Key Changes to Illinois Investment Partnership Tax Rules

For tax years ending on or after Dec. 31, 2023, Illinois has introduced several important changes to the tax treatment of investment partnerships. The new rules, implemented through Senate Bill 1963, redefine qualified investment partnerships (QIPs) and introduce withholding requirements that will impact tiered partnership structures of Private Equity (PE) and Venture Capital (VC) firms.

Below is a breakdown of the key updates and their implications.

Expanded Definition of QIPs

Illinois now offers expanded favorable treatment for partnerships that meet the criteria of a QIP:

• Qualifying Investment Securities: Illinois now includes interests in non-operating partnerships as qualifying securities under the 90% asset test. This change broadens eligibility for QIP status, potentially benefiting a wider range of partnerships.
• Income from Lower-Tier Partnerships: Income (excluding losses) from lower-tier partnerships can now count toward the 90% gross income requirement. Additionally, Illinois has eliminated the business activity test, allowing more entities to qualify as QIPs.

QIPs are not subject to the 1.5% replacement tax, and QIP partners may treat the income from the QIP as nonbusiness income allocable to their state of residence or commercial domicile.

Withholding Requirements for Nonresident Partners

QIPs are now required to withhold tax at a rate of 4.95% on Illinois-sourced income distributed to nonresident partners who are partnerships or S-corporations. The withholding rate for all other partners is based on the partner’s applicable tax rate. Withholding exemptions or waivers are not allowed. This withholding rate contrasts with the 1.5% rate applicable to non-QIP partnerships. Here’s what this means for QIPs and their nonresident partners:

• Entity-Level Tax Deduction: Withholding tax paid by QIPs is treated as an entity-level tax by the state, making it deductible on the partners’ federal tax returns. Withholding tax paid by non-QIP partnerships is still subject to the federal cap on state and local tax (SALT) deductions.
• Resident Partner Implications: Since the withholding is considered an entity-level tax, Illinois resident partners cannot include the QIP income in their credit for taxes paid to other states’ calculations, potentially leading to additional tax owed by residents.
• Nonbusiness Income Classification: QIP income is now treated as nonbusiness income on Illinois K-1-Ps. Nonresident partners who only receive QIP income and have no other Illinois-sourced income are not required to file an Illinois tax return and cannot claim the QIP withholding credit.

Requirements for Partnerships Electing PTE Tax

Even if a QIP elects to pay the Illinois pass-through entity (PTE) tax, it must still fulfill the withholding requirements on behalf of nonresident partners. The state has outlined estimated tax payment obligations for partnerships electing the PTE tax:

• Expected Liability Above $500: If a partnership electing PTE tax expects a total liability over $500 after Illinois credits and withholdings, it must make quarterly estimated payments.
• Voluntary Prepayment Option: For partnerships with lower liabilities or those not electing PTE tax, voluntary prepayments are allowed.

Partnerships may apply any excess cash payments under the QIP withholding regime to their PTE tax obligations or choose to have them refunded.

Implications for Private Equity Groups

The expansion of the QIP rules to include partnerships as qualifying investment securities will allow certain previously disqualified partnerships to be classified as investment partnerships for Illinois income tax purposes, but it also comes with several changes to the compliance process. The intent of these new rules is to allow private equity groups to invest in operating businesses functioning via the partnership (as opposed to corporation) model without losing their investment partnership status.

Additionally, there is now an entity-level withholding tax imposed on the Illinois source income that is passed through the operating business/partnership to the investment partnership without a separate tax or filing obligation on the investors in the QIP. Further, since investment partnerships are not subject to the 1.5% replacement tax, an entity that now qualifies as a QIP under this new law is no longer subject to that tax.

As a result, there could be replacement tax savings for private equity groups who own interests in operating partnerships. These new rules may also alter taxpayers’ tax compliance obligations since the Illinois filing requirement is eliminated for newly classified QIPs with Illinois-source income solely from lower-tier partnerships. Partnerships with QIP status and their partners/investors may also benefit from having income classified as nonbusiness income.

However, since the new rules require QIPs to withhold on all partners without exceptions, this will impact cash flow, even though excess cash may be refunded at a different level. Partnerships should carefully evaluate the impact of these changes, particularly the interaction of the QIP withholding and the PTE tax. The expansion of the QIP definition could create additional compliance requirements for QIPs that have historically had no withholding obligations.

Next Steps

For more information on these regulations and their potential impact on your private equity firm, connect with one of our private equity professionals.