which the owner
files a resident income tax return. If this
state is not Virginia, then the owner in ques-
tion 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 gener-
ated 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 apportion-
ing 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 in-
Taxation • Disclosures • November/December 21
come, gain, loss and deduction from Virgin-
ia 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 al-
located 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
t h e 1 5 th
day of
the fourth
month af-
ter the close
of the entity’s
tax year (April 15
for calendar year enti-
ties). 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 underpay-
ment, 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 with-
holding 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 re-
turn (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 over-
payment, 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 Vir-
ginia source income has a nonresident
owner that is also a pass-through entity?
This is the fact pattern set forth earlier in-
volving Company A owned 50 percent by
Company B. The statute provides an excep-
tion for pass-through entity owners. The
responsibility for making the with-
holding payments shifts to
the upper-tier pass-
through en-
tity
to the
extent it
has nonresi-
dent owners who
must pay tax on its income
from Virginia sources. w
 This exception is available for
multiple tiers of ownership that are com-
posed 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 with-
holding 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.
Oth-
er non-
resident
owners subject
to exceptions to
the withholding rules
include those with diplo-
matic 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
22 Taxation • Disclosures • November/December
their owners. If a single-member LLC is an Therefore, it may be worth consider-
owner of a pass-through entity with income ing making the withholding pay-
from Virginia sources, the owner of this ments in December rather than
LLC is treated as the owner of the pass- waiting until they are due, as it
through entity for purposes of determining may be more advantageous
if withholding payments are required. to individual nonresident
owners. Form 502W
should be used to make
Treatment of owners these early payments.
The withholding rules are designed to Another consid-
cover the tax payments the nonresident eration for nonresi-
owners would otherwise make themselves. dent owners is the
Thus, nonresident owners generally do amount of required
not need to make estimated payments withholding. Vir-
to Virginia on this income from Virginia ginia imposes a tax on
sources. individuals, corpora-
The pass-through entity will issue each of tions and trusts at a rate
its owners a statement VK-1 that will show, of 5.75 percent, but the
among other information, the amount of required withholding is only 5
nonresident withholding made on their percent. In some cases, nonresident owners
behalf. When the nonresident owner files will have additional tax due upon filing their
its Virginia income tax return Virginia returns, especially if this is the only
(Form 763 in the case of income from Virginia sources they have. It
individuals), it reports appears that the withholding was set at a
this amount of the lower rate in order to allow the nonresi-
withholding as taxes dent owners to take advantage of Virginia’s
paid. graduated tax rates and the portion of
These withhold- federal itemized deductions allowed
ing payments are not to nonresident individuals on
a tax assessed to the Form 763.
pass-through entity. The interplay
The proper accounting of these rules
treatment for these pay- and forms
ments is to treat them as dis- can
tributions 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 own-
ers. 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 deduc-
tion on the nonresident
owner’s individual fed- cre-
eral return is only avail- ate a
able in the year in which practical
the payments are made. problem for
The payments are treated the nonresident
as made by the individual owner in this case. As
in the year in which the pass- discussed earlier, the statute either
through entity makes the payments to the allows any excess withholding to be refund-
Virginia Department of Taxation (TAX). ed to the pass-through entity or carried for-

ward
to the
next tax-
able year.
This does not
allow for the en-
tity 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
Taxation • Disclosures • November/December 23
showing no tax liability in the
prior year, and expects that to
We
understand
be the case in the current year, then
no withholding is necessary.
Virginia Society of
Certified Public
Necessary forms
Accountants
and statements
Insurance Service Center
Pass-through entities and their non-
resident owners (i.e. other pass-through The Virginia Society of Certified Public
entities) are required to complete and file
Accountants Insurance Service Center
forms and statements related to these with-
holding requirements. Entities are required is a full-service consultant for health,
to provide information statements to their dental and other insurance benefits.
nonresident owners and file these state-
ments with TAX. Creative
Also, to utilize the exception, pass-
through entity nonresident owners must BENEFIT and
provide a statement to the entities they own
stating that they are treated as pass-through INSURANCE
entities. TAX had not released any of these
forms as press time.
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TAX has said it plans to supplement the We’re committed to serving Virginia
guidance it has issued thus far with perma- Society of CPA members and their
nent regulations. Until these regulations are organizations by delivering the
available, practitioners should rely on the
statute, rulings and instructions provided
highest quality coverage and service
by TAX for applicable forms.  at the best possible price.
Disclaimer: The statements contained herein do not
EXCLUSIVELY
for Virginia Society of CPA
necessarily represent the viewpoints or official positions
of Grant Thornton, LLP.
MEMBERS
Health Insurance
Dental Insurance
Medicare Supplement Health Insurance
By Jay Bethard, CPA,
J.D., LL.M. is a tax Group Term Life Insurance
manager with Grant Group Disability Income Insurance
Thornton’s Private
Wealth Services Group
Brian Marks, CEBS, Director
in McLean, where bmarks@vscpainsurance.com
he focuses primarily
on tax planning and Page B. Gordon, Consultant
compliance for individuals, closely pgordon@vscpainsurance.com
held businesses and trusts. Contact
him at Jay.Bethard@gt.com.
Kim Shackleford, Client Manager
kshackleford@vscpainsurance.com
Tel 804-422-6722 or 877-998-7272
vscpainsurance.com
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