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Illinois Enacts Pass-Through Entity Tax to Help Partners and S Corporation Shareholders Avoid the $10,000 SALT Cap

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).

TIERED PARTNERSHIPS

In the case of tiered partnerships, if a lower-tier partnership makes the PTE Tax election, the upper-tier [...]

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Retroactive Revenue Raisers: A Taxpayer Win in New York; Problems Ahead in Virginia

When state legislatures are in need of additional funds – as they often are – it is tempting to enact retroactive legislation to bring more dollars into state coffers. Two recent developments have Due Process Clause questions of retroactivity back in the news in the SALT world. In Caprio v. N.Y. State Dep’t of Taxation & Fin., No. 651176/11, 2014 NY Slip Op. 02399 (N.Y. App. Div. Apr. 8, 2014), a New York court rejected a retroactive amendment reaching back three years into the past. Virginia, however, recently amended its add-back statute (H.B. 5001, § 3-5.11) with an even longer retroactive period of 10 years.

New York’s Three and a Half Year Retroactive Tax Struck Down As-Applied

In Caprio, Florida residents sold their stock in a New Jersey S corporation in exchange for an installment note. The S corporation was a janitorial services company that also did business in New York. The parties to the transaction made an IRC § 338(h)(10) election for treatment as a deemed asset sale, with the installment note thereby deemed to be distributed in liquidation to the shareholders. When the shareholders subsequently received payments on the installment note, they did not report any New York source income because they treated the payments as gain from the sale of stock, not sourced to New York any more than would be a sale of stock in a Fortune 500 company.

Treatment of gain from a nonresident’s sale of S corporation stock as not sourced to New York was upheld by the New York State Division of Tax Appeals in In re Mintz, DTA nos. 821807, 821806 (Jun. 4, 2009) (for a detailed discussion in Mintz, see Inside New York Taxes), but retroactive legislation in 2010 reversed the result. 2010 N.Y. Laws, c. 57, Part C (amending N.Y. Tax Law § 632(a)(2)).  Caprio voids the retroactive application of the 2010 amendment to the taxpayers as violating the Due Process Clause.

Applying New York’s three-factor test set forth in James Square Assoc. LP v. Mullen, 993 N.E.2d 374, 377 (N.Y. 2013), aff ’g, 91 A.D.3d 164 (N.Y. App. Div. 4th 2011) (which we discussed recently in State Tax Notes), the Appellate Division considered the factors of (1) taxpayer’s forewarning and the reasonableness of the retroactive change, (2) the length of the retroactive period, and (3) the public purpose of the retroactivity. The majority concluded that the 2010 amendment was unconstitutionally retroactive:

  • The taxpayers had no actual forewarning of the 2010 amendment at the time they entered into the transaction, and they reasonably relied on the law as it existed to structure the sale;
  • A three and a half year retroactive period was excessive; and
  • Raising $30 million for the state budget was not a sufficiently compelling public purpose.

The Questionable Validity of Virginia’s 10 Year Retroactive Add-Back Amendments

Just before Caprio came down, Virginia amended its add-back statute, retroactive to 2004, to narrow the subject-to-tax and conduit exceptions. See [...]

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