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Illinois Ends Deduction for Reasonable Compensation Paid to Partners

On July 16, 2009, Illinois Governor Pat Quinn signed SB 1912 into law, which ends the deduction for the greater of personal service income or a reasonable allowance for the compensation of partners on Illinois partnership returns for tax years ending on or after December 31, 2009. To soften the blow of this change, the bill also contains a provision that ends the requirement for partnerships to add back their federally deductible guaranteed payments.

Historically, Illinois has disallowed the federal deduction of guaranteed payments paid to partners in the calculation of Illinois replacement tax. In an effort to level the playing field for service providers who typically have large guaranteed payments, the state introduced a deduction for the greater of personal service income or a reasonable allowance for compensation of partners.

The definition of personal service income is spelled out in a now defunct section of the Internal Revenue Code (IRC Section 1348(b)(1)). However, the definition of a reasonable allowance for compensation of partners is far more ambiguous. It is defined by Illinois as "a reasonable allowance for compensation paid or accrued for services rendered by partners to the partnership" (IITA Section 203(d)(2)(H)). Illinois has not set forth specific methods for calculating the amount and there is no corresponding federal deduction.

Illinois is eliminating the deduction out of concern that it is being abused. The state has taken issue with partnerships where partners perform very few personal services, but take large deductions for the reasonable allowance for compensation of partners. The subjective nature of the allowance required the state to audit a taxpayer for the purpose of questioning the deduction.

The end of the deduction eliminates a subtraction used by many Illinois partnerships. Entities with partners who provide significant services to the partnership and are not provided with guaranteed payments will be hardest hit. The elimination of the add-back of federally deductible guaranteed payments in the calculation of Illinois income will likely have little effect when combined with the elimination of the deduction for the greater of personal service income or a reasonable allowance for compensation of partners.

While the impact of these changes will be felt negatively by many taxpayers, partnerships with considerable guaranteed payments may see reduced tax burdens. As a way to reduce their Illinois replacement tax liabilities, some service partnerships may want to consider a change to their guaranteed payment structure.

Partnerships who have previously paid little to no tax in Illinois may see significantly higher tax liabilities beginning in 2009 as a result of these changes.

For more information please contact Jason Parish at jparish@BlackmanKallick.com or 312-980-2959, or your Blackman Kallick representative. Our thanks to Deb Rood for her contribution to this article.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.