Avoiding the Limit on Deductions for Pass-Thru Entity Income in Virginia: Confusion and Conclusion

Presumably, all individuals that have significant Virginia income (or Virginia source income, for nonresidents) have discussed the federal limitation on itemized deductions for state income taxes. Briefly, this deduction is limited to $10,000 ($5000 for married filing separately) for tax years before 2025 and $40,000 ($20,000) for 2025 through 2029 (adjusted slightly higher each year). Many states, including Virginia, enacted laws that allowed pass-thru entities (“PTEs”, generally, tax partnerships and S corporations) to elect to pay Virginia taxes and to pass-through a credit to their owners for their proportionate share of such payments (a “PTET Regime”). An LLC is usually a tax partnership.

Some (especially those that are relying on AI) may have become discouraged that the Virginia PTET Regime was expiring on January 1, 2027 (with the out-of-state credit expiring on January 1, 2026). Not so. The Virginia PTET Regime has been permanently extended (at least, as much is ever permanent in government). The thirteenth enactment clause of the 2026 Amendments to the 2025 Appropriation Act (House Bill 29, Chapter 7) enacted February 20, 2026.

The impact of resident versus nonresident and Virginia PTET versus state income taxes from other states that may or may not have PTET Regimes is beyond the scope of this Current TET Thought. However, because the federal deduction limitation applies to an individual’s aggregate state income deduction, an individual who makes about $700,000 or more themselves (if unmarried) or on a joint return with their spouse should be consulting their tax advisor if a significant part of their income would be Virginia sourced from a PTE. The PTET Regime also applies to trusts and estates subject to income tax under Virginia Code Section 58.1-360.

For simplicity, this Current TET Thought uses $700,000 as the caution level. An individual, trust, or estate that is subject to income taxes in high tax states may have consumed all, or substantially all, of his or its roughly $40,000 deduction cap already. If he or it also has significant income allocated from a Virginia PTE, PTET planning is critical at a much lower level. High state and local income tax states include California, Massachusetts, New York, Maryland, and Maine.

There are methods and planning to maximize the proper use of the Virginia PTET Regime. Because the Regime has been extended into 2027 and beyond, the time for planning is now.

Nomination and Certification of Virginia Round 2 Opportunity Zones Delayed

The Treasury Department allowed governors a 30-day delay in nominating their Round 2 Opportunity Zones. As the Current TET Thought for 7/28/26 indicated, Governor Spanberger previously had until September 28, 2026 to make such nominations. She has elected to use this delay and now has until October 28, 2026 to make her nominations.

The Treasury Department will now have until November 27, 2026 to certify Virginia Round 2 Opportunity Zones. However, Governor Spanberger can request this certification process be delayed for 30 days (until December 27, 2026), but the November 27, 2026 deadline for nomination cannot be further delayed.

Regardless, all Virginia Round 2 Opportunity Zones duly nominated and certified will begin January 1, 2027.

Have the Section 1202 Gain Exclusion and Rate Changes Made C Corporations the Right Choice?

Summary: Before the 2017 Tax Act, owners of a two or more-owner business should generally have elected that such business be an LLC taxable as a partnership. After the 2017 Tax Act, that advice generally remained sound. However, for a business that can accumulate its operating income without distributions or that has already been successful and is attracting significant additional equity investors, a C corporation may be the best choice of entity. Furthermore, the 2025 Tax Act continues tipping the scale towards C corporations.

When two or more owners truly have a choice of tax classification for an entity, that choice is the most important tax decision they may ever make. Before the 2017 Tax Act, the decision was easy. In almost every circumstance, an entity should have been an LLC that elected to be taxable as a partnership (an “LLC”). After the 2017 Tax Act, the choice became much harder. This difficulty was largely due to inversion of tax rates and to expansion of the Section 1202 Gain Exclusion. These changes caused many owners to select C corporations or to convert their entities into C corporations.

Tax advisors argue that the 2017 Tax Act inverted the tax rates causing C corporations to have lower tax rates than individual owners in an LLC. That argument needs to be examined, however. A C corporation has lower ordinary income tax rates for federal purposes. A C corporation does not get a rate reduction for long-term capital gain nor, in most states, does a C corporation have lower state income taxes than individuals in an LLC. More importantly, the shareholders in a C corporation face double taxation for appreciation in C corporation assets.

For a variety of reasons, an S corporation is almost never a desirable choice of tax entity unless it is the result of a conversion of a C corporation. Moreover, S corporations do not benefit from the rate inversion or the Section 1202 Gain Exclusion.

With the lure of lower federal rates on operating income and the potential of Section 1202 Gain Exclusions, owners currently choosing an entity might seriously consider a C corporation. However, they need to look before they leap. C corporations are relatively easy to organize and capitalize (at least at the beginning or at any time with cash contributions). However, cashing out through an asset sale or liquidation is very painful. If the owners can engineer a stock sale, the Section 1202 Gain Exclusion may assist.

The conditions and limitations on qualifying for the Section 1202 Gain Exclusion are numerous and complex. If an individual holds qualifying stock in a C corporation acquired after September 27, 2010 for more than five years, the excluded “gain” for federal and Virginia income tax purposes is 100%. The 2025 Tax Act liberalized many of the requirements. Although substantial Treasury guidance remains absent, basically:

1.                 These rules only apply to individual shareholders who have held their stock for over five years. However, as discussed below, qualifying stock acquired after July 4, 2025 has special periods and exclusion amounts;

2.                 The stock must have been issued by the C corporation to the individual (and not purchased from another shareholder, for example) although special rules apply for gifts and bequests of stock and stock owned by “pass-thru entities”;

3.                 The C corporation must be involved in an active business, which generally excludes most businesses that are service-provider businesses or that involve farming. Research and development companies have special dispensation;

4.                 The amount and type of assets in the C corporation are limited;

5.                 The exclusion only applies to a sale of stock; and

6.                 The aggregate amount a taxpayer excludes in all stock sales under such Section is limited.

Many owners of current or future businesses are certain their business will be successful. That is one of the keys to success. Some of these owners believe the business will be sold in a stock sale before or after merging with an acquiring corporation. These expectations may compel the owner to choose a C corporation. This compulsion may be especially strong if the C corporation can accumulate its income without creating higher tax rates and without paying dividends (“Accumulating C Corp”) and, thereby, avoid double taxation on operating income.

In capital-intensive businesses, however, appreciation in assets propels this success and accumulating income compounds appreciation. The tax advantages of an LLC when the business has appreciating assets are numerous, substantial, and beyond the scope of this Current TET Thought.

Thus, even if the business can be an Accumulating C Corp, the owners take a substantial risk using a C corporation rather than an LLC. A C corporation cannot benefit from many tax advantages of an LLC if before a stock sale qualifying for the Section 1202 Gain Exclusion, for example, an owner dies, only one owner’s equity is redeemed or is sold, the business splits, or the entity wants to borrow and distribute the loan proceeds tax free. The forfeited tax benefit may be huge.

The 2025 Tax Act made this calculus more difficult. For qualifying stock acquired after July 4, 2025, the excluded “gain” is 50% for such stock held three years or more; 75% for such stock held four years or more; and 100% for such stock held five years or more.

If a business has already become successful and is issuing equity to individual investors, the new investors may dictate that the business be, or become, a C corporation to begin their Section 1202 Gain Exclusion holding period. Our focus, however, is on two or more owners that are organizing an entity and selecting its tax classification.

For the business being organized, the owners may take a “wait and see” approach. The Section 1202 Gain Exclusion will be a mirage to most businesses. An event that benefits from the many LLC tax advantages may occur before the minimum holding period even if it is three years. A tax-sensitive buyer may require a significant discount for numerous tax and business reasons to acquire (or be deemed to acquire) stock rather than assets.

The “wait and see” approach is not without risk. First, if the owners wait to convert their LLC to a C corporation, they may never even eclipse the three-year holding period, much less the five-year period before a stock sale is advisable. Second, generally, the “gain” excluded is limited to the post-stock issuance appreciation. For example, A and B are tax partners in an LLC. At the time the LLC converts to a C corporation (after July 4, 2025), the aggregate tax basis of its assets is $4MM but their value is $10MM. Generally, the basis of the issued stock would be $4MM, but the effective basis for Section 1202 Gain Exclusion is $10MM. Assume that the stock is sold five years after conversion for $22MM and that the many other requirements of the Section 1202 Gain Exclusion are met. Also, assume A and B have never used the exclusion in other instances. The excluded gain Is $12MM (($22MM - $10MM) X 100%) and not $18MM (($22MM - $4MM) X 100%). The $6MM in pre-issuance/pre-conversion appreciation is fully taxed. This example assumes that the stock basis does not change after issuance/conversion. That assumption is much more realistic with a C corporation than with an LLC. The tax basis in an LLC changes constantly.

Before the 2017 Tax Act, an LLC was the choice of entity for nascent businesses and for those converting from a sole proprietorship to a multi-owner business. That choice is still optimum for substantially all such businesses. However, the owners and their advisors must have as much current information as possible and have clairvoyance. Businesses that are already successful with owners certain that the Section 1202 Gain Exclusion will be relevant and significantly beneficial should consider having the business elect or become a C corporation. However, whether a business is being organized as a C corporation or is converting from an LLC to a C corporation through election, conversion, merger, or otherwise, the owners need to consult competent tax advisors. Advanced planning and proper drafting are critical.

Opportunity Zones: Time for Acting and Planning

The opportunity zone rules came into the tax code basically in 2018. The initial tax benefit is the ability to defer capital gain generally from any source through investment of the cash into a qualified opportunity fund (“QOF”). The 2025 Tax Act made the QOF program permanent.

Basically, the Governor of each state will nominate zones, and the Treasury Department will approve these selections if qualified. The original zones are commonly referred to as Round One Zones while those certified to start on January 1, 2027 are commonly referred to Round Two Zones. Any remaining deferral on investments in Round One Zones must generally be recognized on December 31, 2026 (limited by the relevant hypothetical fair market value gain). The recognition of this gain cannot be further deferred in a like-kind exchange or, apparently, through investment in a Round Two Zone.

Because of some esoteric rules applicable to QOFs, the typical structure for a QOF is as a limited liability company taxable as a partnership. The QOF then invests in a lower-tier limited liability company taxable as a partnership (“Property Owner LLC”). Again, typically, the Property Owner LLC acquires land and builds commercial or residential real property used in a trade or business.

The QOF rules are complex and often inconsistent. To make this discussion manageable, this TET Thought addresses general results, and an Investor should consult with his tax advisor regarding his unique situation. We are happy to assist.

An Investor in Round One should plan now regarding his 12/31/26 inclusion. The typical planning would be to recognize capital losses in 2026. That remains valid, and early planning is certainly better. However, that may be insufficient to eliminate the tax. We typically stress not having tax concerns cause bad economic decisions. The recognized gain, however, is limited to the relevant hypothetical gain. Logically, because the qualified investment began with a $0 tax basis, any material 12/31/26 gain indicates that significant equity appreciation has occurred. The QOF might persuade the Property Owner LLC to borrow and make distributions through the QOF to the QOF Members.

Although a tax partner has gain if a distribution exceeds his tax basis in his Interest, that should not be a problem. First, the 12/31/26 recognition increases such basis. Second, depending on the debt, the distributee tax partner’s basis is initially increased for the debt.

 However, whenever an Opportunity Zone Investor receives a distribution, its tax advisor and the tax advisor for the QOF must examine if the distribution is an “inclusion event”. Although any deferred gain is recognized on 12/31/26, such Investor will undoubtedly want the investment to remain qualified for the special ten-year gain exclusion.

Real Estate Developers should also act now. In Virginia, Governor Spanberger has between July 1, 2026 and September 28, 2026 to designate Round Two Zones. At this writing, she has not done so; however, several websites are available to indicate what tracts are eligible. Again, economics should dictate tax and not vice versa. Round One transactions proved, however, that the QOF tax benefits can lower a Developer’s cost of equity capital.

That savings could be even more pronounce for a Developer that can locate, bind, and acquire economically logical Round Two property. No, Round One Investors cannot use a Round Two investment to defer their 12/31/26 gain. However, such an investment could defer other capital gain being recognized in 2026 and allow the Investor’s 2026 capital losses to be available to offset the 12/31/26 recognition. Although an Investor generally has 180 days from the date of the capital gain to invest in the QOF, if such gain is being allocated from a tax partnership, the Investor may have significantly longer.