PTET and Virginia Government Contractors
Note: The information presented below is intended as guidance for Virginia-based government contractors. For PTET payments made to other states, please consult your tax accountant or CPA for additional guidance, as PTET rules can vary from state to state.
For the 2022 tax year, Virginia joined the growing list of states which now allow a qualifying pass-through entity (“PTE”) to pay state income taxes at the entity level, rather than at the individual level of the entity’s owners. As a result, many Virginia-based government contractors organized as PTEs made state income tax payments on behalf of the owners for the first time in 2022. In the rush to implement this new strategy, we’ve received many questions related to the proper accounting treatment and FAR allowability of these pass-through entity tax (“PTET”) payments.
The 2017 Tax Cuts and Jobs Act instituted a $10,000 limit on Federal tax deductions for state and local taxes (“SALT”) claimed by individuals. This SALT limitation was particularly onerous on individuals living in high-tax states and owners of PTEs, who often pay more state taxes than the typical tax filer. Immediately, several states implemented a strategy of allowing PTET payments at the entity level as a workaround for PTE owners who found themselves up against Federal SALT deduction limits. In 2020, the IRS issued Notice 2020-75, which provided additional clarification and “blessing” of the PTET strategy. As a result, approximately 30 states have now adopted PTET provisions.
Accounting Treatment under GAAP
For Virginia taxpayers, PTET payments fall under the scope of FASB ASC 740. ASC 740 makes it clear that while a qualifying PTE can elect to make the tax payment on behalf of the owners, the tax burden and associated tax liability is still attributable to the owners of the PTE. This is because the income tax liability continues to be calculated based on the owner’s allocation of the entity’s net income. Under Virginia’s PTET rules, the owner claims a credit on their personal tax return for their allocation of state PTET paid at the entity level.
Because the state tax burden remains with the owners of the PTE, ASC 740 clarifies that all tax payments made by a PTE on behalf of the entity’s owners should be treated as an equity transaction. In effect, the GAAP treatment is no different than an owner receiving a distribution to pay their tax liability.
Due to ASC 740’S clarification of the GAAP treatment of PTET, Virginia-based government contractors can put to rest the question of PTET allowability. This is because ASC 740’s equity treatment of PTET payments, eliminates the question of cost allowability, altogether. As noted above, PTET payments should be recorded as equity distributions to the entity’s owners and not as a tax expense to the entity. With no expense recorded on the books, there is no cost subject to the allowable cost principles of FAR Part 31.
If you have any questions related to Virginia PTET, please contact Wall, Einhorn & Chernitzer’s Tax Services department.