Change in taxation of personal-service income

There is an effort underway during October's veto session in Springfield  to repeal part of a recently enacted budget bill (Public Act 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 the PPRT. (Personal-Property Replacement-Income Tax.) This tax was meant to be a replacement for the property tax revenue lost by municipalities when the tax on personal property was repealed in the 1980s. The municipalities receive the revenue generated by the PPRT. Illinois has allowed “S” and “C” corporations to deduct compensation paid to owners, but partnerships were 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. In calculating the tax base for the PPRT, partnerships that generate their income through the personal services of its partners and employees (like law firms) are allowed a deduction for the profits of the partnership distributed to the partners (both equity and stipend) so that their PPRT tax base is essentially zero. This deduction was meant to parallel the compensation deduction allowed to C and S corporations in arriving at the PPRT tax base. Public Act 96-45 changes this tax policy effective for tax years ending Dec. 31, 2009 for the PPRT. 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 the 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 now have significant taxable income for Illinois replacement tax purposes.