Replacement tax in Illinois: guide for small businesses
Illinois is one of the few states that imposes tax on pass-through entities. If you own or operate an S corporation or partnership in Illinois, you must pay state replacement tax.
In this article, we will explain the replacement tax in Illinois, including its payment schedules, requirements for each business entity type, and special considerations regarding how base income should be calculated to avoid replacement tax overpayment.
What is the replacement tax?
Replacement tax, also known as Personal Property Replacement Tax, was established to replace the revenue lost by local governments when they lost the authority to impose personal property taxes.
Illinois collects the replacement tax and distributes it to local governments to compensate for this loss.
Who must pay the replacement tax in Illinois?
The replacement tax applies to:
- corporations
- partnerships
- S corporations
- trusts and utilities
Payment schedules and requirements
Corporations
Corporations must pay replacement tax payments along with state income tax payments. Estimated payments are required quarterly.
Partnerships and S corporations
Partnerships and S corporations pay replacement income tax annually. These entities only need to make a single annual payment unless they elect to pay the state pass-through entity tax.
Trusts and utilities
Trusts pay replacement tax annually, with no need for estimated quarterly payments. Utilities must make quarterly estimated payments based on their invested capital and file an annual tax return.
Special considerations for pass-through entities
Partnerships
The amount entered on line 26 of Form IL-1065, Partnership Replacement Tax Return, is a key element of the partnership replacement tax calculation.
This line requires the greater of:
- your personal service income as defined in the now-repealed IRC Section 1348(b)(1), or
- a reasonable allowance for compensation paid or accrued for services rendered by partners
In businesses where capital is not a major income-producing factor, guaranteed payments to partners and distributive shares of ordinary income to individuals are considered personal services income. Upon completion of line 26, IL base income subject to replacement tax will be limited to income items other than compensation for personal services."
Ines Zemelman, enrolled agent (EA), founder, and President at TFX
Nonresident partners
Nonresident partners are generally subject to withholding and payment of allocated income in Illinois.
Pro tip. Nonresident partners can report Illinois income on their personal tax returns if the partnership completes Form IL-1000-E, Certificate of Exemption for Pass-through Withholding, on their behalf. This election is made individually and must be reflected in the partnership's tax filings. The exclusion is done on Form 1065 K-1 Allocation detail schedule.
S corporations
S corporations incorporated in Illinois or having shareholders residing in Illinois report their replacement tax on Form IL-1120-ST, Small Business Corporation Replacement Tax Return.
However, the subtraction of compensation for personal services occurs outside this form. Instead, this reduction is reported on Form 1120-S, U.S. Income Tax Return for an S Corporation, under:
- line 7 (compensation of officers), or
- line 8 (wages)
The compensation must also be reported on Form W-2, Wage and Tax Statement, to qualify for this tax base reduction.
Understanding replacement tax is vital for Illinois business owners. Seek advice from a tax professional to fulfill your obligations.
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Book discovery callDisclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.
Ines Zemelman, EA, is the founder and president of TFX, specializing in US corporate, international, and expatriate taxation. With over 30 years of experience, she holds a degree in accounting and an MBA in taxation. See more
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