Can a corporation subtract a refund of out-of-state taxes from its federal taxable income when computing Illinois base income?

Plain-English summary

A corporation ("COMPANY, Inc.") wrote to the Illinois Department of Revenue after the Department made a change to its 2013 Illinois corporate income tax return (Form IL-1120). On that return, COMPANY had subtracted $968,404.00 on Schedule M, Line 33 as an "Other Subtraction" from its federal taxable income base. The money came from refunds COMPANY received from New York City in 2013, relating to overpayments of taxes from prior years (2008-2010). Because no receivable had been booked for these refunds in advance, they were recorded as income and included in COMPANY's 2013 federal taxable income. COMPANY argued the refunds shouldn't be taxable in Illinois because it didn't register to do business in Illinois until March 27, 2013, and during the refund years it had no employees or real property in Illinois and had never filed an Illinois return or taken any related tax deductions there.

The Department explained that under Section 203(b) of the Illinois Income Tax Act (35 ILCS 5/203), a corporation's Illinois "net income" starts with its federal taxable income, which is then adjusted by specific addition and subtraction modifications to reach "base income," which in turn is apportioned to Illinois. Section 203(h) states that no modification to taxable income is allowed unless it is expressly provided for in Section 203. Because there is no provision in Section 203 allowing a subtraction simply because income is not allocated or apportioned to Illinois, Schedule M does not (and properly should not) provide a line for that kind of subtraction.

The Department characterized COMPANY's real argument as being about apportionment, not about a subtraction modification. Under Section 1501(a)(1) of the Illinois Income Tax Act (35 ILCS 5/1501), "business income" is income treated as apportionable business income under the U.S. Constitution, net of allocable deductions. A federal income tax deduction for state or local taxes on business income is a deduction allocable to that business income, so a taxable refund of such taxes is itself business income - which, under Section 304(a) (35 ILCS 5/304), is apportioned to Illinois using the same sales-factor formula as the company's other business income for the year.

Because the ordinary apportionment rules would sweep the refund into Illinois' apportionment base, the Department pointed COMPANY toward the one avenue that could exclude the refund: Section 304(f) of the Illinois Income Tax Act, which allows a taxpayer to petition (or the Director to permit or require) an alternative apportionment method - such as separate accounting, excluding a factor, adding a factor, or another equitable method - when the standard rules don't fairly represent the taxpayer's business activity or market in Illinois. Since COMPANY had already filed its 2013 return, the Department noted that under 86 Ill. Adm. Code Section 100.3390(e)(2), any such petition would need to be filed along with an amended return applying the requested alternative method.

What this means for you

Subtraction modifications are narrow and must be explicit

Illinois only allows a subtraction from federal taxable income if it is expressly listed in Section 203 of the Illinois Income Tax Act. You cannot subtract income simply because you believe, as a factual or policy matter, that it "shouldn't" be taxed by Illinois. If there's no specific subtraction modification on point, Schedule M is not the right mechanism - even for income tied to a period before you did business in the state.

Apportionment, not subtraction, is the right lever for out-of-state income

If your argument is really that certain business income (such as a refund of taxes on business income) isn't fairly attributable to Illinois, the correct tool is Illinois' apportionment framework, not a Schedule M subtraction. A taxable refund of state or local income taxes on business income is itself treated as business income and is apportioned using the standard sales-factor formula unless you successfully petition for an alternative method.

Alternative apportionment requires a petition, potentially with an amended return

If you believe standard apportionment doesn't fairly represent your business activity or market in Illinois, Section 304(f) of the Illinois Income Tax Act lets you petition the Department for an alternative method (separate accounting, excluding or including specific factors, or another equitable approach). The procedures are in 86 Ill. Adm. Code Section 100.3390. If you've already filed the return in question, the petition must be submitted with an amended return applying the alternative method you're requesting.

Common questions

Can a corporation subtract a refund of out-of-state taxes from its federal taxable income on the Illinois return?
No. There is no subtraction modification in Section 203 of the Illinois Income Tax Act for income that a taxpayer believes is not allocable or apportionable to Illinois. Schedule M does not have - and should not have - a line for this kind of adjustment.

Why is a state tax refund treated as "business income" that can be apportioned to Illinois?
Because the original federal deduction for the state or local income tax was a deduction allocable to business income, any taxable refund of that tax is properly characterized as business income under Section 1501(a)(1) of the Illinois Income Tax Act, and so it is apportioned like the corporation's other business income for the year.

What can a taxpayer do if it believes standard apportionment doesn't fairly capture its Illinois business activity?
It may petition the Department under Section 304(f) of the Illinois Income Tax Act for an alternative apportionment method, following the procedures in 86 Ill. Adm. Code Section 100.3390. If the return in question has already been filed, the petition must accompany an amended return.

Is this letter binding on the Illinois Department of Revenue?
No. This is a General Information Letter (GIL), which provides general information but is not a statement of Department policy and is not binding, per 86 Ill. Adm. Code 1200.120(b) and (c). A taxpayer who wants a binding answer on its specific facts (and is not under audit) can request a Private Letter Ruling under 86 Ill. Adm. Code 1200.110(b).

Citations and references

• 35 ILCS 5/203 (Illinois Income Tax Act, Section 203) - computation of net income from federal taxable income; Section 203(b) starting point; Section 203(h) bar on modifications not expressly provided
• 35 ILCS 5/304 (Illinois Income Tax Act, Section 304) - apportionment of business income; Section 304(a) sales-factor apportionment; Section 304(f) alternative apportionment petitions
• 35 ILCS 5/1501 (Illinois Income Tax Act, Section 1501) - Section 1501(a)(1) definition of "business income"
• 86 Ill. Adm. Code 1200.120(b) and (c) - General Information Letters are non-binding and do not state Department policy
• 86 Ill. Adm. Code 100.3390 - procedures for petitioning for an alternative apportionment method, including Section 100.3390(e)(2) on filing with an amended return
• 86 Ill. Adm. Code 1200.110(b) - procedure for requesting a binding Private Letter Ruling

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/income-tax/2015.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/income-tax/2015/it-15-0009-gil.pdf

Original ruling text

IT 15-0009 GIL – 8/31/2015 – Subtraction Modifications – Other Rulings
No subtraction modification is allowed for refund of state taxes included in corporation’s
federal taxable income.

August 31, 2015

Re:

Subtraction for Non-Illinois Income

Dear Mr. XXXX:
This is in response to your letter dated August 12, 2015, in which you request a letter ruling. The
nature of your request and the information you have provided require that we respond with a
General Information Letter, which is designed to provide general information, is not a statement
of Department policy and is not binding on the Department. See 86 Ill. Adm. Code 1200.120(b)
and (c), which may be found on the Department's web site at www. tax.illinois.gov.
In your letter you have stated the following:
I am writing in response to the letter referenced above regarding the change made
to our 2013 COMPANY, Inc. Illinois tax return (Form IL-1120). We included the
amount $968,404.00 on Schedule M, Line 33 as an Other Subtraction from our
federal taxable income base. The facts below will describe why this income is not
taxable in the state of Illinois.
In 2013, COMPANY, Inc. received refunds from New York City relating to an
overpayment of taxes in prior years (2008 - 2010). Since there was no receivable
established for these refunds, they were recorded in our income statement and
included as a part of our 2013 Federal taxable income.
COMPANY first registered to do business in the state of Illinois on March 27,
2013. During the refund years, COMPANY did not have employees or real
property in the state of Illinois, so the company did not file a tax return in the state
of Illinois. As such, no tax deductions were taken, and the refunds included in the
2013 Federal taxable income would not be taxable in the state of Illinois.
Illinois Form IL-1120 uses Federal taxable income as a starting point on Step 2,
Line 1. When completing the 2013 Illinois Form IL-1120, we were uncertain
what line should be used to reflect non-taxable income. The adjustment may not
fall on Schedule M, Line 33, since it is not specifically described in Publication
101, but there does not seem to be another line that fits the description of nontaxable income.

Response
Under Section 203(b) of the Illinois Income Tax Act (35 ILCS 5/203), the computation of a
corporation's "net income" taxed by Illinois begins with the taxpayer's federal taxable income, as
properly computed for the taxable year. Various addition and subtraction modifications are then
made, and the resulting "base income" is then allocated and apportioned to Illinois. Section
203(h) provides that no modification may be made to taxable income unless expressly provided
in Section 203. There is no provision in Section 203 that allows a subtraction for income that is
not allocated or apportioned to Illinois, and so the Schedule M, Other Additions and Subtractions
(for businesses), properly does not allow such a subtraction.
In this case, your argument is that the refund is not properly allocable or apportionable to Illinois.
Section 304(a) of the Illinois Income Tax Act (35 ILCS 5/304) apportions business income of
nonresidents to Illinois using the sales factor. Section 1501(a)(1) of the Illinois Income Tax Act
(35 ILCS 5/1501) provides:
The term "business income" means all income that may be treated as
apportionable business income under the Constitution of the United States.
Business income is net of the deductions allocable thereto. Such term does not
include compensation or the deductions allocable thereto.
Under this definition, a federal income tax deduction for state or local income taxes imposed on
business income of a corporation would be a deduction allocable to business income, and any
taxable refund of that tax would properly be characterized as business income. As business
income, the refund would be apportioned to Illinois in the same manner and to the same extent as
the taxpayer’s other business income for the taxable year.
Section 304(f) of the Illinois Income Tax Act provides:
If the allocation and apportionment provisions of subsections (a) through (e) and
of subsection (h) do not, for taxable years ending before December 31, 2008,
fairly represent the extent of a person's business activity in this State, or, for
taxable years ending on or after December 31, 2008, fairly represent the market
for the person's goods, services, or other sources of business income, the person
may petition for, or the Director may, without a petition, permit or require, in
respect of all or any part of the person's business activity, if reasonable:
(1) Separate accounting;
(2) The exclusion of any one or more factors;
(3) The inclusion of one or more additional factors which will fairly
represent the person's business activities or market in this State; or
(4) The employment of any other method to effectuate an equitable
allocation and apportionment of the person's business income.
If your assertion that the refund is not properly taxable by Illinois is correct, the solution would
be to file a petition to be allowed to use an alternative apportionment method or to separately
account for that refund. The procedures for filing a petition are contained in 86 Ill. Adm. Code
Section 100.3390, which can be found at:
http://www.ilga.gov/commission/jcar/admincode/086/086001000M33900R.html

Since COMPANY has already filed its return for 2013, Section 100.3390(e)(2) provides that the
petition should be filed with an amended return applying the alternative apportionment method
requested. If you have any questions regarding the filing of a petition, you may contact me at
(217) 524-3951 or at [email protected].
As stated above, this is a general information letter which does not constitute a statement of
policy that applies, interprets or prescribes the tax laws, and it is not binding on the Department.
If you are not under audit and you wish to obtain a binding Private Letter Ruling regarding your
factual situation, please submit all of the information set out in items 1 through 8 of Section
1200.110(b).
Sincerely,

Paul S. Caselton
Deputy General Counsel – Income Tax