Some of our pass-through entity's nonresident owners hold their interest through an IRA -- do we still have to withhold Virginia tax on the income allocated to those IRA-held interests?

Plain-English summary

A pass-through entity had Virginia-source income in 2020 from selling rental real estate. Some of its individual owners lived outside Virginia, and some of those nonresident ownership interests were held through Individual Retirement Accounts (IRAs) rather than directly by the individuals. The entity asked the Department whether it had to withhold Virginia tax on the income allocated to those IRA-held interests.

Virginia's pass-through entity withholding rules generally require an entity with Virginia-source taxable income to withhold 5% tax on the share allocable to nonresident owners (people who aren't Virginia domiciliary or actual residents, treated as a partner, member, or shareholder for federal tax purposes). Owners of pass-through entities are taxed individually on their distributive share of the entity's income, so ordinarily each nonresident owner's share requires withholding, remitted with the entity's annual return. But the Department's own published guidance carves out an exception: entities exempt from federal and Virginia income tax aren't required to withhold, and IRAs are generally exempt from federal income tax under federal law -- except to the extent an IRA has "unrelated business taxable income" (UBTI). If the pass-through entity here is engaged in a trade or business, an IRA that holds a limited-partnership-style interest could have UBTI; separately, if the property sale involved debt-financed real estate, a portion of the capital gain could be "unrelated debt-financed income" (UDFI) under a related federal provision, which is also treated as UBTI.

The Department couldn't give a yes-or-no answer, because whether a specific IRA actually has UBTI or UDFI from this transaction is a question of federal tax law that depends on facts about each IRA's own investment and the entity's own activities -- not something the Department has authority to decide. Its ruling was conditional: if the IRA(s) do have UBTI or UDFI from this income, the entity may need to withhold Virginia tax on that portion; if they don't, no withholding would be required on the IRA-held interests.

What this means for you

Pass-through entities with nonresident owners whose interests are held through an IRA

You can't assume IRA-held interests are automatically exempt from your withholding obligation, nor that they're automatically subject to it. The answer turns on whether the specific IRA has unrelated business taxable income (UBTI) from your entity's activities -- a federal tax determination the IRA's own custodian or tax advisor typically has to make, not something Virginia will decide for you.

Entities selling debt-financed real property with IRA investors

If the property being sold was financed with debt, a portion of the resulting capital gain can count as "unrelated debt-financed income" under federal law, which is treated as UBTI even for an otherwise-exempt IRA -- worth flagging to your IRA-holding owners before closing so they (and their IRA custodians) can assess their own federal filing obligations.

Anyone requesting a Virginia ruling on a withholding question that turns on an underlying federal tax issue

Expect the Department to decline to resolve the federal question itself (here, whether an IRA has UBTI) and instead issue a conditional ruling: withholding follows whatever the correct federal answer turns out to be.

Common questions

Q: Do we have to withhold Virginia tax on income allocated to a nonresident owner whose interest is held through an IRA?
A: Only if that IRA has unrelated business taxable income (UBTI) or unrelated debt-financed income (UDFI) from the transaction. If the IRA has none, it's generally exempt from tax and no withholding is required on that portion; if it does have UBTI/UDFI, withholding may be required on that share.

Q: Who decides whether our IRA-holding owners actually have UBTI here?
A: That's a federal tax determination based on each IRA's own facts (whether the entity is engaged in a trade or business, and whether any gain is debt-financed) -- the Virginia Department of Taxation doesn't decide it and instead conditions its withholding answer on that federal outcome.

Q: Does selling real estate that was financed with debt affect an IRA owner's tax treatment?
A: It can. A portion of capital gain from debt-financed real estate can be treated as unrelated debt-financed income under federal law, which counts as UBTI even for an IRA that's otherwise exempt from tax.

Citations and references

• Va. Code § 58.1-486.1 (defines "nonresident owner"; requires pass-through entities to compute, report, and remit withholding tax on their behalf)
• Va. Code § 58.1-486.2 A and B 1 (pass-through entity withholding requirement; 5% rate on the nonresident owners' Virginia-source income share)
• Va. Code § 58.1-390.2 (pass-through entity owners are taxed individually on their distributive share of entity income)
• 26 U.S.C. § 408(e) (IRAs generally exempt from federal income tax, except on unrelated business taxable income)
• 26 U.S.C. § 514 (unrelated debt-financed income treated as unrelated business taxable income)
• P.D. 15-240 (12/12/2015) (Guidelines for Pass-Through Entity Withholding, including the exemption for entities not subject to federal/Virginia income tax)
• P.D. 07-150 (cited by the Department as a related document on pass-through entity withholding)

Subject

Pass-Through Entity (PTE): Withholding - Individual Retirement Account (IRA)

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 22-118

Original ruling text

July 21, 2022

Re: Request for Ruling: Pass-Through Entity Withholding

Dear *:

This will reply to your letter in which you request whether * (the “Taxpayer”), a pass-through entity, is required to withhold tax from a nonresident individual whose ownership interest in the Taxpayer is held by an Individual Retirement Account (IRA).

FACTS

The Taxpayer had income allocable to Virginia as a result of the sale of rental real estate in 2020. The Taxpayer has individual owners who reside outside of Virginia. Several of the ownership interests are held in IRAs. The Taxpayer seeks a ruling as to whether tax must be withheld from the owners whose interests are held by IRAs.

RULING

Virginia Code § 58.1-486.2 A provides that “a pass-through entity that has taxable income for the taxable year derived from or connected with Virginia sources, any portion of which is allocable to a nonresident owner” must pay withholding tax. The amount of tax that must be withheld is equal to 5% of the nonresident owner’s share of income from Virginia sources of all nonresident owners that may lawfully be taxed by Virginia and which is allocable to a nonresident owner. See Virginia Code § 58.1-486.2 B 1.

Under Virginia Code § 58.1-486.1, a “nonresident owner” is any person treated as a partner, member, or shareholder of the pass-through entity for federal income tax purposes and, in the case of an individual, is not a domiciliary or actual resident of Virginia. Pursuant to Virginia Code § 58.1-390.2, owners of pass-through entities are liable for tax “only in their separate or individual capacities on income passed through to the owners of pass-through entities.” As such, owners are subject to tax on their distributive share of items of income, gain, loss, deduction, or credit of the pass-through entity. Therefore, when nonresidents are owners of pass-through entities, the pass-through entity must compute, report and remit withholding tax. See Virginia Code § 58.1-486.1 A, and the Guidelines for Pass-Through Entity Withholding , issued as Public Document (P.D.) 15-240 (12/12/2015).

Pass-through entities that have taxable income from Virginia sources and that must allocate any portion of that income to at least one nonresident owner during any portion of the taxable year must pay the withholding tax unless an exemption applies. See P.D. 15-240. Generally, pass-through entities must remit the required withholding tax with the Pass-Through Entity Return of Income and Return of Nonresident Withholding (Form 502). In such cases, the pass-through entity withholding must be remitted by the 15th day of the fourth month following the close of the taxable year on the Pass-Through Entity Withholding Tax Payment form (Form 502W).

In accordance with P.D. 15-240, pass-through entities that are exempt from federal and Virginia income tax are not required to withhold. Pursuant to Internal Revenue Code (IRC) § 408(e), IRAs are generally not subject to federal income tax, but may be subject to income tax on unrelated business taxable income (UBTI).

If the Taxpayer is engaged in a trade or business, then the IRAs that purchased a limited partnership interest may have UBTI. In addition, a portion of any capital gains realized from a sale of real estate that was financed with debt would be reported as unrelated debt financed income (UDFI) under IRC § 514. Accordingly, the Taxpayer may have to withhold tax from the nonresident owners of the IRAs if the IRAs have UBTI or UDFI.

This response is based on the facts provided as summarized above. Further because the determination as to whether an IRA is considered to have UBTI is a federal tax matter, the Department cannot render an opinion as to whether the Taxpayer is required to withhold Virginia income tax for income passed through to IRAs. Further, any change in facts or the introduction of new facts may lead to a different result.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3890.B

Related Documents

07-150

15-240