Can a partnership subtract, from its Illinois Replacement Tax base, the lifetime payments it makes to a retired partner for engineering services that partner performed before retiring?

Plain-English summary

An Illinois LLC that provides engineering services to the electric power industry is treated as a partnership for federal and Illinois income tax purposes. The firm has two kinds of members: active members, who are practicing engineers and pay self-employment tax on their earnings, and retired members, who stop working and stop being members under the LLC's operating agreement, but continue to receive annual payments for the rest of their lives. Those payments are not guaranteed payments -- they are an allocation of the firm's income, deductions, and credits, reported to the retired members on federal and Illinois Schedule K-1(-P).

The company asked the Illinois Department of Revenue whether it could subtract these retired-member payments from its income when computing its Illinois personal property tax replacement income tax, relying on the subtraction modification in 35 ILCS 5/203(d)(2)(H). That provision lets a partnership subtract "personal service income," a term Illinois law defines by pointing to how the federal Internal Revenue Code defined "personal service income" in Section 1348(b)(1) as it existed on December 31, 1981 (a provision since repealed federally, but frozen in time for this Illinois cross-reference).

The Department traced the legislative history of that 1981-era federal provision, including amendments in 1976 and 1978 that extended the definition to cover pensions and annuities arising from an employer-employee relationship or from personal services previously rendered -- explicitly including payments to a retired partner for personal services performed before retirement. The Department also pointed to a 1974 IRS revenue ruling involving two licensed engineers whose partnership consulting fees qualified as this kind of earned income, and to the statutory purpose of Section 203(d)(2)(H): putting partnerships on equal footing with S corporations, which can deduct compensation and retirement payments to shareholder-employees.

Based on this analysis, the Department ruled that the company could include the retired partner's distributive share of the firm's engineering-services income in its Section 203(d)(2)(H) subtraction modification. The ruling also noted it did not matter whether the retired partner separately qualified for the individual retirement-income subtraction under 35 ILCS 5/203(a)(2)(F) -- the partnership-level subtraction and any individual-level subtraction are not mutually exclusive, just as an S corporation's deduction and a shareholder-employee's individual subtraction can coexist.

What this means for you

If you run a partnership or LLC with retired-partner payment obligations

If your partnership or LLC (taxed as a partnership) pays a retired partner or member for personal services that partner performed while still active -- structured as a share of ongoing income under a retirement arrangement rather than a fixed guaranteed payment -- this ruling supports treating that amount as personal service income under IITA Section 203(d)(2)(H). That can reduce the partnership's Illinois personal property tax replacement income tax base under IITA Section 201(c) and (d).

Why the structure of the payments matters

The ruling turned on specific facts: the retired members ceased providing services and ceased being members, the payments were an allocation of partnership income (not a guaranteed payment), and the payments continued for the retired member's life under the LLC's operating agreement. Partnerships with materially different arrangements -- for example, fixed guaranteed payments unrelated to the firm's actual income, or payments to someone who never rendered personal services to the firm -- should not assume the same result without their own analysis or ruling.

Remember this ruling binds only the requesting taxpayer

As a Private Letter Ruling, this conclusion legally binds the Department only with respect to the specific company that requested it, and only if the facts it described were complete and accurate. Other partnerships facing a similar fact pattern can look to this ruling for the Department's reasoning, but should not treat it as binding precedent for their own return positions.

Common questions

Q: What is the "subtraction modification" under IITA Section 203(d)(2)(H)?
A: It lets a partnership subtract, from the income used to compute its Illinois personal property tax replacement income tax, any income that constitutes "personal service income" as defined by reference to former IRC Section 1348(b)(1) (as in effect December 31, 1981), or a reasonable allowance for compensation for partners' services to the partnership, whichever is greater.

Q: Why does Illinois law point to a federal tax provision that was repealed decades ago?
A: The Illinois statute freezes the federal definition as it existed on December 31, 1981, even though the federal provision (which capped tax rates on personal service income) was later repealed. Illinois continues to use that historical definition purely as a reference point for what counts as "personal service income" for this state-law subtraction.

Q: Does it matter that the retired partner might also claim an individual retirement-income subtraction?
A: No. The ruling states it is irrelevant whether the retired partner separately qualifies for the individual retirement-income subtraction under 35 ILCS 5/203(a)(2)(F). The partnership can claim its Section 203(d)(2)(H) subtraction regardless, just as an S corporation's compensation deduction does not prevent a shareholder-employee from also claiming an individual subtraction.

Q: Can other partnerships rely directly on this ruling for their own returns?
A: No. A Private Letter Ruling binds the Department only as to the taxpayer who requested it, and only if the facts presented were complete and correct. Other taxpayers with similar facts can look to the reasoning here as informal guidance but would need their own ruling or independent analysis to have the same binding protection.

Citations and references

• 35 ILCS 5/203(d)(2)(H) -- partnership subtraction modification for personal service income
• 35 ILCS 5/203(a)(2)(F) -- individual subtraction for certain retirement income
• 35 ILCS 5/203(b)(1) -- S corporation starting point of federal taxable income before net operating loss deduction
• 35 ILCS 5/201(c) and (d) -- Illinois personal property tax replacement income tax
• 2 Ill. Adm. Code 1200.110 -- Private Letter Ruling procedures and binding effect
• IRC Section 1348(b)(1) (as in effect December 31, 1981) -- former federal definition of "personal service income"
• IRC Section 401(c)(2)(C) (as in effect 1981) -- referenced but found irrelevant to the analysis
• IRC Section 911(b) (as in effect December 31, 1981) -- federal definition of "earned income"
• Treasury Regulations Section 1.911-2(b)(3) -- earned income for professional occupations
• Treasury Regulations Section 1.1348-3(a)(2) -- professional fees treated as earned income
• Revenue Ruling 74-231, 1974-1 C.B. 240 -- IRS ruling on engineers' partnership consulting fees as earned income
• IT 98-0036-PLR -- prior Illinois PLR cited for the statutory purpose of Section 203(d)(2)(H)
• Public Law 91-172, Section 804 (Tax Reform Act of 1969) -- original enactment of IRC Section 1348
• Public Law 94-455, Section 302 -- 1976 amendment adding pensions/annuities to earned income
• Public Law 95-600, Section 701(x)(1) (Revenue Act of 1978) -- clarifying amendment on employer-employee pensions/annuities
• Senate Committee Report, H.R. 6715 -- legislative history cited on retired-partner payments

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/income-tax/2016.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/income-tax/2016/it-16-0001-plr.pdf

Original ruling text

IT 16-0001-PLR 7/11/2016

SUBTRACTION MODIFICATIONS

Distributive Share of income from Partnership’s engineering services business
allocated to retired partner qualifies for the subtraction modification under IITA
Section 203(d)(2)(H).
July 11, 2016

Re:

Request for Private Letter Ruling
COMPANY

Dear Xxxxx:
This is in response to your letter dated January 28, 2016 in which you request a Private
Letter Ruling on behalf of COMPANY. Review of your request for a Private Letter Ruling
indicates that all information described in paragraphs 1 through 8 of subsection (b) of 2
Ill. Adm. Code 1200.110 is contained in your request. This Private Letter Ruling will bind
the Department only with respect to COMPANY. Issuance of this ruling is conditioned
upon the understanding that COMPANY and/or any related taxpayer(s) is not currently
under audit or involved in litigation concerning the issues that are the subject of this ruling
request.
The facts and analysis as you have presented them are as follows:
COMPANY is a professional services firm that provides engineering services to
the electric power industry. COMPANY is a limited liability company (hereinafter
“LLC”) treated as a partnership for federal and Illinois income tax purposes.
COMPANY has two types of members: active and retired. The active members are
all trained engineers and most all of them practice engineering. All active members
provide services to the firm as their livelihood. They pay self-employment tax on
income received from the LLC.
Pursuant to the LLC operating agreement, upon retirement a retired member of
COMPANY ceases to be a member and ceases to provide services to the firm.
Pursuant to the LLC operating agreement, the retired members receive payments
from COMPANY on an annual basis for the remainder of their life. The income
earned by the retired members is not a guaranteed payment but is instead an
allocation of all types of income, deductions and credits earned by COMPANY. For
federal and Illinois income tax purposes, the retired partners continue to be treated
as partners for as long as they are receiving these payments. Therefore, these
payments are reported to the retired members on a federal schedule K-1 and
Illinois schedule K-1-P. These payments are not self-employment earnings under
Internal Revenue Code §1402. It is COMPANY’s understanding that the members
are not subject to Illinois income tax on these retirement payments because they
qualify for the subtraction modification under 35 ILCS 5/203(a)(2)(F).

Conclusion of the Taxpayer
For the reasons stated in our analysis below, we respectfully request the
following ruling:
That the payments to the retired members qualify for the subtraction
modification in 35 ILCS 5/203(d)(2)(H).
Analysis
In computing a partnership’s income subject to the Illinois Replacement
Tax, Illinois provides a subtraction for personal services income. 35 ILCS
5/203(d)(2)(H). The statute defines personal service income by reference
to the Internal Revenue Code (hereinafter “IRC”) section 1348 as effective
in 1981.
The Illinois statutory definition reads in whole:
Any income of the partnership which constitutes personal service income
as defined in Section 1348(b)(1) of the Internal Revenue Code (as in effect
December 31,1981) [repealed] or a reasonable allowance for compensation
paid or accrued for services rendered by partners to the partnership,
whichever is greater. 35 ILCS 5/203(d)(2)(H).
The IRC as in effect December 31, 1981 defined personal services income
as:
[A]ny income which is earned income within the meaning of section
401(c)(2)(C) or section 911(b) or which is an amount received as a pension
or annuity which arises from an employer-employee relationship or from taxdeductible contributions to a retirement plan. IRC Sec.1348(b)(1)(A).
(Emphasis added.)
Section 401(c)(2)(C) as in effect in 1981 dealt with gains from the sale of
property by an individual whose personal efforts created such property and
is irrelevant for the present analysis. Section 919(b) (as it existed in 1981)
was the definition of earned income and stated that it was amounts received
as compensation for services rendered. It did not, however, provide any
specific guidance into payments to retired members.
Section 1348 as in effect December 31, 1981, included “an amount received
as a pension or annuity which arises from an employer-employee
relationship or from tax-deductible contributions to a retirement plan.” IRC
Sec. 1348(b)(1)(A). (Emphasis added.) The legislative history and earlier
adoptions of this code section provide insight into this issue. As originally
enacted as part of the Tax Reform Act of 1969, section 1348 specifically
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excluded deferred compensation from the definition of earned income. P.L.
91-172, §804.
However, the statute was amended in 1976 to include pensions and
annuities as earned income. P.L. 94-445, §302. According to the General
Explanation of P.L. 94-455, this extension applied to pensions and annuities
that were personal services income. Id. The change was intended by
Congress to correct the situation where an individual would retire on a
pension; and, even though his or her before-tax income would fall, his or
her after-tax income would rise because he or she would lose the benefits
of the maximum tax. Id.
Section 1348 was amended again in 1978 as a clarification. The Tax
Reform Act of 1978 amended section 1348(b)(1)(A) striking out “pension or
annuity” and inserting in lieu thereof “pension or annuity which arises from
an employer-employee relationship or from tax-deductible contributions to
a retirement plan.” P.L. 95-600, §701(x)(1). The General Explanation of P.L.
95-600 further clarified the legislative intent of this provision when it stated
that personal services income was intended to include a pension or annuity
when that pension or annuity arises from a situation where personal
services were rendered either as an employee or as a self-employed
person. This clarification applied to “pensions and annuities established by
an employer for his employee (whether or not made under a qualified
pension plan) and to amounts received from H.R. 10 plans and individual
retirement accounts, annuities, and bonds.” P.L. 95-600, §701(x)(1).
The legislative history further stated that “[p]ensions or annuities that are
not connected with earned income from personal services do not qualify.
However, this amendment was not intended to deny the benefits of the
maximum tax provisions to other deferred compensation arrangements
where the compensation is ‘earned income’ within the meaning of 911(b)…
For example, payments to a retired partner where the payments are for
personal services actually performed prior to retirement are eligible for the
50-percent maximum tax rate.” P.L. 95-600, §701(x)(1).
While the 1981 version of section 1348 did not provide guidance into
whether payments to retired partners or members should be included in the
definition of personal service income, the above legislative analysis clearly
shows that it was Congress’ intent to include such payments. Therefore,
since the payments are included under section 1348 as in effect December
31, 1981, they should be deductible by the LLC under 35 ILCS
5/203(d)(2)(H).
Furthermore, the statutory purpose of 35 ILCS 5/203(d)(2)(H) supports
allowing a subtraction for retirement payments to partners. The purpose of
the subtraction modification in 35 ILCS 5/203(d)(2)(H) is to put partnerships
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on par with S corporations. IT 98-0036-PLR. For federal income tax
purposes, S Corporations are allowed to deduct salaries paid to their
shareholders for personal services rendered as employees. Likewise, S
Corporations are allowed a deduction for deferred compensation, such as
pension and retirement payments to shareholders who are employees.
These deductions enter into the computation of Illinois net income of the S
Corporation, because Illinois’ starting point in computing an S Corporation’s
Illinois Replacement Tax liability is federal taxable income before federal
net operating loss deduction. 35 ILCS 5/203(b)(1). However, partners of
partnerships cannot be employees. As a result, for federal income tax
purposes partnerships are not allowed the same deduction for payments
made to partners for their personal services. 35 ILCS 5/203(d)(2)(H) grants
partnerships a subtraction for the personal services rendered by the
partners. As a result, similarly situated partnerships and S Corporations pay
the same amount of Illinois Replacement Tax. As stated above, S
Corporations are generally allowed to deduct payments to pension plans
and retirement plans for shareholders who are employees. Therefore,
partnerships should be able to subtract similar payments.
It is irrelevant whether or not the individual partners pay Illinois Income Tax
on these retirement payments. Individuals are allowed a subtraction for
income received from certain retirement plans under 35 ILCS
5/203(a)(2)(F). Retirement payments to S Corporations shareholders who
are employees usually qualify for this subtraction, even though the S
Corporation received a deduction for the expense. Therefore, it is not
inconsistent for the partnership to receive a subtraction under 35 ILCS
5/203(d)(2)(H) for payments made to retired partners and for the retired
partner to receive a subtraction under 35 ILCS 5/203(a)(2)(F). In fact, such
treatment would be similar to the treatment of S Corporations.
Summary
35 ILCS 5/203(d)(2)(H) provides a subtraction modification to partnerships
for personal service income and in defining “personal service income”
references section 1348 of the IRC (1981). Since the intent of the Revenue
Act of 1978 which modified section 1348 as in effect in 1981 was to include
payments made to retired partners who had previously rendered services
to the partnership, COMPANY payments to retired members should qualify
for the deduction available in computing Illinois Replacement Tax liability.
Statement of Authorities Contrary to the Taxpayer’s View
The Department ruled on this issue and published guidance to COMPANY
consistent with the position stated above in a PLR dated September 22,
2004. Neither the Taxpayer nor the Taxpayer’s representatives are aware

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of any contrary rulings, cases, statutes or regulations to the position
requested in this letter.

RULING
Section 203(d)(2)(H) of the Illinois Income Tax Act (“IITA,” 35 ILCS 5/203(d)(2)(H)) allows
a partnership, for purposes of computing its personal property tax replacement income
tax under IITA Section 201(c) and (d), the following subtraction modification:
Any income of the partnership which constitutes personal service income as
defined in Section 1348(b)(1) of the Internal Revenue Code (as in effect December
31, 1981) or a reasonable allowance for compensation paid or accrued for services
rendered by partners to the partnership, whichever is greater.

Section 1348(b)(1) of the Internal Revenue Code, as in effect on December 31, 1981,
provided that “personal service income” means:
Any income which is earned income within the meaning of section 401(c)(2)(C) or
section 911(b) or which is an amount received as a pension or annuity which arises
from an employer-employee relationship or from tax-deductible contributions to a
retirement plan.
Section 911(b) of the Internal Revenue Code (as in effect on December 31, 1981)
provided:
For purposes of this section, the term “earned income” means wages, salaries, or
professional fees, and other amounts received as compensation for services
actually rendered, but does not include that part of the compensation derived by
the taxpayer for personal services rendered by him to a corporation which
represents a distribution of earnings and profits rather than a reasonable allowance
as compensation for the personal services actually rendered. In the case of a
taxpayer engaged in a trade or business in which both personal services and
capital are material income-producing factors, under regulations prescribed by the
Secretary, a reasonable allowance as compensation for the personal services
rendered by the taxpayer, not in excess of 30 percent of his share of the net profits
of such trade or business, shall be considered earned income.
Note that Section 1348(b)(1)(A) provided:
For purposes of this subparagraph, section 911(b) shall be applied without regard
to the phrase “, not in excess of 30 percent of his share of net profits of such trade
or business”.

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Regarding the Code definition of earned income, Treasury Regulations §1.911-2(b)(3)
provided as follows:
Earned income includes all fees received by a taxpayer engaged in a professional
occupation (such as a doctor or lawyer) in the performance of professional
activities. Professional fees constitute earned income even though the taxpayer
employs assistants to perform part or all of the services rendered, provided the
taxpayer’s patients or clients look to the taxpayer as the person responsible for the
services.
Treasury Regulations §1.1348-3(a)(2) provided:
The entire amount received as professional fees shall be treated as earned income
if the taxpayer is engaged in a professional occupation, such as a doctor, dentist,
lawyer, architect, or accountant, even though he employs assistants to perform
part or all of the services, provided that the patients or clients are those of the
taxpayer and look to the taxpayer as the person responsible for the services
performed.
In Revenue Ruling 74-231, 1974-1 C.B. 240, the Service ruled that the professional fees
of a partnership derived from consulting services performed by its partners, both of whom
were licensed engineers, qualified as earned income within the meaning of former IRC
Section 1348(b)(1). As your letter points out, the legislative history of the Tax Reform Act
of 1978 makes clear that income qualifying as earned income under this provision does
not lose that characterization in the case of a retired partner whose share of partnership
income is received under a retirement plan maintained for retired partners. See Senate
Committee Report, H.R. 6715. Therefore, COMPANY may include in its subtraction
modification under IITA Section 203(d)(2)(H) the distributive share of the income from the
partnership’s engineering services business allocated to a retired partner pursuant to the
COMPANY retirement plan for retired partners.
This ruling shall bind the Department as provided herein. The facts upon which this ruling
is based are subject to review by the Department during the course of any audit,
investigation or hearing and this ruling shall bind the Department only if the material facts
as recited and incorporated in this ruling are correct and complete. This ruling shall bind
the Department for all taxable years, except as limited pursuant to 2 Ill. Adm. Code
1200.110(d) and (e).This ruling will cease to bind the Department if there is a pertinent
change in statutory law, case law, rules or in the material facts recited in this ruling.
Sincerely,

Brian L. Stocker
Chairman, PLR Committee (Income Tax)

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