On August 27, 2021, Illinois Governor J. B. Pritzker signed S.B. 2531 that provides a pass-through entity workaround to the recent federal limits on state and local taxes (SALT). Illinois thus became the latest state to adopt such a workaround.
Seven states had already passed legislation for entity-level workarounds since the SALT limitation took effect in 2018, and 11 more states have adopted this approach in 2021.
The Tax Cuts and Jobs Act established a $10,000 limitation on the amount an individual could deduct for state and local taxes. Any SALT taxes paid by the taxpayer above this $10,000 ceiling, in effect, were nondeductible. The workaround some states introduced allowed a pass-through entity (S Corporation or Partnership/LLC) to pay the state income tax on the business at the entity level. This tax was then deducted for federal tax purposes by the business and was not subject to the $10,000 SALT limitation. The owner(s) of the pass-through entity would not pay tax at the individual level. While this SALT workaround was slowly picked up by a handful of states, it gathered real attention this past year after the IRS issued guidance that essentially approved of these SALT workarounds (see IRS Notice 2020-75).
The states that approved the workaround were more or less revenue neutral in the process, as entities were paying state income tax the individual owners of the pass-through entities would have paid regardless. States also realized the merits of the program, as it could assist their residents in reducing their federal tax liabilities.
While many states have now adopted these SALT workarounds, the specific provisions differ from state-to-state.
Illinois’ SALT Workaround
S.B. 2531 was passed with board bi-partisan support by the Illinois Legislature in May 2021. It was lauded as providing tax relief to small business owners in Illinois without impacting Illinois’ fiscal posture.
The bill permits S Corporations and Partnership/LLCs (but not Publicly Traded Partnerships (PTPs)) to elect to pay an Illinois state income tax of 4.95% on the pass-through’s income at the entity level. Shareholders and partners of a pass-through entity are then entitled to a state tax credit for the taxes paid on their share of the entity’s income. This credit can offset the Illinois income tax related to the pass-through entity income, but it is not allowed to reduce the Illinois Replacement Tax.
The new law takes effect for tax years on or after December 31, 2021 and runs through 2025. Meaning, 2021 is the first year this provision is available in Illinois.
- As indicated above, this new payment of individual tax at the entity level is elective. It is an election made each year by the entity. Once the election is made, it cannot be revoked.
- If a pass-through entity makes the election to pay tax at the entity level, it would also need to pay the Illinois Replacement Tax, and the entity-level tax would not affect the computation of the replacement tax.
- The Illinois income methodology used to compute the pass-through entity tax is different from that applied with the replacement tax. The taxable income for the new pass-through entity tax applies to the total income allocated to Illinois. For partnerships, any guaranteed payments as well as any income distributable to the partners is all part of the tax calculation for the Illinois entity-level tax.
With a partnership, there is no deduction for a reasonable level of compensation paid to partners for providing services to the partnership. Further, there is no deduction for income distributable to a partner or shareholder.
- The pass-through entity tax applies to all income, even income allocable to tax-exempt partners (even if the partner would not be liable for any Illinois tax).
- A pass-through entity that elects to pay this entity-level tax must make Illinois estimated tax payments if it anticipates the tax for the year to exceed $500. The due dates for the first three quarterly payments are April 15, June 15 and September 15. The fourth payment varies: payment is due December 15 for S Corporations and on January 15 of the following year for partnerships.
There is no safe harbor for prior year’s tax for the pass-through entity. Perhaps the Illinois Department of Revenue (IDOR) may provide relief for the first two quarters of 2021 for any estimates. It is unsure what form entities should use for these payments (possibly Form IL-1120-ST-V for an S Corporation). The entity-level tax payments will likely be available to be paid online.
Any taxes paid to other states at the entity level are treated as paid by the owners of the entity for purposes of the Illinois credit on taxes paid to other states if such taxes are “substantially similar” to the Illinois pass-through entity tax. The IDOR will likely offer more guidance on how this credit will work.
- While this Illinois workaround will provide a tax benefit to these entities and their owners, it may not make sense in every situation. Each business should analyze the new law and apply it to its unique circumstances. Remember, this is an annual election, so if an entity does not make this election in 2021, it could make it for 2022 (and vice versa).
Further information is expected to be released by the IDOR. Illinois pass-through entities should begin studying this new law to determine the possible impact and whether the election should be made. Your Sikich tax advisor can assist in this process.