Illinois Apportionment of Service Income and Unitary Partnerships

Editor: Mindy Tyson Weber, CPA, M.Tax.

State & Local Taxes

Effective for tax years ending on or after Dec. 31, 2008, Illinois enacted a form of market sourcing for sales of services. As part of this change, Illinois implemented a service receipts throw-out provision that excludes a taxpayer’s sales of services from the sales factor when the taxpayer is not subject to tax in the state where the services are received. When applied to partnerships with one or more unitary partners (partners whose business activities are integrated and interdependent), the impact of this provision may be substantially reduced or eliminated because partnerships and unitary partners combine their nexus profiles. However, issues with Illinois’s forms may make reporting based upon this position difficult.

Illinois Services Apportionment

Under 35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv), a taxpayer’s gross receipts from sales of services are included in the numerator of the Illinois sales factor if the services are received in Illinois. If the state where the customer receives the services cannot be determined or is a state where the recipient does not have a fixed place of business, the services are deemed to be received at the location from which the customer ordered the services. In instances where the ordering office cannot be determined, the services are deemed to be received at the location at which the customer was billed for the services. When the taxpayer is not subject to tax in the state where the customer receives the services, the gross receipts from the sale of those services are excluded from both the numerator and denominator of the taxpayer’s sales factor.

Subject to Tax

Under 35 Ill. Comp. Stat. 5/303(f), a taxpayer is subject to tax in another state for the purposes of the throw-out rule provided in 35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv) if either (1) the taxpayer is subject to a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business, or a corporate stock tax in the state; or (2) the state has the jurisdiction to subject the taxpayer to a net income tax, regardless of whether it actually does so. The provisions of Ill. Admin. Code, tit. 86, §100.3200(a)(2) subject a taxpayer to one of the taxes enumerated in 35 Ill. Comp. Stat. 5/303(f) if the tax imposed reasonably relates to the taxpayer’s income-producing activities in the state and the taxpayer actually pays the tax due. Further, Ill. Admin. Code, tit. 86, §100.3200(a)(2) provides that a taxpayer falls within the jurisdiction of a state’s power to impose a net income tax if the taxpayer has nexus with the state under the Constitution, statutes, and treaties of the United States and the imposition of net income tax would not be barred by the provisions of the Interstate Income Tax Act of 1959, P.L. 86-272.

Applicability to Unitary Partnerships

In the context of a unitary group of corporations, each member of the unitary group is treated as a separate entity for purposes of determining whether it is subject to tax in another state. Accordingly, a taxpayer is not subject to tax in another state merely because another member of the taxpayer’s unitary group is subject to tax in another state. See, e.g., Beatrice Companies, Inc. v. Whitley, 685 N.E.2d 958 (Ill. App. Ct. 1997). The Illinois Department of Revenue, in its 2001 Practitioners’ Questions and Answers, indicated that the same rule applies to partnerships and partners. However, this approach runs contrary to Illinois jurisprudence, under which a partner’s ownership interest in a unitary partnership with Illinois nexus has been held to constitute sufficient contact with the state to support subjecting the partner to tax. See, e.g., Borden Chemicals and Plastics, L.P. v. Zehnder, 726 N.E.2d 73 (Ill. App. Ct. 2000).

Viewed in combination with Ill. Admin. Code, tit. 86, §100.3380(d) and cases such as Exxon Corp. v. Bower, 867 N.E.2d 115 (Ill. App. Ct. 2004) (a partnership’s business income must be included in its corporate partner’s tax base even if the partnership does not operate in the state), it is clear that, for Illinois tax purposes, a partnership is treated as a single entity combined with its unitary partners to the extent of their partnership interests therein, so that the partnership’s activities, income, and receipts are treated as the unitary partners’ activities, income, and receipts. Accordingly, it stands to reason that the throw-out rule under 35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv) should apply only to the service receipts of a partnership and a unitary partner if neither the partnership nor the partner is subject to tax in the state to which the receipts are sourced.

Further, it is arguable that, if the partner is unitary with more than one partnership, the overall activities of each of the other partnerships and the unitary partner would be taken into account in making throw-out determinations for the partnerships and the unitary partner. However, where a partnership is unitary with more than one of its partners, the throw-out determination would have to be done separately for each unitary partner. Partnership nexus attribution is done separately for each unitary partner’s share of the partnership, and no reasonable basis exists for cross-attribution of nexus from one partner to another.

Example: Partner 1 and Partner 2 are members of a unitary group. Separately, Partner 1 has nexus in State X, and Partner 2 has nexus in State Y. Neither Partner 1 nor Partner 2 has sales outside of State X or State Y, respectively. Partner 1 and Partner 2 are unitary partners in Partnership A and Partnership B. Partnership A has nexus in Illinois and makes sales of services to unrelated parties in State X and State Y. Partnership B has nexus in Illinois and State Y and makes sales of services to unrelated parties in State X, State Y, and State Z.

For Illinois purposes, Partner 1 has nexus with State X due to its own activities, and its interests in Partnership A and Partnership B give it nexus with State X, State Y, and Illinois. Similarly, Partner 2 has nexus with State Y and Illinois, but not State X, because it cannot be attributed State X nexus from Partner 1 either directly or through its interests in Partnership A and Partnership B. Partnership A has nexus in Illinois due to its own activities, and State X and State Y nexus attributed from its partners. Partnership B has nexus in Illinois and State Y due to its own activities, and State X nexus from Partner 1. Accordingly, when applying Illinois’s throw-out provision, Partnership A would throw out none of its services receipts from the sales factor, and Partnership B would throw out only its sales sourced to State Z (see the exhibit).

Reporting Issues

Regardless of the merits of the position that the service receipts should not be thrown out, practical application is not without difficulty. The primary problem is that Illinois’s forms are not designed to reflect the attribution of nexus between partnerships and unitary partners. Illinois requires each partnership with Illinois nexus to file Form IL-1065, Partnership Replacement Tax Return, along with a Schedule K-1-P, Partner’s or Shareholder’s Share of Income, Deductions, Credits, and Recapture, for each partner. Form IL-1065 and Schedule K-1-P provide no mechanism through which a partnership can report throw-out determinations reflecting the nexus profiles of both the partnership and a unitary partner at the partnership level. Further, even if the forms allowed such throw-out determinations to be reported at the partnership level, it would be burdensome to do so outside of the context of a partnership that is wholly owned by members of a unitary group, because the facts necessary to make the determinations regarding unity and partner nexus are outside of the partnership’s purview and control.

To correct these problems, a partnership could apply throw-out at the partnership level as if it were not unitary with any of its partners and attach to Schedule K-1-P a supporting schedule showing its sales without applying the throw-out rule and a statement that (1) lists the states in which the partnership has nexus on its own account, (2) provides a clear explanation of the law, and (3) states that it is the responsibility of each partner to determine whether it is unitary with the partnership and to apply the throw-out rule at the partner level.

Each partner would then have the data necessary to determine the proper sales factor numerator and denominator and, if appropriate, reduce the impact of the throw-out rule at the partner level by applying the rule based on the combined nexus profile of the partner and the partnership. The only problem with this approach is that it would result in the partner’s reflecting partnership items on its returns in a different manner from the way in which they were reported by the partnership.

Conclusion

The Illinois service receipts throw-out rule under 35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv) and other guidance outlined above appear to allow partnerships and unitary partners to determine the states in which they are subject to tax on a combined basis, so that the partnership is treated as if it is subject to tax in all states in which the partner has nexus, and vice versa. Depending upon the facts, combining a partnership’s nexus profile with that of a unitary partner may reduce or eliminate the impact of the throw-out provision. Taxpayers should be aware of this opportunity and the nuances of reporting tax based on this position on Illinois partnership returns.

EditorNotes

Mindy Tyson Weber is a director, Washington National Tax in Atlanta for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.