New changes in partnership tax (96-45)

Currently, the Federal Government and most states do not tax income of partnerships, “S” corporations, and limited liability companies (LLCs) that elect to be treated as partnerships. Instead, the income is taxed after it flows through to individual partners or shareholders. Illinois has followed this practice for regular income tax purposes but does tax these entities with a “personal-property replacement-income tax.” Illinois has allowed “S” and “C” corporations to deduct compensation paid to owners, but partnerships are not allowed to do so. To treat partnerships in the same way as S and C corporations, Illinois has allowed partnerships to deduct a portion of their distributable income that represented reasonable compensation. Public Act 96-45 changes this tax policy effective for tax years ending Dec. 31, 2009 for the personal-property replacement-income tax. It limits partnerships’ deduction to “guaranteed payments” instead of “reasonable compensation.” The difficulty is guaranteed payments for federal purposes is limited to payments made regardless of the profitability of the partnership. This would generally limit the deduction to income partners because equity partners’ income is based on their share of distributable income of the partnership. Public Act 96-45 will affect personal-service partnerships such as law firms, accounting firms, private equity, and investment fund managers because almost all of the distributable income to the equity partners represents the personal services of the partners. Since these distributions cannot be categorized as guaranteed payments, the partnerships may have significant taxable income for Illinois replacement tax purposes.