A Long Time in the Making: Illinois (Finally) Proposes Draft Regulations to Clarify the Reasonable Compensation Deduction

The Illinois Income Tax Act (“Act”) allows a partnership (or an LLC taxed as a partnership) to deduct from its base income: 1) any income of the partnership which constitutes “personal services income,” as defined in Section 1348(b)(1) of the Internal Revenue Code, or 2) a “reasonable allowance for compensation” paid or accrued for services rendered by the partners to the partnership, whichever is greater. 35 ILCS 5/203(d)(2)(H).

The deduction, which is commonly claimed by real estate partnerships, engineering firms, accounting firms and law firms, has for many years been taken freely and in full by taxpayers, resulting in the zeroing out of the partnership’s base income.

Although the deduction has been in the Act since 1979, neither the General Assembly, the Department of Revenue, nor the courts have clarified the scope of the deduction or the meaning of “services rendered by partners”. The Act’s ineffectiveness is underscored by its reference to 26 USCS ? 1348, a section repealed from the Internal Revenue Code on August 13, 1981. This uncertainty has left taxpayers reeling because there has been a surge of audit activity, frequently resulting in Department auditors denying the deduction in full.

In January 2017, the Department took steps to clarify the scope of the deduction by proposing draft regulations. The draft regulations, which would be inserted at Section 100.2850, provide that the purpose of the deduction under the Act is to put partnerships on equal footing with corporations, which can deduct compensation paid to a shareholder-employee for services rendered to the corporation. Despite the admirable intention of the Department to shed light on the scope of the deduction, the regulations only seem to shine a dim flashlight on the opaque statute.

Key takeaways from the draft regulations

1. What is a “Reasonable Allowance”?

A key issue with applying the deduction is that the Act does not clarify when an amount exceeds a “reasonable allowance.” The regulations provide that in determining whether an amount claimed as a subtraction for compensation exceeds a reasonable allowance, the rules under 26 USCS ? 162(a)(1) apply. Additionally, the regulations set forth that where income of the partnership is allocated to partners in such amounts as to result in a satisfactory return on partnership capital, there will be a rebuttable presumption that any remaining income allocated to the partners for services actually provided to the partnership is a reasonable allowance deductible under the Act. In other words, if the partnership’s payment of salaries to shareholder employees results in insufficient funds available for a return of partnership capital, the payments are actually distributions of earnings and are therefore not deductible.

2. Little New Guidance for Deducting Personal Services Income

The regulations provide no practical new guidance for applying the personal services income deduction. Rather, the regulations merely repackage and reiterate the definitions of “personal service income” and “earned income” provided by 25 USCS ? 401(c)(2)(C) or 26 USCS ? 911(b), as in effect on December 31, 1981. The regulations do, however, clarify that the deduction for personal services income may only consist of that portion of the taxable income of the partnership that constitutes earned income from a trade or business. The Department’s concern is that if the deduction is applied to the partnership’s gross income, rather than its taxable income, a partnership would be able to convert taxable passive income into tax-exempt earned income. Accordingly, where a partnership incurs a loss from a trade or business, it cannot claim a subtraction with respect to any personal services income resulting from the trade or business.

Result

Despite the efforts of the Department to clarify the applicability of the deduction, the proposed regulations fail to set forth clear and concise meanings for either a “reasonable allowance for compensation paid” or for “personal service income”. Although taxpayers should plan for the potential adoption of the proposed regulations, they should not expect the regulations to resolve the ambiguity of the Act that has caused the recent upswing of audit activity.