A stealth amendment to the Illinois Income Tax Act (“Income Act”) that was buried in the recently enacted Illinois Emergency Budget Implementation Act of Fiscal Year 2010 (“Budget Act”) will have the effect of raising the state income tax rate on the income on many accountants, lawyers, doctors, consultants and certain other individuals providing services from 3% to 4.5%.
Ironically, the Administration in Illinois recently advocated raising the state income tax rate on individuals by 50% and otherwise taking action to make Illinois income tax more “progressive” to help solve Illinois fiscal problems. It has been widely believed that such efforts had been rejected by the legislature and withdrawn by the Administration. Yet, with no advance notice, many service professionals who are members of partnerships, or entities such as limited liability companies (“LLCs”) that are taxed as partnerships, will find that their Illinois income tax has been increased exactly as proposed by the Administration. The scope and effect of the recent amendment to the Income Act may not have been fully understood. Information supplied by an authoritative source indicates that this amendment to the Income Act was a surprise to the Illinois Department of Revenue.
The Illinois Replacement Tax and Partnership Taxation Generally
Partnerships (and most LLCs) are generally not subject to federal income tax at the entity level. However, partnerships that engage in business in Illinois are subject to the “replacement tax” component of Illinois income tax at a rate of 1.5%. The replacement tax was enacted to “replace” the repealed Illinois personal property tax. Illinois taxable income for a partnership begins with its income as determined for federal income tax purposes, but is subject to apportionment, allocation and various addition and subtraction modification rules. The Income Act has historically provided for a subtraction modification for an amount of reasonable compensation earned by individual partners. Accordingly, most professional service partnerships have claimed substantial subtraction modifications, and such modifications have had the effect of substantially reducing a service partnership’s liability for Illinois “replacement” income tax.
2009 Amendments: Deductible Compensation Limited to Guaranteed Payments
The Budget Act amends the Income Act to limit the modification allowed for partner earnings to “guaranteed payments” to individual partners, as such term is defined for purposes of determining the taxation of partners and partnerships for federal income tax purposes. This means that partner earnings that are not guaranteed payments are included in the tax base. The amendment to the Income Act is effective for taxable years that end on and after December 31, 2009. The overwhelming majority of professional partnerships generally do not provide for significant “guaranteed payments” to their individual partners. Thus, many professional service partnerships will find that they are now subject to “replacement” income tax at a 1.5% rate. When combined with the 3% Illinois income tax rate on individuals, this means that professionals practicing through partnerships will find that the income tax rate on income derived from providing services has effectively been raised from 3% to 4.5%, the precise general rate increase that was advocated by the Administration and seemingly rejected by State legislators. Also, unless the amendment to the Income Act is repealed or substantially modified, the recently enacted 1.5% tax rate increase on certain partnerships would remain in addition to whatever increased general tax rate may be enacted. (Professionals practicing as sole proprietors or through a corporation or a wholly-owned LLC will not be adversely affected by this recent change in the Income Act.)
Personal Service Partnership Considerations Under the New Law
Partnerships engaged in business in Illinois may benefit by assessing how the amendment to the Income Act will affect their tax liability and, if the partnership is facing a significant tax liability, carefully evaluating what actions may be available to reduce or eliminate such liability. There are strategies that can be implemented to mitigate or completely avoid this stealth tax increase. However, unless the Income Act is amended to correct for what may have been unintended but far-reaching consequences, partnerships that do not address the recent change to the Income Act may face some surprising consequences when tax returns are prepared next year.