On August 27, 2021, Illinois Governor J.B. Pritzker signed into law an act* establishing an alternative way to tax the income of partnerships, LLCs and S corporations (“pass-through entities” or “PTE” for short). This new alternative resembles a composite tax arrangement which will look familiar to investors and owners with pass-through entity interests out-of-state and who have seen this kind of arrangement before.
In effect, the PTE tax will circumnavigate the Federal limitation on deduction of taxes limited to $10,000 per year as enacted in the Tax Cuts and Jobs Act of 2017 (TCJA). And as a reminder, it is not just state income taxes that are limited to the cap of $10,000 per year—the cap also applies to the aggregate real property taxes, sales taxes, income taxes, or other taxes as well. Under current law, state income taxes paid by individuals, whether attributable to PTE income or other income, are subject to the TCJA’s $10,000 cap whereas the tax paid at the entity level is not subject. Indeed, the IRS has blessed this type of arrangement in their Notice 2020-75 in which they approved the Federal deduction of state PTE taxes paid by the entity in circumstances where the PTE owner receives a state tax credit and where the PTE tax essentially is paid in lieu of the state income tax otherwise imposed directly upon the PTE owner.
Pass-Through Entity Tax is Made on Annual Basis
The PTE Tax is elective, meaning that it is made on an annual basis. Based on discussions with the Illinois Department of Revenue (“IDOR”), the election will be made by checking a box on the PTE return indicating consent to the PTE tax. The tax on electing partnerships and S corporations will be at a flat tax rate of 4.95%. The tax is based on Illinois base income after apportionment or allocation. PTE owners will be able to claim a refundable Illinois credit equal to their distributive share of the Illinois PTE Tax paid by the PTE. Illinois base income for this purpose will be computed without deduction of net loss carryovers or exemption amounts. Further, in determining Illinois base income, the PTE will have to add back any subtraction modification for reasonable compensation of partners (including guaranteed payments to partners) and the subtraction modification for income allocable to partners or shareholders subject to the Illinois replacement tax. The PTE Tax does not affect the 1.5% personal property replacement tax currently on the books hence will be in addition to the replacement tax.
In each year that the PTE tax election is effective, the company will need to pay estimated payments if the estimated tax is expected to exceed $500. Under the election, since the PTE is paying the tax, the PTE is not required to remit nonresident withholding on the Illinois distributable share of income to a nonresident owner in the same year. Failure to pay the estimated tax will subject the PTE to estimated tax penalties. Given the recent enactment of the law with three quarterly payments having come and gone, the IDOR will waive late estimated payment penalties related to an election to pay the pass-through entity-level tax for tax years ending before December 31, 2022.
Taxpayers Encouraged to Make Voluntary Prepayments
For taxpayers electing to pay the PTE tax, IDOR encourages making voluntary prepayment of the pass-through entity-level tax to reduce any tax payment due when the return is filed. These prepayments can be made electronically using MyTax Illinois or ACH Credit or by mail using 2021 Form IL-1065-V, Payment Voucher for Partnership Replacement Tax, or 2021 Form IL-1120-ST-V, Payment Voucher for Small Business Corporation Replacement Tax. In a more onerous posture, if the PTE fails to pay the tax, the partners or shareholders are directly liable to pay the PTE tax, including penalties and interest. The 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.
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. Special rules will apply for tiered partnerships. The PTE owner’s share of the tax credit that exceeds its respective Illinois income tax liability will be treated as an overpayment.
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 only if the PTE owner’s sole 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.
There will be more instructions and procedures in this area and taxpayers are encouraged to check the IDOR website regularly for updates or contact your DHJJ CPA.
DHJJ Business Advisors
DHJJ offers advisory services to clients for all aspects of taxation, including this alternative way to tax the income of partnerships, LLC’s and S corporations in Illinois.