The Illinois Department of Revenue (Department) is turning its attention to the personal service income/ reasonable compensation subtraction modification afforded partnerships in calculating their Personal Property Tax Replacement Income Tax (replacement tax or RT) liability. At its annual Tax Practitioners' meeting attended by EY tax professionals on October 28, 2016, the Department announced that it is drafting a regulation to provide a framework for calculating the subtraction modification to coincide with renewed audit efforts. According to a Department representative, the draft regulation is currently being reviewed by the Department's regulatory policy group and is anticipated to be formally proposed for public comment later this year or early next year.

Background

Illinois is one of only a few states to impose a direct tax measured by income on pass-through entities, such as partnerships and LLCs treated as partnerships. Specifically, partnerships are subject to replacement tax at a rate of 1.5% of their "base income" (i.e., federal taxable income plus/ minus statutory modifications) allocated to Illinois.¹

In determining "base income," a partnership may subtract from its federal taxable income an amount equal to the greater of:

1. Income of the partnership constituting personal service income as defined in IRC Section 1348(b)(1) (as in effect on December 31,1981), or
2. A reasonable allowance for compensation paid or accrued for services rendered by partners to the partnership²

The first prong of the subtraction is aimed at personal service partnerships, such as accounting firms and law firms. The second prong of the subtraction is essentially aimed at allowing any partnership to determine an amount representing the amount of compensation it would pay partners providing services to the partnership had they been employees providing such services to the partnership.³

Personal service income

The personal service income prong of the subtraction looks to IRC Section 1348(b)(1) as in effect on December 31, 1981. This outdated section is used to determine the amount of partnership income, if any, that qualifies as "personal service income."

Outdated IRC Section 1348(b)(1) defines "personal service income" to mean any income that is earned income within the meaning of IRC Sections 401(c)(2)(C) or 911(b) or is an amount received as a pension or annuity arising from an employer-employee relationship or from tax-deduction contributions to a retirement plan (emphasis added). Since IRC Section 1348 (b)(1)(A) specifies that Section 911(b) should be applied without regard to the phrase "not in excess of 30% of his share of the net profits of such trade or business," IRC Section 911(b) should be read for purposes of the definition of "personal service income" in relevant part as follows:

The term "earned income" means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation [that] represents a distribution of earnings or profits rather than a reasonable allowance as compensation for services actually rendered. In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, under regulations prescribed by the Secretary, a reasonable allowance as compensation for the personal services rendered by the taxpayer … shall be considered as earned income.⁴

Two Treasury Regulations (Treas. Regs. Sections 1.911-2(b)(3) and 1.1348-3(a)(2)), elaborate on the statutory meaning of "earned income" in the context of professional services by stating that earned income includes all fees received by a taxpayer engaged in a professional occupation (such as a doctor or lawyer) in the performance of professional activities. Professional fees constitute earned income even though the taxpayer employs assistants to perform all or part of the services rendered, provided the taxpayer's patients or clients look to the taxpayer as the person responsible for providing the services.

IRC Section 401(c)(2)(C) further specifies that personal service income can include or exclude certain gains. For purposes of this section, the term "earned income" includes gains (other than any gain treated under any provision of this chapter as gain from the sale or exchange of a capital asset) and net earnings derived from the sale or other disposition of, the transfer of any interest in, or the licensing of the use of, property (other than good will) by an individual whose personal efforts created such property.

Administratively, in one private letter ruling,⁵ the Department ruled that payments to retired partners should be considered personal service income and thus, constitute allowable subtractions under the 1981 version of IRC Section 1348, which explicitly includes "an amount received as a pension or annuity [that] arises from an employer-employee relationship or from tax-deduction contributions to a retirement plan," but which did not explicitly provide guidance otherwise with respect to payments to retired partners. The Department concluded the payments were deductible under Illinois Income Tax Act (IITA) Section 203(d)(2)(H), because they were within the spirit of the subtraction and it would not be inconsistent for partnerships to receive this treatment.

Reasonable allowance for compensation

With respect to the second prong of the subtraction modification, the IITA does not statutorily define "reasonable allowance," nor does it outline any particular method of determining the amount. The term "compensation" is defined in the IITA as wages, salaries, commissions and any other form of remuneration paid to employees for personal services.⁶ Guidance for the reasonable allowance for compensation prong is generally confined to a few letter rulings from the Department.

In two dated general information letter rulings,⁷ the Department indicated that one reasonable method for computing the reasonable compensation deduction is to "determine the number of hours each partner worked in performing personal services for the partnership during the particular year and multiplying that amount by a fair hourly wage, giving consideration to the kind of work performed." The key to both rulings appears to be whether the partners were actively involved in the partnership. Further, it is clear from the rulings that other reasonable methods of calculating the deduction are allowed. Both rulings stated that Illinois law "does not prescribe any particular method of determining a 'reasonable allowance' for compensation for services." Instead, the Department views the deduction as a matter of "factual interpretation" on which it will not rule.

In a very dated private letter ruling,⁸ the Department stated that the amount may or may not include an amount equal to the guaranteed payments paid to partners or the partners' proportionate share of partnership income, and that the Department looks to the federal rules and case law regarding what is considered reasonable compensation. The ruling specifically states: "… As a general rule, reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under the circumstance [Treas. Reg. Section 1.162-7(b)(3)]. It then follows that what is reasonable depends on the facts and circumstances of each particular case — knowledge that the taxpayer possesses. The Department will not contest deductions for compensation paid to partners, unless the amount subtracted is patently unreasonable."

Illinois policy landscape

Due to the lack of guidance regarding what constitutes a reasonable allowance for compensation, partnerships relying on the second prong of the subtraction have been forced to develop methods to determine the subtraction. Regardless of the method/ approach deployed, in our experience, it is not uncommon for partnerships relying on the reasonable allowance prong of the subtraction modification to limit the amount to the income of the partnership — effectively, relying upon the theory of the first prong to self-impose a limitation.

From a historical audit perspective, the reasonable compensation subtraction modification has periodically been a priority audit issue for the Department's Audit Division, particularly as applied within the asset management industry. Among other points, the Audit Division has in the past questioned whether capital gain from a management partnership's carried interest should be considered income from which the subtraction can be determined. The focus of such an inquiry is presumably targeted at the personal service income prong of the subtraction modification, when, in fact, most management partnerships in the asset management industry are claiming the subtraction modification based on the reasonable allowance prong instead. The Department's announcement of a pending regulation was coupled to the announcement that the issue is once again a priority audit issue.

Also important to note, in 2009, the General Assembly, in a surprise legislative move, eliminated the subtraction modification in a budget implementation bill, but the repeal was reversed before it became operative. During the repeal/ restoration process, certain members of the General Assembly indicated that there was concern over capital gain from carried interest being a source of income to produce a subtraction modification akin to compensation. In fact, during the legislative restoration debate, one proposal included limiting the subtraction modification to the amount of partnership income that constituted self-employment earnings to partners. Ultimately, the subtraction modification was restored without any changes.

Implications

With regard to the expected direction of the Department, it is unclear at this time what specific guidance and/ or calculation framework will be provided in the draft regulation. The Department indicated that it is currently focused on what services are being provided by partners on whose behalf the partnership is claiming the deduction as well as whether that compensation or income taken as a deduction is reasonable. For the time being, the Department indicated that it is not focused on who is receiving the benefit of the service, rather on which partners are being compensated and for what services. The Department's stated concern appears to be passive partners whose partnership income or compensation could be simply a return on investment. The Department also indicated that, given some of the outdated federal statutory guidance on which the Illinois statute relies, taxpayers are justifiably confused as to the proper calculation of the deduction.

Accordingly, partnerships claiming this subtraction modification should review their current approach and assess how they will respond if queried about the subtraction modification claimed. We anticipate any audit inquiry will focus on documenting active versus passive partners, time incurred by partners providing services to the partnership, and how the taxpayer determined the reasonable amount. We also anticipate renewed confusion over carried interest/capital gain and its place within the calculation. In short, if a taxpayer has not performed a compensation study as a proxy to determine a reasonable amount, we anticipate that audits will focus on documentation, notwithstanding the fact that the Department to date provides no guidance on the type of documentation required. We recommend, to the extent prudent and feasible, that partnerships take proactive documentation steps in advance of any Illinois replacement tax audit. Documentation might include a comprehensive memorandum describing the partnership's business, the contractual arrangements by which it is compensated (including a description of the character of its income), the active partners' profile/ job descriptions, as well as how all such factors are collectively considered in determining a reasonable allowance for compensation for services rendered by partners.

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ENDNOTES

¹ 35 ILCS 5/201.

² 35 ILCS 5/203(d)(2)(H) (emphasis added).

³ More specifically, the reason for the second prong of the test was to respond to the disparity between an S corporation (which is allowed to deduct compensation paid to shareholders/ employees for federal income tax purposes) and a partnership (which is not allowed a similar deduction). Notably, in determining its base income under the Illinois statute, a partnership must add back to income all guaranteed payments deducted by the partnership for federal income tax purposes.

⁴ Current IRC Section 911(d)(2) addresses compensation representing a distribution of earnings or profits and also when both personal services, in addition to capital, are material income-producing factors.

⁵ Ill. Dept. of Rev., IT 04-0002-PLR (9/22/2004).

⁶ 35 ILCS 5/1501(a)(3).

⁷ Ill. Dept. of Rev., IT 00-0033-GIL (3/27/2000); and IT 98-0036-GIL (4/3/1998).

⁸ Ill. Dept. of Rev., IT 91-0339-PLR (12/24/1991).