Illinois enacted a pass-through entity tax (PTE Tax) that may be elected by partnerships and S corporations to permit a federal deduction of state income taxes that otherwise are limited to $10,000 per year from 2018 to 2025 by the Tax Cuts and Jobs Act of 2017 (TCJA). State income taxes paid by individuals, whether attributable to pass-through entity income or other income, are subject to the TCJA’s $10,000 “SALT Cap.”
In Internal Revenue Service (IRS) Notice 2020-75, the IRS announced its approval of the federal deduction of state PTE Taxes paid by the entity in circumstances where the partner or shareholder receives a state tax credit, and the PTE Tax essentially is paid in lieu of the state income tax otherwise imposed upon the partner or S corporation shareholder.
The new Illinois PTE Tax was signed into law by Governor JB Pritzker on August 27, 2021 (Public Act 102-658) and applies to taxable years ending on or after December 31, 2021, and prior to January 1, 2026. Eighteen other states have also enacted PTE Taxes and 14 of those (including Illinois) are effective for 2021.
TAX AT ENTITY LEVEL
The Illinois PTE Tax is imposed on electing partnerships and S corporations at a rate of 4.95%, the flat income tax rate applicable to individuals. The tax is imposed upon the Illinois net income of the partnership or S corporation, which is equal to Illinois base income after apportionment or allocation. As discussed below, partners and S corporation shareholders may claim a refundable Illinois credit equal to their distributive share of the Illinois PTE Tax paid by the partnership or S corporation. Illinois base income of a partnership or S corporation for purposes of the PTE Tax is computed without deduction of Illinois net loss carryovers or the standard exemption. It’s also computed after addback of the partnership 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 replacement tax computation.
The Illinois PTE Tax is paid by the partnership or S corporation on all of its Illinois net income after apportionment or allocation. As a result, any tax exempt owner of a partnership or S corporation may be required to file Illinois refund claims in order to recoup PTE Taxes paid at the entity level (including as estimated payments). In some cases, this may be avoided by forming an upper-tier partnership for partners that are not tax exempt. Other states have avoided this problem by permitting the PTE Tax to be elected on a partner-by-partner basis rather than for the entity as a whole (e.g., California) or by imposing the PTE Tax only upon income that is allocable to partners subject to the state’s personal income tax (e.g., New York State).
In the case of tiered partnerships, if a lower-tier partnership makes the PTE Tax election, the upper-tier partnership that also makes a PTE Tax election will exclude income allocated by the lower-tier partnership to the upper-tier partnership. The partners in the upper-tier partnership will be allowed a credit for their distributive share of the PTE Tax paid by both partnerships. Corporate partners with a higher Illinois tax rate (7%) will also be allowed a credit for their distributive share of the PTE Tax (at 4.95%) and will pay the difference to the State of Illinois.
ANNUAL ELECTION OF PTE TAX AND ESTIMATED PAYMENTS
The election to pay the PTE Tax is required to be made on an annual basis “at such time, and in such form and manner as prescribed” by the Illinois Department of Revenue. A separate election is made for each year and is irrevocable once made. The PTE Tax requires the partnership to make estimated payments in the same manner as individuals (in April, June, September and January). S corporations are to make estimated payments in the same manner as corporations (in April, June, September and December). If the PTE Tax is elected, the partnership or S corporation is not required to withhold income tax on nonresident partners (and Illinois does not allow composite returns).
For the 2021 taxable year, the Department of Revenue is expected to announce a decision as to when the election must be made, and whether estimated payments will be due for the entirety of 2021. Taxpayers should be aware that Illinois may follow the lead of New York State, which also recently enacted a PTE Tax. New York requires the election for 2021 to be made by October 15 and requires estimated payments to be made by both the pass-through entity and the partners or shareholders in 2021. Alternatively, the Department of Revenue could require the election to be made with the 2021 tax return. In order to claim the federal deduction for 2021, the PTE Tax must be paid to the State of Illinois (and other states with PTE Taxes) during 2021.
STATE INCOME CREDITS FOR PARTNERS AND SHAREHOLDERS
Partners and S corporation shareholders are allowed a refundable credit for the PTE Tax paid by the pass-through entity. Partners and S corporation shareholders must addback their distributive share of the PTE Tax to their Illinois income so that the tax liability at the partner level equals the PTE Tax paid at the entity level.
Illinois explicitly allows a credit to resident partners and S corporation shareholders for “substantially similar” PTE Taxes imposed by other states. The Illinois credit for PTE Tax paid to other states is based upon the partner’s share of the partnership income allocated or apportioned to the other state (without specifying whether Illinois or the other state’s apportionment rules are applied for this purpose—another detail to be addressed by the Department of Revenue).
As noted above, 18 other states have adopted pass-through entity taxes. Some of these taxes differ from the Illinois PTE Tax in important respects. For example, nine states allow a credit for PTE Tax paid in a manner similar to Illinois while the other nine states allow a deduction or exclusion of the income taxed at the entity level rather than a credit.
Although it is expected that Illinois will allow its residents a credit for PTE Taxes paid in all of these states, multistate partnerships and S corporations should consult their tax advisors to avoid unexpected adverse results that could occur if Illinois (or possibly other states) do not allow a credit for PTE Taxes paid in some other states. In particular, states that have not enacted a similar PTE Tax may or may not allow their residents to claim a credit for PTE taxes paid to states that have enacted PTE Taxes (since the tax is imposed on the entity rather than the individual partner or shareholder that seeks the credit).
CONSULT WITH A TAX ADVISOR
Taxpayers deciding whether to make a PTE Tax election in one or more states or establish a partnership or S corporation to qualify for the federal tax deduction should consult their tax advisors generally and with respect to several issues. For example, multistate partnerships and S corporations and entities with owners in multiple states should consider whether all partners or shareholders will receive a tax credit in their state of residence, which may be a significant issue in states that have not enacted a PTE Tax. Multistate partnerships should also be aware that many of the state PTE Tax rules differ from one another.
Investment partnerships that are not engaged in a trade or business should consult their tax advisors regarding the availability of the federal deduction and the federal income tax reporting rules for state PTE Taxes paid by investment partnerships. Partnerships with nonbusiness income and nonresident partners may be subject to Illinois PTE Tax at the entity level on such nonbusiness income (if the commercial domicile of the partnership is in Illinois) but should be allowed an Illinois credit at the partner level. Highly-compensated employees that may consider establishing a personal service S corporation to take advantage of the federal deduction should consult their tax advisors as well.