On June 7, 2023, Illinois enacted Senate Bill (S.B.) 1963 to expand the rules for determining whether an entity qualifies as an investment partnership and instituted a new investment partnership withholding tax. Both changes are effective for tax years ending on or after Dec. 31, 2023. On July 26, 2024, Illinois adopted final regulations to implement S.B. 1963.
Because the new treatment of investment partnerships is effective beginning with the 2023 tax year and the final regulations were published this summer, Illinois investment partnership reporting could be challenging for taxpayers that already completed their returns or are in the middle of return preparation.
Background
Generally, an Illinois investment partnership is an entity treated as a partnership for federal income tax purposes that is not a dealer in qualifying investment securities and that satisfies the following requirements:
- Asset test: At least 90% of the partnership’s costs of its total assets consist of qualifying investment securities, deposits at banks or other financial institutions, or office space and equipment reasonably necessary to carry on its activities as an investment partnership.
- Gross income test: At least 90% of the partnership’s gross income consists of interest, dividends, and gains from the sale or exchange of qualifying investment securities.
For this purpose, qualifying investment securities include common stock, bonds, debentures and other debt securities, derivatives, and a partnership interest in another partnership so long as the other partnership is an investment partnership.
It can be beneficial for an Illinois partnership to qualify as an investment partnership. An investment partnership is not subject to Illinois’ 1.5% partnership entity income tax, and taxable income distributable to a nonresident partner is treated as nonbusiness income allocated to the nonresident partner’s state of residence or commercial domicile. Additionally, prior to the new law, an investment partnership did not have a withholding tax obligation with respect to its nonresident partners.
Investment partnerships under the new law
Under S.B. 1963, for tax years ending on or after Dec. 31, 2023, the term “qualifying investment securities” includes a partnership interest that qualifies as a security under federal law. The new Illinois law also removes the provision that prohibits investment partnerships from being dealers in qualifying investment securities.
Additionally, starting with the tax year ending Dec. 31, 2023, investment partnerships are required to withhold and remit tax for nonresident partners on Illinois-sourced income flowing up from operating partnerships. There is no exemption from the investment partnership withholding tax. However, nonresident partners that are exempt from tax under IRC Section 501(a) or the Illinois Income Tax Act (IITA) Section 205 and retired partners are not subject to the investment partnership withholding tax to the extent that partner’s distributions are exempt under IITA Section 203(a)(2)(F).
A nonresident individual partner may not claim a credit for investment partnership withholding unless the income from the investment is business income in the hands of the partner. However, there is no requirement for the nonresident individual partner to file an Illinois return merely because the individual is a partner in an Illinois investment partnership.
The new investment partnership withholding rules do not change the requirement for an operating partnership to withhold at that level.
Impact on private equity groups
Allowing an interest in a partnership that is not an investment partnership to be treated as a qualifying investment security is likely to significantly expand the number of partnerships that can qualify as an investment partnership and avoid the Illinois 1.5% partnership entity income tax. For example, PEGs no longer will be disqualified from investment partnership treatment if they own an interest in a partnership that is not an investment partnership. Additionally, nonresident partners of a qualifying PEG will be able to treat gain from the disposition of a partnership interest as nonbusiness income, although they will be subject to the new investment partnership withholding tax on Illinois-sourced income from the operating partnership.
The concept of an Illinois investment partnership has been a part of Illinois law for many years. Before the 2023 law change, only proceeds from the sale of securities such as stocks, bonds, and various other securitized investments were exempt. No prior statutory basis existed for exempting the proceeds from the sale of an operating partnership from Illinois tax.
Crowe observation
While there are a number of incidental changes to how investment partners are taxed on their Illinois allocated and apportioned operating profits, the new law should have the effect of exempting nonresident investors from Illinois taxation on the gains from the sale of private equity portfolio companies.
Looking ahead
For 2023, an understanding of new treatment is critical because many partnerships that had not previously qualified as an investment partnership might now qualify due to the expanded definition of qualifying investment securities. Additionally, new and established investment partnerships with nonresident partners are subject to new withholding requirements.
The new Illinois law and regulations are expected to introduce many complications into 2023 Illinois partnership compliance, including evaluating whether a partnership meets the asset test and gross income test to qualify as an investment partnership; complying with new withholding requirements with respect to nonresident partners; preparing the new Schedule K-1-P(4), “Investment Partnership Withholding Calculation for Nonresident Partners,” which is required to be prepared by investment partnerships with tax years ending on or after Dec. 31, 2023; and understanding the interplay between the new form and existing Schedules B, “Interest and Ordinary Dividends,” and K-1-P.
Given the fast-approaching 2023 Illinois partnership return filing deadline, taxpayers should consult with their tax advisers now about additional information and analysis that might be needed, including information from lower tiered partnerships.
