Effective for tax years ending on or after Dec. 31, 2009, Illinois will tax the personal service income of partnerships under the "replacement" income tax provisions of the Illinois Income Tax Act. The change will increase tax collections for local governments, but decrease state income tax collections (because the replacement income tax increase will result in reduced after-tax income distributable to the partners). Although the effects of this change are clear, what it is unclear is whether this result was intentional or was merely the result of a legislative mistake.
On July 15, 2009, Senate Bill 1912 passed out of the Senate and also signed into law as P.A. 96-45. Senate Bill 1912 was a Budget Implementation bill, otherwise referred to as a "BIMP." BIMP bills are massive bills that historically have only included those changes necessary to keep the state's spending spigots open. BIMPs are not supposed to contain any substantive amendments. At least that had always been the case, until Senate Bill 1912. As Senate Bill 1912 awaited a final vote, a Floor Amendment was added by the Senate President to make a "technical correction" to the Illinois Income Tax Act partnership add-back and deduction provisions.1 Those reading the bill after it became law quickly discovered that the last-minute "technical correction" will actually significantly increase the replacement income tax on partnerships that earn their income primarily from the rendition of personal services (e.g., accountants, architects, brokers, doctors, investment advisors, lawyers, etc.). Curiously, for a state that is unable to pay its bills and is furloughing its employees, the "technical correction" indirectly reduces state income tax revenues while increasing the revenues distributed to local governments.
Illinois state income tax applies to individuals and to corporations. However, the Illinois income tax does not apply to partnerships, S corporations and trusts. Instead partnerships, S corporations and trusts are subject to a separate, income-based, tax imposed at a rate lower than the regular income tax. (C corporations are also subject to this second, income-based, tax.) This second, income-based, tax is referred to as the "replacement tax," because amounts collected by the state under this tax are distributed to local governments as a "replacement" for personal property taxes that were abolished under the 1970 Illinois Constitution. Until now, partnerships subject to the "replacement tax" have been allowed a deduction for the greater of "personal service income" earned by a partnership or for a "reasonable compensation" allowance paid or accrued for services rendered by the partners to the partnership. For most professional service firms (accounting, architecture, brokerages, law, etc.), this deduction greatly reduced, or entirely eliminated, partnership income subject to the replacement tax. The lower the replacement tax paid by the partnership, the greater the after-tax income available for distribution to the partners who are subject to Illinois tax at the higher personal income tax rate. In contrast, the "technical correction" language added to Senate Bill 1912 will increase the replacement tax liability of most professional service partnerships and, thus, reduce partners' distributive shares of after-tax income.
The rationale behind the "technical correction" language added to Senate Bill 1912 remains mysterious. The Department of Revenue drafted the "technical correction" language. It seems hard to believe that the Department could be ignorant of the fiscal effect of the language, and it would be foolhardy for the Department to push for its adoption except upon direction from the governor's office. However, the Governor wanted the General Assembly to pass a state income tax increase, so he and his Department of Revenue are unlikely to have been proponents of a bill that would indirectly reduce state income tax revenues. The Senate President is not known for misdirection and sleight of hand; quite to the contrary, in fact. Thus, it would seem that someone must have led the Senate President to believe that all that the floor amendment would accomplish was a "technical correction." Those who voted to pass the BIMP certainly had no notice that they were voting for another tax increase (the Senate passed an income tax increase earlier in the session but, as expected, it failed to gain concurrence in the House), so they have cause to be upset.
Part of the reason for the historical reluctance of the legislature to include substantive legislative changes in BIMPs is that substantive legislative changes could include constitutional defects that, if challenged, could put the entire BIMP at risk. The "technical correction" added to Senate Bill 1912 highlights this risk. S corporations and trusts are not affected by the "technical correction," which suggests discriminatory treatment, since there is no reasonable basis to allow partnerships to deduct compensation only in the form of guaranteed payments, while allowing other pass-through entities to deduct salaries, bonuses and various other types of compensation. In addition to the discriminatory treatment, the stealth tax increase suggests a violation of the "single subject" requirement for legislative measures.
It is hoped that the General Assembly can restore the deduction for personal service income or compensation during the Veto Session later this year, but recent years have proved that it is foolish to make predictions about what the Illinois legislature will do. So, for now, partnerships should watch out for that BIMP in Illinois; it may result in an unexpected tax increase for tax years ending on or after Dec. 31, 2009.
For more information, please contact one of the authors below, or the Reed Smith attorney with whom you usually work. For more information on Reed Smith's State Tax Practice, visit www.reedsmith.com/statetax.
- 35 ILCS 5/203(d)(2)(C), and (d)(2)(H).