{"id":2037,"date":"2019-10-14T12:41:58","date_gmt":"2019-10-14T17:41:58","guid":{"rendered":"https:\/\/illinoistax.org\/?p=2037"},"modified":"2019-10-14T13:02:56","modified_gmt":"2019-10-14T18:02:56","slug":"another-business-income-tax-primer-carol-portman","status":"publish","type":"post","link":"https:\/\/illinoistax.org\/?p=2037","title":{"rendered":"A(nother) Business Income Tax Primer – Carol Portman"},"content":{"rendered":"

A(nother) Business Income Tax Primer<\/u><\/strong><\/h3>\n

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September\/October 2019 (72.7)<\/strong><\/p>\n

By Carol Portman*<\/p>\n

This article provides a high-level summary of what income tax(es) Illinois businesses pay and how their tax liability is calculated. It is important to understand the basics in order to address the more complicated issues and concerns associated with Illinois\u2019 income taxes.\u00a0 We have also attempted to estimate how much income tax is paid by businesses.<\/p>\n

Tax on Business Income Varies by Entity Type
\n<\/u><\/strong>There is a widely held misconception that all businesses pay corporate income tax, and that individual income tax applies only to wage and personal investment income.\u00a0 The reality is more complicated.\u00a0 What tax is paid on a business\u2019s profits \u2013 whether it is corporate income tax, individual income tax, or personal property tax replacement income tax (\u201cPPRT\u201d or \u201cReplacement Tax\u201d), or some combination of the three \u2013 depends on the business\u2019s organizational structure.<\/p>\n

Businesses operate as sole proprietorships, partnerships, corporations, or limited liability companies.\u00a0 Generally speaking, Illinois taxes these business forms in the same way as the federal government, as discussed below and summarized in the table on page 3.<\/p>\n

Sole Proprietorship.<\/u>\u00a0 A sole proprietorship is not a separate legal entity; it is a business owned and run by one individual and in which there is no legal distinction between the owner and the business.\u00a0 The business\u2019s income or loss is calculated and reported by the owner on his or her individual income tax return, combining it with any other income or losses the owner might have.\u00a0 This is true at the federal and Illinois level.\u00a0 An interesting side note:\u00a0 there has been a gradual trend towards using independent contractors, instead of employees, to perform some types of work.\u00a0 As a result, what was formerly characterized as wage income is now, in some instances, paid to a sole proprietorship and characterized as business income.<\/p>\n

Partnership<\/u>.\u00a0 A partnership is a relationship between two or more persons (individuals or corporations or other partnerships) who join forces to carry on a trade or business.\u00a0 Partnerships file annual informational returns with the IRS but do not pay income tax. Instead, each partner pays tax on its share of the partnership\u2019s taxable income.\u00a0 For this reason, partnerships are referred to as \u201cpass-through\u201d or \u201cflow-through\u201d entities.\u00a0 Illinois follows the federal treatment of partnerships, subjecting the partners rather than the partnership to the regular income tax, with one significant (and unique-to-Illinois) difference: the partnership also owes PPRT as a separate entity.<\/p>\n

Corporation.<\/u> A corporation is a separate legal entity formed under state law.\u00a0 Many corporations are subject to the corporate income tax, for both Illinois and federal purposes.\u00a0 In Illinois, corporations also pay PPRT.\u00a0 When a corporation pays dividends to its shareholders, the shareholders include that dividend income in their tax base, and pay tax accordingly. (In other words, if there is no relevant deduction, that income is taxed twice, at the entity and<\/em> shareholder level.)<\/p>\n

If a corporation meets certain requirements it can elect to be taxed under Subchapter S of the Internal Revenue Code.\u00a0 An \u201cS corporation\u201d becomes a pass-through entity, similar to a partnership: there is no entity-level taxation and the individual shareholders include their distributive share of corporate profits, losses, etc. on their own returns.\u00a0 Illinois, like most states, respects the federal S corporation election, but as with partnerships, also subjects the S Corporation to entity-level PPRT.\u00a0 (Corporations that do not make the S election are sometimes called \u201cC Corporations\u201d because they pay tax pursuant to Subchapter C of the Internal Revenue Code.)<\/p>\n

Limited Liability Company.<\/u>\u00a0 A limited liability company, or LLC, is a legal entity that can be taxed like any of the other entity types, depending on the number and nature of owners and the elections filed with the IRS.\u00a0 Illinois follows the federal characterization of LLCs, and the discussions herein of sole proprietorships, partnerships, C corporations and S corporations apply to LLCs falling into those classifications.<\/p>\n

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Entity choices have changed over the years
\n<\/u><\/strong>Given the double taxation that occurs when dividends are taxed and the traditionally higher federal and state corporate income tax rates, businesses have increasingly organized in forms other than C corporations, as shown in the chart below.<\/p>\n

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Multi-state Business Taxation\u2014the Basics
\n<\/u><\/strong>No matter what type of entity, a business that operates solely in Illinois pays Illinois income tax (directly or through its partners or shareholders) on 100% of its taxable income.\u00a0 Multi-state businesses with operations in several states, however, must answer two questions: can Illinois tax the business at all, and if so, what share of the business\u2019s taxable income is subject to Illinois tax?<\/p>\n

First, a word about taxable income: For Illinois and most states, the starting point in calculating state income tax liability is the business\u2019s federal taxable income.\u00a0 This is generally the business\u2019s net income, after deductions for business expenses have been taken. (For individuals, the starting point is federal adjusted gross income, and most personal expenses are not deductible).\u00a0 Illinois is considered a \u201crolling conformity\u201d state, meaning changes to the Internal Revenue Code\u2019s tax base provisions are automatically incorporated into Illinois\u2019 tax base as well.\u00a0 Illinois requires a number of adjustments, decoupling from certain federal provisions like bonus depreciation, sometimes replacing them with our own alternative (in the case of depreciation, for example) and sometimes making adjustments to compensate for odd mis-matches or to avoid unconstitutional results (in the case of the foreign dividends received deduction, for example).\u00a0 The nuances of calculating Illinois taxable income are outside the scope of this article, so we return to the two issues unique to multistate businesses:\u00a0 nexus and apportionment.<\/p>\n

Nexus.<\/u> If a business\u2019s presence in a state is significant enough that the state can tax the business, it is said to have nexus in that state.\u00a0 Income tax nexus standards vary from state to state, and there are federal constitutional and statutory nexus limitations as well.\u00a0 Broadly speaking, though, a business has nexus in Illinois (and therefore must file an Illinois income tax return) if it has employees or assets in the state, or makes more than a de minimis level of sales to Illinois customers.<\/p>\n

Apportionment<\/u>. Multistate businesses are naturally subject to income tax in multiple states.\u00a0 It wouldn\u2019t be fair (or constitutional) for each of those states to tax 100% of every business\u2019 income.\u00a0 The process of determining how much of a business\u2019 income is taxable by a particular state is called apportionment.\u00a0 Apportionment methods vary by state, despite repeated efforts at standardization.\u00a0 The most significant such effort, in the 1950\u2019s, resulted in the Uniform Laws Commission adopting the Uniform Division of Income for Tax Purposes Act (\u201cUDITPA\u201d). UDITPA sets forth a three factor apportionment formula which gives equal weight to each of the following:<\/p>\n

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  1. The percentage of a business\u2019s total property <\/strong>located in a state;<\/li>\n
  2. The percentage of a business\u2019s total payroll <\/strong>paid to residents of a state; and<\/li>\n
  3. The percentage of a business\u2019s total sales <\/strong>made to customers in a state.<\/li>\n<\/ol>\n

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    Over the years, states moved away from the three-factor formula and towards formulas that more heavily weighted the sales factor.\u00a0 This had the effect of reducing the tax burden on businesses with significant operations in the taxing state and \u201cexporting\u201d the burden onto businesses based elsewhere.\u00a0 Illinois first double-weighted the sales factor and since 2001 most businesses have used only the sales factor to determine their Illinois apportionment percentage.<\/p>\n

    The following examples illustrate how apportionment is calculated and the impact of using different formulas.<\/p>\n

    Example 1 \u2013 <\/strong>Company A had 50% of its property in Illinois, 50% of its payroll in Illinois and 20% of its sales in Illinois.\u00a0 Its Illinois apportionment (and therefore the percentage of its taxable income subject to Illinois tax) would be as follows:<\/p>\n