Outlier or beginning of a trend? Illinois redefines investment partnerships

Editor: Rochelle Hodes, J.D., LL.M.

On June 7, 2023, Illinois enacted S.B. 1963 (103rd General Assembly), introducing significant changes to the taxation of Illinois investment partnerships for tax years ending on or after Dec. 31, 2023. The law expands the definition of “qualifying investment securities” and makes investment in Illinois–based operating companies a more attractive prospect for nonresident investors, including private equity, by making gain on the sale of these assets free from Illinois tax for nonresidents. The law also imposes new withholding and reporting obligations that are generally focused on earnings from operating company investments.

Background

Prior to the law change, an Illinois investment partnership was a partnership under federal income tax law that met the following tests:

• Asset test: At least 90% of the partnership’s costs of its total assets consisted of qualifying investment securities, bank deposits, and necessary office space and equipment reasonably necessary to carry on its activities as an investment partnership.
• Gross income test: At least 90% of gross income was derived from interest, dividends, or gains from the sale or exchange of qualifying investment securities.
• Dealer test: The partnership was not a dealer in qualifying investment securities (this test was removed by S.B. 1963) (35 Ill. Comp. Stat. 5/1501(a)(11.5)).

Under the prior law, qualifying investment securities were limited to common stock, bonds, debentures, derivatives, and similar types of securities, as well as interests in other investment partnerships.

Under the investment partnership framework, the taxable income of a nonresident partner in an Illinois investment partnership is treated as nonbusiness income and, from Illinois’s perspective, allocated to the partner’s state of residence or commercial domicile, with no withholding tax applied (35 Ill. Comp. Stat. 5/305(c–5)). Also, for tax years ending on or after Dec. 31, 2004, an Illinois investment partnership is exempt from the state’s 1.5% replacement tax (an entity–level tax imposed on most passthrough entities) (35 Ill. Comp. Stat. 5/205(b)). For tax years ending before Dec. 31, 2023, an Illinois investment partnership was not required to file a return; for tax years ending on or after that date, if an Illinois investment partnership has no income subject to investment partnership withholding (discussed below), it is not required to file an Illinois return (Partnerships ­— Illinois Department of Revenue website).

Key provisions under S.B. 1963

Expansion of qualifying investment securities to include operating partnerships: S.B. 1963 expands the definition of the types of assets that qualify a partnership to be treated as an Illinois investment partnership to include any asset treated as a security under U.S. federal securities law, specifically referencing the definition of a security under the Federal Securities Act of 1933 (15 U.S.C. §77b(1)). Accordingly, the new law means that partnerships holding interests in operating partnerships are no longer automatically disqualified from investment partnership treatment, potentially increasing the number of qualifying entities.

In April 2025, the Illinois Department of Revenue issued an addendum to the instructions to 2024 Form IL–1065, Partnership Replacement Tax Return, to provide additional guidance for determining when a partnership interest is treated as a security. The addendum provides that the department “will follow the federal courts’ examples … by applying a four–factor test to the interest’s key attributes.” Specifically, the addendum incorporates the four–factor test articulated in the Supreme Court case SEC v. W.J. Howey Co., 328 U.S. 293 (1946), to determine whether a partnership’s investment is considered a security under the federal securities laws. Under Howey, an interest in a partnership is considered an investment contract if all of the following factors are true: (1) the investor has made an investment of money; (2) the money is invested in a common enterprise; (3) the investor has an expectation of profits; and (4) profits are derived solely from the efforts of persons other than the investor (IL–1065 Instructions Addendum (N–04/25)).

The addendum also includes the following rebuttable presumptions based on the type of ownership interest:

• General partnership interests are presumed not to be securities;
• Limited partnership interests are presumed to be securities; and
• Limited liability company (LLC) interests have no presumption, but an interest in a manager-managed LLC is more likely to qualify as a security than an interest in a member-managed LLC.

Withholding and reporting: Even though gains from the sale of qualifying investments are generally free from Illinois tax, investment partnerships are required to withhold and remit tax for nonresident partners on Illinois–source income flowing from investments held in operating partnerships. This withholding is effectively a new entity tax on earnings from operating company investments.

The withholding rates match the applicable Illinois income tax rates: 9.5% for corporate partners and 4.95% for individuals and passthrough entity partners (35 Ill. Comp. Stat. 5/709.5(d)(2)).

Unlike traditional Illinois nonresident withholding, no waivers are available for this tax. However, there are exemptions from this withholding: (1) partners that are tax–exempt entities under federal Sec. 501(a) or 35 Ill. Comp. Stat. 5/205 and (2) retired partners to the extent their distributions are exempt under 35 Ill. Comp. Stat. 5/203(a)(2)(F). Nonresident partners cannot claim credit for investment partnership withholding, except if at least one of the following applies:

• Where the income is business income in the hands of the partner;
• If the investment partnership is itself a partner in a second investment partnership;
• If a partner in the investment partnership is itself a passthrough entity with Illinois-resident partners, shareholders, or beneficiaries; or
• Nonresidents that are commercially domiciled in Illinois (Ill. Admin. Code tit. 86, §100.7034(f)).

Investment partnerships are required to file an Illinois return if they have income subject to investment partnership withholding. The withholding tax introduces significant complexity such as:

• Requiring partnerships to track Illinois-source income for computing investment partnership withholding;
• Complying with new reporting requirements, such as preparing new Schedule K-1-P(4), Investment Partnership Withholding Calculation for Nonresident Partners, which computes investment partnership withholding;
• Determining how the Illinois partnership tax return schedules for investment partnership withholding interact with Schedule B, Partners’ or Shareholders Information, and Schedule K-1-P, Partner’s or Shareholder’s Share of Income, Deductions, Credits, and Recapture; and
• For partners, determining when they can claim a credit for withholding made at the investment-partnership level.

While investment partnerships may elect to pay the Illinois passthrough entity tax (PTET) on behalf of their partners, they remain subject to investment partnership withholding. If the PTET is elected, income subject to the PTET is computed by deducting income subject to investment partnership withholding from base income on line 35 of Form IL–1065 (generally, federal taxable income with certain state adjustments). If an investment partnership invests in a partnership that itself elected PTET, the investment partnership may use the PTET credit to reduce its amount of withholding owed, to the extent that such credit would otherwise be distributable to its nonresident partners. Careful modeling of consequences and cash flows should be done before committing to the PTET for an investment partnership, especially in a year where there has been a gain from the sale of the investment asset.

The following example is modified from the examples provided by the department in its regulation for investment partnership withholding (Ill. Admin. Code tit. 86, §100.7034(j)):

Example: Partnership A, an investment partnership, has two partners, Partner B, itself an investment partnership, and Partner C, a nonresident individual. Partner B has two partners, Partner D, an Illinois–resident individual, and Partner E, a nonresident individual.

During the tax year, Partnership A receives Illinois–source income from an operating partnership that qualifies as a security under the investment partnership rule and computes investment partnership withholding tax at the 4.95% individual rate. Unlike under general nonresident withholding, Partner C cannot take credit for the investment partnership withholding. Partnership B may take a credit against investment partnership withholding with respect to Partner E’s share. Partner D, as an Illinois–resident individual, may claim a credit for its share of the withholding. If Partnership A later sells its interest in the underlying partnership, that gain is not subject to investment partnership withholding and is allocated to the partners’ state of residence or domicile.

Under prior law, Partnership A would not have been an Illinois investment partnership, and the disposition of its interest in the operating partnership would have required analysis of whether gains should be allocated as nonbusiness income or apportioned using Illinois sales factor rules.

Implications and current Issues

The expanded definition of qualifying investment securities may enable more partnerships to qualify as Illinois investment partnerships. If a partnership qualifies as an investment partnership, the treatment is not elective, and it must file as such. So, while investment partnership treatment can be beneficial, it requires additional analysis to determine whether the partnership qualifies, and if it does, such treatment comes with additional compliance obligations.

2024 new instructions require additional documentation: The department included the following provision in the 2024 Form IL–1065 instructions: “Investment partnerships must attach their federal return and any additional documentation that supports their status as an investment partnership (including a balance sheet and an organization chart showing the tiered partnership) to their Form IL–1065 or Form IL–1065–X.”

There is uncertainty regarding whether this reference to attaching a balance sheet and organizational chart is required for filing the return or whether the reference should be understood as a more general instruction to provide adequate substantiation of the position, adding further complexity.

Potential adverse impact on resident credit for taxes paid: A glitch in the way the law is currently drafted could be interpreted to prevent Illinois resident partners of an Illinois investment partnership from taking a credit against taxes paid by the investment partnership in other states on behalf of its investors for 2023 and 2024 tax years. A technical correction was considered during the 2025 spring legislative session but was not included in the final budget bill signed into law.

Is the Illinois law the beginning of a trend?

S.B. 1963 marks a notable expansion of the tax benefits associated with Illinois’s taxation of investment partnerships, although it does introduce new compliance challenges. Partnerships must carefully assess their eligibility, implement withholding processes, and stay informed about evolving state and multistate developments. By understanding and adapting to these changes, investment partnerships can navigate the complexities of Illinois tax law effectively.

The changes in Illinois may signal a broader trend in state taxation of partnerships. Indiana passed investment partnership legislation effective Jan. 1, 2026, which includes rules similar to Illinois’s (Ind. H.B. 1427 (2025)). Meanwhile, the Multistate Tax Commission drafted a white paper and is working on a model investment partnership statute, which could influence legislation in other states.

Editor

Rochelle Hodes, J.D., LL.M., is principal with Washington National Tax, Crowe LLP, in Washington, D.C.

For additional information about these items, contact Hodes at Rochelle.Hodes@crowe.com.

Contributors are members of or associated with Crowe LLP.