Illinois enacts potential solution to SALT limitation for pass-through entity owners

On Aug. 27, 2021, Illinois enacted Senate Bill 2531, which allows entities taxed as partnerships and S-corporations an election to pay taxes that could grant individuals a federal deduction for state income taxes where it otherwise may not be available. The election, commonly referred to as the pass-through entity election (PTE), is effective for tax years ending on or after Dec. 31, 2021, and prior to Jan. 1, 2026.

The passage of the PTE is in response to the state and local tax (SALT) limitation, enacted as part of the Tax Cuts and Jobs and Acts of 2017 (TCJA), that put a $10,000 limitation on the amount of state and local taxes an individual can deduct on their federal income tax return. Many taxpayers take the standard deduction because of the SALT limitation, and, thus, do not benefit from a SALT deduction.

The Illinois tax paid under the PTE is allocated to each partner and shareholder as an income tax credit to report on their Illinois income tax returns. The credit is generally 4.95% of the owner’s share of Illinois-sourced distributive income. Credits that exceed the partner’s or shareholder’s Illinois income tax is generally treated as an overpayment of tax.

The PTE is made on an annual basis in accordance with Illinois Department of Revenue rules and is irrevocable for the year the election is made. The PTE applies to all owners of the partnership and S corporation, including tax-exempt entities, and taxpayers can’t pick and choose owners to which the PTE applies.

Benefit of the PTE

Based on Internal Revenue Service Notice 2020-75 issued in November 2020, owners of an entity with a PTE should be allowed a deduction for Illinois income tax, which may exceed the $10,000 SALT limitation enacted by the TCJA. Accordingly, an individual partner or shareholder could achieve a benefit of 37% of their share of Illinois income tax.

Tax computation of the PTE

Eligible entities making the PTE will generally compute tax in the same manner as Illinois replacement tax, which includes sourcing income to Illinois under the allocation and apportionment provisions. However, the tax base doesn’t allow deductions for the standard exemption, net operating loss carryforward deduction, and the subtraction for owners that are themselves subject to replacement tax or exempt organizations. Further, partnerships aren’t allowed the deduction for reasonable compensation or personal service income. This provides similar treatment between the pass-through entity income tax and the individual income tax, since individuals are generally not allowed these deductions in computing Illinois income tax.

Tiered partnerships

The partner of a partnership that is itself an S corporation or a partnership is allowed to make a PTE. Such partner should subtract the income of an underlying partnership that itself made a PTE.

Residents

Residents are required to file an individual Illinois income tax return even if their only source of income is from a partnership or S corporation that made the PTE. A significant change afforded by Senate Bill 2531 allows Illinois residents a credit for taxes a pass-through entity pays under a regime that is “substantially similar” to Illinois’ PTE. Prior to Senate Bill 2531, Illinois residents weren’t allowed a credit for taxes paid by the entity to other states. Because of this change, Illinois residents may now be able to take advantage of the SALT deduction for taxes paid to other states without losing the credit. States with “substantially similar” PTE laws haven’t been defined, but the Illinois Department of Revenue is expected to provide guidance in the future.

Nonresidents & nonresident withholding

Nonresident individuals are not required to file an Illinois income tax return if the only source of income is from an entity that made the PTE, and the nonresident individual’s credit is greater than or equal to the taxpayer’s Illinois tax liability.

Partnerships and S corporations are not required to withhold tax on behalf of nonresident owners if the pass-through entity makes a PTE.

Estimated tax requirements

Partnerships and S corporations are required to make quarterly estimated tax payments in the year the PTE applies if the tax liability is reasonably expected to exceed $500. Estimated tax payments are due on the 15th day of the fourth, sixth, and ninth months of the tax year.

• For corporations: The last estimated payment is due on the 15th day of the last month of its tax year.
• For individuals: The last estimated tax payment is due on the 15th day of the first month after the tax year-end.

Penalties may apply if estimated taxes are not timely and accurately paid.

The Illinois Department of Revenue is expected to provide additional guidance, including how and when to make the election and whether a partnership’s last estimated tax payment is due on the same day as due for a corporation or an individual.

Each taxpayer’s situation is different and consideration needs to be given to all the facts as to if Illinois’ PTE or other states’ PTE is beneficial for that taxpayer. Our SALT specialists have experience with Illinois’ PTE, as well as the PTE regime in other states (e.g., California and New York) and can assist businesses with determining and securing PTE benefits where beneficial. For more information, please contact a member of our state and local tax team.