Publications: Tax law change impacts service partnerships, LLCs

Ungaretti & Harris Tax Attorney James C. Shanley, who is Of Counsel to the firm, authored the recent article, "Tax law change impacts service partnerships, LLCs," in the Chicago Daily Law Bulletin.  The article addresses changes to the Illinois income taxation of "service partnerships" that have occured with the enactment of the Emergency Budget Implementation Act of Fiscal Year 2010, effective July 15, 2009.

To read the full article, please see below or click the Related Files link.

The Illinois income taxation of “service partnerships” (any partnership or limited liability company primarily engaged in providing personal services, such as the practice of law, accounting, consulting, engineering, or medicine) has changed dramatically with the enactment of the Emergency Budget Implementation Act of Fiscal Year 2010, L. 2009, S1912 (P.A. 96-45), effective July 15, 2009.

Prior to the 2010 budget act, any service partnership, in calculating its liability for personal property replacement tax, was able to claim a deduction for a reasonable allowance for compensation paid for services rendered to the service partnership by its partners or members. Now, pursuant to section 5-45 of the budget act, the service partnership will only be able to deduct the amount of any “guaranteed payments” made by the service partnership to its partners or members.

The term “guaranteed payment” is defined in section 707(c) of the Internal Revenue Code to mean any payment made by a partnership to one of its partners for services or for the use of capital, but only if and to the extent that the payment being made by the partnership to the partner is determined without regard to the income of the partnership.

For a service partnership that maintains its books and records, and files its income tax returns, using the cash basis method of accounting (a “cash basis service partnership”), this change in Illinois income taxation may come as a big surprise. The reason is that, pursuant to Treasury Regulations section 1.707-1, a cash basis service partnership will only be able to deduct, for any particular fiscal year, guaranteed payments that are actually paid by the service partnership to its partners or members during that fiscal year.

Note that, for many, if not most, service partnerships, this change in Illinois income taxation is already effective, because section 5-45 of the budget act applies to the first fiscal year of the service partnership that ends on or after Dec. 31, 2009. Thus, if a cash basis service partnership maintains its books and records, and files its income tax returns, on the basis of the calendar year, this change in Illinois income taxation will apply to the service partnership’s fiscal year that began on Jan. 1, 2009, and that will end on Dec. 31, 2009. Accordingly, the cash basis service partnership would only be able to deduct those guaranteed payments that are actually paid to its partners or members during the period of time that starts on Jan. 1, 2009, and that ends on Dec. 31, 2009.

Recommendations

If a cash basis service partnership wants to reduce substantially the risk that the Illinois Department of Revenue may contend that some or all of the amounts paid to its partners or members fail to satisfy the requirements for being valid guaranteed payments, then the following actions would be recommended.

(a) The partnership should determine, substantially before the end of its fiscal year, the amount of the guaranteed payment, if any, which is to be paid by the partnership to each of its partners or members.

(b) The partnership should take reasonable steps in order to be able to prove that the partnership did, in fact, determine, substantially before the end of its fiscal year, the amount of the guaranteed payment, if any, which is to be paid by the partnership to each of its partners or members.

(c) The partnership should arrange its financing of its guaranteed payment obligations substantially in advance of the required payment date, in order to avoid any assertion by the department of the use of “circular cash flows” (a series of related financial transactions which are often ignored for income tax purposes, involving identical or substantially similar amounts of cash being transferred among two or more persons, but with the effect being that the economic position of each person is essentially the same both before and after these financial transfers).

(d) The amount of the guaranteed payment to be made by a service partnership to any of its partners or members should be based on the value of the services of that partner or member to the service partnership, and not based on that partner’s or member’s share of the projected income of the service partnership.

(e) Each partner or member of the service partnership that is entitled to receive a guaranteed payment should be required to execute an agreement with the service partnership that addresses what will happen if the partner or member (i) withdraws or is expelled from the service partnership, or (ii) receives guaranteed payments in excess of his or her share of the income of the service partnership, or (iii) receives aggregate payments from the service partnership which are less than the amount of the guaranteed payment promised by the service partnership to that partner or member.

Reprinted with permission from Law Bulletin Publishing Company.