Illinois enacts changes to qualifying investment partnerships: PwC

Illinois enacts changes to qualifying investment partnerships

June 2023

In brief

Enacted on June 7, S.B. 1963 makes several changes that affect investment partnerships. Like several other states, Illinois provides favorable tax treatment to qualifying investment partnerships (QIP). For example, an entity that qualifies as a QIP is not subject to replacement tax.

S.B. 1963 amends the definitions of “investment partnership” and “qualifying investment securities’’ and expands two qualifying tests. The 90% asset test now includes partnerships as a qualifying security, and the 90% income test now includes partnership income from lower-tier partnership interests as qualifying income. The legislation also now requires QIPs to report and withhold Illinois-sourced income on nonresidents.

These changes are effective for tax years ending on or after December 31, 2023.

In detail

Illinois provides beneficial tax treatment to entities that qualify as investment partnerships. Unlike other entities filing as a partnership, a QIP is not subject to the Illinois Replacement Tax.

Under current law, the term investment partnership means any entity that is treated as a partnership for federal income tax purposes and that meets all the following requirements:

Asset Test - 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,

Gross Income Test - No less than 90% of its gross income consists of interest, dividends, and gains from the sale or exchange of qualifying investment securities; and

Business Test - The partnership is not a dealer in qualifying investment securities.

The legislation amends the term “qualifying investment securities” to include a partnership interest that, in the hands of the partnership, qualifies as a security under 15 USC sec. 77b(a)(1).

The new legislation also provides that, for tax years ending on or after December 31, 2023, the Gross Income Test is expanded and now includes “the distributive share of partnership income from lower-tier partnership interests meeting the definition of “‘qualifying investment security.’” However, partnerships that are operating at a federal taxable loss are excluded from this definition.

Additionally, the legislation eliminates the Business Test in its entirety, thereby allowing partnerships that are dealers in qualifying investment securities to qualify as investment partnerships if they meet the asset and gross income tests.

Finally, the legislation requires partnerships to withhold Illinois-sourced income for all taxable partners (i.e., nonresident individuals, nonresident trusts, corporations, and partnerships). For QIP partnerships, the withholding rate for partnerships is 4.95%, which is the individual rate, instead of 1.5% that is required for non-QIP partnerships. In addition, QIP entities cannot accept withholding exemptions or waivers, so every taxable partner is subject to withholding.

Observation: Overall, the expansion of the QIP rules to include partnerships as qualifying and the removal of the dealer limitation will eliminate replacement tax for many partnerships. At the same time, the new law requires QIPs to withhold on Illinois-sourced income for each taxable partner without an exemption, which may impact cash flow as there could be payments required at different or more entities. However, the excess cash can be refunded and/or applied to pass-through entity taxes if an entity has nontaxable or resident partners.