On June 7, 2023, Illinois Gov. J.B. Pritzker signed the Revenue Omnibus Act, Senate Bill (SB) 1963 (Public Act 103-0009), into law. The legislation makes several tax changes impacting investment partnerships and more.
Like many other states, Illinois provides favorable tax treatment to qualifying investment partnerships (QIPs). Under Illinois law, investment partnerships are not subject to the entity-level replacement tax, and their partners treat the income as nonbusiness income allocable to their state of residence or commercial domicile.
For tax years ending before December 31, 2023, the definition of an investment partnership requires that the partnership not be a dealer in a qualifying security (the Business Test), no less than 90% of the partnership’s cost of its total assets consist of qualifying investment securities (the Asset Test), and no less than 90% of the partnership’s gross income be from qualifying investment securities (the Gross Income Test). Under this definition, many partnerships that are partners in lower-tier partnerships are unable to satisfy the three tests because of the flow-up of the lower-tier partnership operating activities.
Under SB 1963, for tax years ending on or after December 31, 2023, the definition of a qualifying investment security, for purposes of determining whether a partnership is an investment partnership, is updated to include a partnership interest if it qualifies, in the hands of the partnership, as a security within the meaning of 15 USC (U.S. Code) Section 77b(a)(1).
The updated definition of an investment partnership under SB 1963 does not change the Asset Test (as defined above) but modifies the Gross Income Test to require that no less than 90% of the investment partnership’s gross income is from qualifying investment securities and the distributive share of partnership income from lower-tier partnership interests meets the definition of qualifying investment security (gross income does not include income from a partnership operating at a federal taxable loss). The Business Test is eliminated in its entirety.
Nonresident Withholding Requirements
Along with the update to the definition of investment partnership, new language was added to the nonresident withholding requirements of 35 ILCS (Illinois Compiled Statutes) 5/709.5. For tax years ending on or after December 31, 2023, an investment partnership must withhold tax from each taxable nonresident partner based on the amount of business income that would be apportioned to Illinois and nonbusiness income that would be allocated to Illinois, if not for the modification of the investment partnership definition. Investment partnerships are not allowed to accept withholding exemptions or waivers.
If the partner is a partnership or a subchapter S corporation, the applicable tax rate is the individual tax rate of 4.95%, rather than the entity’s applicable replacement tax rate of 1.5%, which is required for non-QIP partnerships. The withholding for all other partners is based on the partner’s applicable tax rate.
In general, partnerships that previously qualified as investment partnerships under the historic provisions will likely not see a change to their withholding requirements. Any excess funds withheld can be refunded and/or applied to pass-through entity taxes if the entity has nontaxable or resident partners.
The expansion of the QIP rules to include partnerships as qualifying and the removal of the dealer limitation will likely eliminate replacement tax for partnerships.
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