On June 7, 2023, Illinois Gov. J.B. Pritzker signed into law P.A. 103-0009 (SB 1963), which, among other things, modifies the definition of “investment partnership” and requires investment partnerships to withhold tax on Illinois-sourced income allocated to its nonresident partners. The new investment partnership definition is intended to permit private equity funds to invest in operating businesses classified as pass-through entities without causing the private equity funds to lose their status as investment partnerships. The effect of the new law is to impose a “withholding tax” on the Illinois source income that is passed through from an operating partnership to an investment partnership, without imposing tax or a tax filing obligation on the investors in the investment partnership. While the new rules are intended to benefit private equity funds, they impact all investment partnerships to the extent they invest in partnerships that generate Illinois source income. These changes are effective for tax years ending on or after December 31, 2023.
Background
Under prior law, investment partnerships were exempted from Illinois’ entity-level Personal Property Tax Replacement Income Tax (the Replacement Tax). Income of an investor in an investment partnership was generally treated as nonbusiness income sourced to the residence or commercial domicile of the investor. An investment partnership was defined as any entity that is a partnership for federal income tax purposes and meets the following requirements:
- No less than 90% of the partnership’s cost of its total assets consists of qualifying investment securities, deposits at banks or other financial institutions, and office space and equipment reasonably necessary to carry on its activities as an investment partnership;
- No less than 90% of its gross income consists of interest, dividends, and gains from the sale or exchange of qualifying investment securities (hereinafter referred to as the “gross income requirement”); and
- The partnership is not a dealer in qualifying investment securities.
“Qualifying investment securities” included investments in partnerships that were themselves qualifying investment partnerships.
New Law
For tax years ending on or after December 31, 2023, P.A. 103-0009 expands the definition of an investment partnership by modifying the gross income requirement and the definition of a “qualifying investment security.” A “qualifying investment security” now includes any partnership interest that “in the hands of the partnership, qualifies as a security within the meaning of subsection (a)(1) of Subchapter 77b of Chapter 2A of Title 15 of the United States Code.” The new gross income requirement provides that no less than 90% of an investment partnership’s gross income can consist of “interest, dividends, gains from the sale or exchange of qualifying investment securities, and the distributive share of partnership income from lower-tier partnership interests meeting the definition of qualifying investment security ....” (new language emphasized). A partnership that qualifies as an investment partnership must withhold tax from its nonresident partners based on the amount of business and nonbusiness income that would have been allocated to Illinois if not for the new gross income requirement. There is no exception to this withholding obligation. There is, however, no requirement that a partner in such an investment partnership file a return, and no ability of the partner to claim a credit, unless the income from the investment is business income in the hands of the partner.
Considerations for Taxpayers
The new gross income requirement expands the definition of an investment partnership, thereby exempting from the entity-level Replacement Tax much or all of the income of many private equity funds that would not have otherwise qualified for the exemption under prior law due to their investments in operating partnerships. The modification to the withholding rules, however, requires an investment partnership to withhold from its nonresident partners the investment partnership’s distributive share of income that is sourced to Illinois. Because the nonresident partners are not required to file returns and generally not entitled to a credit for the withholding tax paid by the partnership, the “withholding” rule in effect imposes the personal income tax on the partnership. Managers of investment funds will need to give careful consideration to whether such a Replacement Tax should be treated as an expense of the fund, or as a tax incurred on behalf of the fund’s investors, under the terms of the fund documents.
It is our understanding that the new rule was intended to exempt an investment partnership and its nonresident partners from tax on gains from the sale of portfolio companies. The way the legislation is drafted, however, it exempts that income only upon the sale of the partnership interest itself; it does not exempt gain when the portfolio company sells all or a portion of its assets and distributes the proceeds to the investment partnership. Thus, if an investment partnership owns interests in a lower-tier operating partnership and the operating partnership sells all or a portion of its assets and distributes the proceeds to the investment partnership, any Illinois source gain from the asset sale flows through to the investment partnership and is subject to the new withholding rules with respect to its nonresident partners.
