Illinois PTE tax would provide SALT cap workaround

Editor: Howard Wagner, CPA

On May 30, the Illinois Legislature passed S.B. 2531, which includes a passthrough entity (PTE) tax that allows a workaround to the federal $10,000 limitation for state and local tax (SALT) deductions. As of this writing, Gov. J.B. Pritzker was expected to sign the bill. [Update: The bill was signed by the governor on Aug. 27, 2021.]

Background

Generally speaking, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, paid for its tax rate cuts, in part, by broadening the tax base. One of the more controversial increases to the tax base is the $10,000 limitation on the deductibility of SALT payments made by individuals (except for state taxes paid in connection with a trade or business).

This limitation, known colloquially as the “SALT cap,” significantly limited the itemized deductions of many individual taxpayers, including owners of PTEs, which generally incur state tax at the individual owner level. However, the SALT cap does not limit deductibility of state taxes imposed on business entities. In response, a number of states have enacted new entity-level taxes on PTEs designed to permit the entity to deduct state income taxes that the individual owners would have otherwise been unable to deduct under the SALT cap.

In Notice 2020-75, the IRS confirmed that PTEs are permitted to fully deduct entity-level state and local income taxes that would otherwise have been paid by the owners of a PTE, in effect allowing a reduction to federal taxable income of a partnership or S corporation for taxes paid by the entity. The notice provided that the tax amounts are deductible even if the owner/partner “receive[d] a partial or full deduction, exclusion, credit, or other tax benefit that is based on their share of the amount paid by the partnership or S corporation.” This flexible approach by the IRS effectively approves the SALT cap workarounds that a growing number of states are adopting. Although there are variations among the states, the general workaround structure is that state taxes that would otherwise be paid at the individual level are paid at the PTE level and credited at the individual owner level.

Illinois

S.B. 2531 provides a workaround for the SALT cap in Illinois. It will be effective for tax years ending on or after Dec. 31, 2021, to tax years beginning prior to Jan. 1, 2026, once signed into law (corresponding to the remaining effective years under the TCJA for which the SALT limitation is currently in effect). Highlights of the new Illinois PTE tax include:

• Partnerships and S corporations can make an annual election to pay tax on Illinois-source net income at the 4.95% rate applicable to individuals. Illinois does not appear to allow an option for resident owners to pay tax on 100% of their pro rata distributive share. The tax is computed the same for resident and nonresident owners’ based on Illinois-source income (contrast with Connecticut’s PTE tax, which allows a resident option). As a result, Illinois residents in multistate passthrough entities will need to pay estimated taxes on income that is not subject to the SALT cap tax.
• Each individual owner of an electing entity would then be entitled to an Illinois tax credit against the tax imposed, equal to 4.95% times the owner’s distributive share of Illinois-source income from the entity.
• Special rules are provided to coordinate payment of the tax and receipt of the corresponding credit for tiered partnership structures.
• The bill provides a credit for Illinois residents for taxes paid to other states that have enacted substantially similar elective PTE taxes.
• The bill suspends withholding requirements for electing PTEs.
• The bill requires estimated tax payments (unlike Illinois’s current withholding rules, which do not require quarterly estimates).
• Nonresident individual partners and shareholders of a participating PTE are not required to file an Illinois income tax return if they have no other Illinois-source income and the tax credit generated meets or exceeds any Illinois income tax liability.
• The Illinois Department of Revenue is expected to provide procedural information soon.

Considerations on the resident credit for taxes paid

A significant consideration for owners of PTEs is whether taxes paid in the jurisdictions where they are a nonresident would be eligible for a credit against their resident state tax or taxable income. The general rule is that resident states do not permit a credit for net income taxes imposed on a business entity.

A multistate PTE should evaluate the state tax position of all of its owners before making the election to pay the entity-level workaround tax. There is some question whether the owners would be permitted to take into account the tax or income, as the case may be, in calculating their resident state credit for taxes paid to other states. Unless the owner’s resident state provides affirmative guidance regarding whether and how to calculate the credit for PTE taxes paid, the owner assumes some risk in treating the PTE tax (and/or taxable income) as creditable in the resident state. The decision will be more complicated for PTEs with nonresident owners in multiple states. State tax administrators may maintain that they do not have authority to extend the credit for taxes paid to these types of PTE taxes/credit mechanisms. The example below highlights the pitfall for nonresidents if their home state does not give a credit for SALT cap taxes.

Assume that a multistate PTE elects to pay its Illinois taxes in the way that avoids the SALT cap under Illinois S.B. 2531. Assume this PTE has $1 million of income, a 100% Illinois apportionment factor, and one resident partner and one nonresident partner who each own 50% of the partnership. Using the 4.95% Illinois tax rate, the PTE will pay $24,750 of tax on behalf of the nonresident owner. The nonresident owner lives in a state with a 5% rate, but that state does not clearly provide that the SALT cap tax in Illinois is creditable against the nonresident individual’s resident state income tax liability. Assume that these individuals have no other income and that their federal marginal tax rate is 32%.

If the nonresident gets a credit for the Illinois SALT cap tax, he or she would save $7,920 ($24,750 × 32%) by virtue of the federal tax deduction for net tax cost of $16,830.

However, if the home state does not grant a credit for the Illinois SALT cap tax, the nonresident individual’s tax burden would be $41,830, computed as follows:

• In his or her home state the individual would pay tax of $25,000 on the income taxed by Illinois without a credit;
• Plus the $16,830 Illinois SALT cap tax (net of federal benefit).

Uncertainty may deter usage

Given the lack of positive guidance around the issue of whether the various SALT cap taxes would be treated as creditable taxes for purposes of the resident state credit for taxes paid in the various states that have an income tax, the authors think it is unlikely that many taxpayers will avail themselves of this option without certainty of a credit. Assuming Gov. Pritzker signs the bill, Illinois residents can comfortably take part in SALT cap taxes in other states without jeopardizing their credit for taxes paid to those other states.

EditorNotes

Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowe.com.

Contributors are members of or associated with Crowe LLP.