September 7, 2021
Illinois enacts elective pass-through entity tax
On August 27, 2021, Illinois Governor J.B. Pritzker signed Public Act 102-0658 (the Act and formerly, Senate Bill 2531), establishing an elective income tax regime for pass-through entities (PTEs), including partnerships, S corporations and LLCs treated as either. Unlike many other states that have recently enacted these elective PTE tax regimes, Illinois already subjects the income of PTEs to the state's personal property replacement tax (Replacement Tax). This new PTE tax regime is an additional, elective entity-level income tax. Under the Act, eligible PTEs will pay an entity-level tax, with a proportionate share of the paid PTE tax credited to the PTE owners' Illinois income tax liability. Publicly traded partnerships are not eligible for this new PTE tax.
The PTE tax is intended to allow Illinois individual income taxpayers to deduct, for federal income tax purposes, Illinois taxes that are paid on PTE income and exceed the $10,000 annual limitation imposed by IRC Section 164(b)(6) (the SALT deduction limitation), consistent with IRS Notice 2020-75 (see Tax Alert 2020-2690). This benefit is accomplished by treating PTE tax paid at the entity level as an "above the line" deduction by the trade or business rather than as an itemized deduction at the individual PTE owner level that would otherwise be subject to the SALT deduction limitation.
The Illinois elective PTE tax applies beginning with tax years ending on or after December 31, 2021, and beginning before January 1, 2026. Key features of the new PTE tax law are summarized below.
Under the Act, a PTE can elect to pay the PTE tax. The election must be made for each tax year; once made for a given tax year, it cannot be revoked.
Calculating net income
For an S corporation, the modification for income distributable to an entity subject to the Replacement Tax would be excluded; 1 for a partnership, the modifications for personal service income (or a reasonable allowance for compensation paid) and for income distributable to an entity subject to the Replacement Tax would be excluded.2 If the electing PTE is itself a partner of another entity making the election (i.e., tiered partnerships), net income is further modified by subtracting the taxpayer's distributive share of net income from the electing partnership (i.e., the lower-tier partnership).
The PTE tax applies to electing partnerships and S corporations at a rate of 4.95%, which is the same as the existing Illinois individual income tax rate.
Estimated payments and withholding
In each year that the PTE tax election is effective, the PTE must make estimated payments if the estimated tax exceeds $500. A PTE is not required to remit nonresident withholding on the Illinois distributable share of income to a nonresident owner for those years.
PTE tax credits
Each partner or shareholder of a PTE may claim a credit against its Illinois income tax liability equal to 4.95% of the partner's or shareholder's distributive share of net income from the electing PTE, as long as the credit does not exceed the partner or shareholder's pro rata share of the PTE tax actually paid. This tax credit is also allowed for partners and shareholders in tiered partnerships and is determined for their distributive share of net income. The PTE owner's share of the PTE tax credit that exceeds its respective Illinois income tax liability will be treated as an overpayment in line with Illinois's general rules.
Nonresident partners or shareholders of an electing PTE are not required to file Illinois individual income tax returns for any year in which a PTE election is in effect. This applies if the PTE owner's only source of income from Illinois is from the electing PTE and the owner's share of the PTE tax credit equals or exceeds its respective nonresident Illinois income tax liability.
If an electing PTE paid tax to another state, and the Illinois Department of Revenue (IL DOR) deems the tax paid to that other state to be substantially similar to Illinois's PTE tax, then the Illinois resident may receive a proportional credit for that amount.
Under the Act, electing PTEs are liable for the payment of the PTE tax. If the PTE fails to pay the tax, the partners or shareholders are directly liable to pay the PTE tax, including penalties and interest. Liability of each partner or shareholder for any unpaid PTE assessment will be based on the ratio of that partner's or shareholder's share of the PTE's net income.
The Act does not specify whether an electing PTE partner's or shareholder's liability is affected based on when it first held an interest in the partnership or S corporation.
The Act presents significant income tax implications for PTEs, as well as their individual and corporate owners.
Illinois's PTE tax provisions are unique to Illinois but share similarities with those enacted by other states.3 Similar to PTE taxes enacted in California, Colorado and Oregon, Illinois's elective PTE tax law will expire. Unlike Connecticut's PTE tax, which is mandatory, the Illinois PTE tax is elective, as are most others that have been enacted by other states.
Unlike most other states that have enacted these new PTE taxes, Illinois has for many years already subjected PTEs to a direct entity-level tax (i.e., the Replacement Tax.) The Act does not address, or modify in any manner, any of the provisions of the existing Replacement Tax. Therefore, partnerships and S corporations subject to the Replacement Tax that opt into Illinois's new PTE tax will be subject to both the Replacement Tax and, if elected, the PTE Tax. It remains to be seen how the IL DOR will incorporate the elective PTE tax regime into the existing direct tax on PTEs.
For electing PTEs, the Act creates new reporting and payment requirements. Because the Replacement Tax and nonresident withholding regimes on PTEs already exist, the IL DOR will likely modify its existing materials and guidance, except for estimated payments, which will require the IL DOR to implement a revised system for making estimated payments. It is not yet known when revised materials and guidance will be forthcoming.
1 35 ILCS 5/203(b)(2)(S).
2 35 ILCS 5/203(d)(2)(H), (I).
3 Other states that have enacted similar PTE tax workarounds are Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Idaho, Louisiana, Maryland, Minnesota, New Jersey, New York, Oklahoma, Oregon, Rhode Island, South Carolina and Wisconsin. Bills that would implement a similar elective PTE tax are currently being considered in North Carolina and Pennsylvania. Bills that would have implemented a similar, elective PTE tax were vetoed in Michigan and Massachusetts. The IL DOR is instructed to determine whether any of these "other state" PTE taxes are "substantially similar" to the Illinois elective PTE tax for purposes of the Illinois resident credit.