What Is a Pass-Through Entity Tax in Illinois? A Full Guide.

As Naperville income tax preparers and strategic advisors, at Elder Hanson & Company, Ltd. we often field questions about complex tax topics. One area that frequently causes confusion is pass-through entity taxation, particularly in light of recent changes in Illinois. This comprehensive guide demystifies pass-through entity taxes and explains their implications for Illinois businesses and individuals.

Understanding Pass-Through Entities

Before diving into the specifics of pass-through entity taxes, it’s crucial to understand what a pass-through entity is and how it typically functions for tax purposes.

What Is a Pass-Through Entity & What Is Pass-Through Income?

A pass-through entity, also known as a flow-through entity, is a type of business structure where the company’s income “passes through” to the owners or shareholders. Instead of the business itself paying corporate income taxes, the profits and losses are reported on the individual income tax returns of the owners, who then pay taxes at their personal income tax rates.

This taxation method contrasts with that of C corporations, which are subject to corporate income tax at the entity level, and then shareholders are taxed again on dividends received, leading to what’s often referred to as “double taxation”.

Common Types of Pass-Through Entities

Several business structures fall under the pass-through entity umbrella:

1. Sole Proprietorships

The simplest form of business entity, where there’s no legal distinction between the owner and the business.

2. Partnerships

Business entities owned by two or more individuals or entities. There are two main types:

• General partnerships: All partners share in the management and liability of the business.
• Limited partnerships: Have at least one general partner who manages the business and assumes liability, and one or more limited partners who are typically just investors.

3. Limited Liability Companies (LLCs)

LLCs in Illinois, provide liability protection and allow for flexibility in choosing the IRS income tax entity classification. An LLC in Illinois that is owned by one member could choose to be taxed as a sole proprietor or C corporation. Conversely, an LLC in Illinois that is owned by two or more members could choose to be taxed as an S corporation, partnership or C corporation.

4. S-Corporations

As well as LLCs — S-Corporations electing to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.

Each of these entity types has its own unique characteristics, but they all share the common feature of pass-through taxation.

How Pass-Through Taxation Works

In a traditional pass-through taxation model:

1. The business calculates its net income for the year.
2. This income is then allocated to the owners based on their ownership percentage or agreement.
3. Each owner reports their share of the business income on their personal income tax return.
4. The income is taxed at the individual’s personal income tax rate.

This system allows businesses to avoid the double taxation that C corporations face, where profits are taxed at both the corporate and individual levels.

Pass-Through Entity Tax in Illinois

Illinois introduced its pass-through entity tax (PTET) option in 2021, effective for tax years beginning on or after January 1, 2022. This new tax regime allows eligible pass-through entities to elect to pay tax at the entity level instead of passing the income through to their owners.

The Illinois PTET was designed to help Illinois businesses and their owners mitigate the impact of the federal SALT deduction cap while maintaining the state’s tax revenue.

How the Illinois PTET Works

Under the Illinois PTET system:

1. The pass-through entity elects to pay tax on its income at the entity level.
2. The entity pays tax at a rate equal to the highest individual income tax rate in Illinois (currently 4.95%).
3. The entity’s owners receive a credit on their individual Illinois tax returns for their share of the tax paid by the entity.
4. The owners can then claim a deduction on their federal tax returns for their share of the state tax paid by the entity, effectively bypassing the SALT deduction cap.

This system effectively converts what would have been a non-deductible personal state income tax payment (due to the SALT cap) into a fully deductible business expense.

Eligibility for Illinois PTET

Not all pass-through entities are eligible for the Illinois PTET. Eligible entities include:

• Partnerships
• S Corporations
• Multi-member LLCs taxed as a partnership or as an S corporation

Single-member LLCs and sole proprietorships are not eligible for the PTET election. This exclusion is because these entities are disregarded for federal tax purposes, and thus cannot achieve the desired tax treatment under the PTET regime.

Making the PTET Election

The election to pay the pass-through entity tax in Illinois:

• Must be made annually.
• Is irrevocable for the tax year.
• Requires consent from all owners.
• Must be made by the due date of the entity’s tax return (including extensions).

It’s important to note that the election is made on an annual basis. This flexibility allows businesses to reassess their tax situation each year and determine whether the PTET election continues to be beneficial.

Estimated Payments and Reporting

Entities that elect to pay the PTET are required to make estimated payments throughout the tax year. These payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of the taxable year.

For calendar year taxpayers, this means payments are due on:

• April 15
• June 15
• September 15
• December 15
  

Proper planning and cash flow management are crucial to meet these payment deadlines.

State-by-State Comparison

While many states have introduced PTET options, the specifics vary widely. Here’s a comparison of PTET provisions in Illinois and some neighboring states for tax year 2024:

For businesses with multi-state operations, the decision to elect PTET in one state could have ripple effects on their tax situation in other states.

Emergence of Pass-Through Entity Taxes

The concept of pass-through entity taxes gained prominence following the Tax Cuts and Jobs Act (TCJA) of 2017. This landmark legislation made significant changes to the U.S. tax code, including the introduction of a $10,000 cap on the state and local tax (SALT) deduction that individuals can claim on their federal tax returns.

Before the TCJA, taxpayers who itemized deductions could deduct the full amount of state and local taxes paid from their federal taxable income. This included state and local income taxes, real estate taxes, and personal property taxes. The deduction was especially valuable for residents of high-tax states.

Impact on High-Tax States

The SALT deduction cap particularly affected residents of high-tax states, including Illinois. It effectively increased the federal tax burden for many taxpayers in these states, as they could no longer fully deduct their state and local taxes on their federal returns.

For example, consider a taxpayer in Illinois who pays $15,000 in state income taxes and $10,000 in property taxes. Before the TCJA, they could deduct the full $25,000 on their federal return. Under the new law, their deduction is limited to $10,000, potentially increasing their federal taxable income by $15,000.

This change was especially impactful for high-income individuals and owners of successful pass-through businesses in states with high income tax rates.

State-Level Responses

In response to the SALT deduction cap, several states, including Illinois, have introduced pass-through entity tax (PTET) options. These new tax structures are designed to provide a workaround to the federal SALT deduction limit for owners of pass-through entities.

The basic idea behind these PTET regimes is to shift the tax burden from the individual owners (where deductions are limited) to the business entity (where deductions are not capped). This shift allows the state taxes to be fully deductible for federal purposes, as they’re treated as a business expense rather than an individual SALT deduction.

Advantages of the Pass-Through Entity Tax

There are many upsides, including:

1. Federal Tax Benefits

The main advantage of electing to pay the pass-through entity tax is the potential for significant federal tax savings. By shifting the state tax burden to the entity level, owners can effectively deduct state taxes that would otherwise be limited by the SALT cap on their individual returns.

For high-income taxpayers or those with substantial state tax liabilities, this can result in considerable federal tax savings.

2. State Tax Credits

In addition to the federal tax benefits, Illinois provides a credit to the owners of pass-through entities that elect to pay the PTET. This credit ensures that the owners aren’t double-taxed on the same income at the state level.

The credit is refundable, meaning that if the credit exceeds the owner’s Illinois income tax liability, the excess will be refunded to the taxpayer.

3. Potential for Increased Deductions

For some businesses, the PTET election may result in a larger overall deduction than would be available under the traditional pass-through taxation model, even without considering the SALT cap.

This is because the PTET is deducted at the entity level before income is allocated to the owners, potentially reducing the overall taxable income passed through to the owners.

Considerations and Potential Drawbacks

There are a few things to keep in mind:

1. Complexity

The PTET adds a layer of complexity to tax planning and compliance. Businesses need to carefully evaluate whether the potential benefits outweigh the additional administrative burden.

This complexity includes:

• Understanding the interplay between federal and state tax laws.
• Managing cash flow for entity-level tax payments.
• Coordinating between entity and individual tax filings.
• Navigating potential changes in tax laws or IRS interpretations.

2. Cash Flow Implications

Electing to pay tax at the entity level may impact a business’s cash flow, as the entity will need to make estimated tax payments throughout the year. This can be especially challenging for businesses with uneven cash flows or those that typically distribute most of their income to owners.

Businesses need to carefully consider their cash flow projections and distribution policies when deciding whether to make the PTET election.

3. Interaction with Other Tax Provisions

The PTET election can interact with other tax provisions in complex ways. For example, it may affect the calculation of the qualified business income deduction under Section 199A of the Internal Revenue Code.

Other potential interactions include:

• Impact on the basis of owner’s interest in the entity.
• Effect on passive activity loss limitations.
• Implications for foreign tax credits.

Given these potential interactions, it’s crucial to conduct a comprehensive analysis of all relevant tax provisions before making the PTET election.

4. Multi-State Considerations

For businesses operating in multiple states, the decision to elect PTET in Illinois may have implications for their tax situation in other states. Be sure to consider the overall tax picture across all jurisdictions.

Factors to consider include:

• Whether other states where the business operates offer similar PTET regimes.
• How other states treat the Illinois PTET for credit purposes.
• The potential for double taxation if credits are not available in all relevant states.

5. Uncertainty and Future Tax Law Changes

While the IRS has generally been accepting of state PTET regimes, there is always the possibility of future challenges or changes in interpretation. Additionally, future changes to federal or state tax laws could impact the benefits of PTET elections.

Businesses should stay informed about potential tax law changes and be prepared to adjust their strategies as needed.

Making the Decision: Is PTET Right for Your Business?

Deciding whether to elect the pass-through entity tax requires careful consideration of several factors:

1. The total state and local tax liability of the entity’s owners: How much do the owners currently pay in state and local taxes? How much of their SALT deduction is currently limited by the $10,000 cap?
2. The federal tax brackets of the owners: Higher-bracket taxpayers generally benefit more from the PTET election due to the greater value of deductions at higher tax rates.
3. The entity’s profitability and cash flow situation: Can the business manage the cash flow requirements of making entity-level tax payments? How might the PTET election affect distributions to owners?
4. The administrative capacity to handle additional tax compliance requirements: Does the business have the resources to manage the additional complexity of PTET compliance? Are there additional costs (e.g., professional fees) associated with making the election?
5. The long-term tax planning goals of the business and its owners: How does the PTET election fit into the overall tax strategy of the business and its owners? Are there anticipated changes in the business or ownership structure that could affect the benefits of the PTET election?
6. Multi-state operations: How will the PTET election in Illinois affect the business’s tax situation in other states? Are there opportunities to make PTET elections in multiple states?
7. Potential future tax law changes: How might potential changes to federal or state tax laws affect the benefits of the PTET election? Is the business prepared to adapt its strategy if tax laws change?

This decision is complex, so it’s crucial to work with tax professionals who can analyze your specific situation and provide tailored advice along the way.

Discover the Benefits of Professional Tax Advice

At Elder Hanson & Company, Ltd., our Naperville income tax preparation and planning services are designed to help businesses navigate complex tax decisions like the pass-through entity tax election.

Our team of experienced CPAs and strategic advisors can:

• Analyze your business structure and tax situation.
• Model the potential impact of a PTET election on your overall tax liability.
• Assist with compliance requirements if you choose to elect PTET.
• Provide ongoing tax planning advice to optimize your tax position.

Don’t navigate the complexities of pass-through entity taxation alone — reach out to us today for professional, personalized tax advice tailored to your unique business needs.