2001 Practitioners' Questions and Answers

This issue was just raised with the Department this month. Regulation Section 100.5270(d)(6) provides guidance for the carryforward of credits based on property used by the taxpayer under IITA Sections 201(e), (f) and (h) and 206(b). Those carryforwards go with the member that owns the property, assuming that member would be eligible to claim the credit. If qualifying property is divided among more than one member, the carryforward from a particular year is apportioned between the members using the credit base of the property owned by each.

For other credits for which there is no current guidance, some have a basis that can serve to allocate the carryforward among members. A carryforward of the environmental remediation credit, for example, should probably follow the land. Others have no such basis. For example, the credit under IITA Section 206(a) for donations to the Illinois Center for Research on Sulfur in Coal cannot be attributed to any factor that clearly follows any member of a group. Other credits have what may seem to be a clear basis for allocation, but that basis cannot apply in all cases. For example, it would seem appropriate that a carryforward of the training expense credit should go to the member who employs the trainee, but this allocation does not work if the trainee is no longer employed by any member. The Department is open to suggestions for credits where a basis for allocation is not clear. One possibility is to have the carryforward apportioned according to each member's Illinois apportionment factors, in the same manner as is done for net losses.

The taxation of income from partnerships that engage solely in investment in securities, options or other publicly-traded intangibles is becoming an important issue. The major issues are whether the income of an investment partnership is business or nonbusiness and, if it is business income, how it is sourced under the "costs of performance" test when many investment partnerships act merely as vehicles to hold investments and have no payroll or property.

The Department has received a suggested regulation from Scott Heyman that would provide guidance for investment partnerships and their partners. Heyman's regulation would provide that an investment partnership's income is business income unless clearly classifiable as nonbusiness income. It also provides that an investment partnership can have no apportionment factors and cannot have a commercial domicile in Illinois. Accordingly, nonresident partners would not allocate any business income from an investment partnership to Illinois. An exception to this conclusion is provided for a partner who is engaged in managing, advising, promoting, marketing or sponsoring the partnership. Such a partner must include his partnership share of income in his own business income, and apportion it using his own factors.

Other investment partnerships have taken the position that they are not engaged in a trade or business, and therefore have no business income. Consistent with this argument, some also assert that they have no commercial domicile, which is defined in the IITA as the place from which a taxpayer's trade or business is directed or managed. The Department is considering the merits and consequences of this argument as well.

In the very near future, the Department will organize a meeting of all interested parties to discuss investment partnership issues. Anyone who is interested in attending the meeting or otherwise expressing their views on these issues should contact Paul Caselton at (217) 524-3951 or at Paul.Caselton@illinois.gov.

Income producing activity/cost of performance test - The Department's regulations and form instructions provide almost no guidance on how one determines what costs are considered for purposes of sourcing sales of services or intangibles.

a.What standard does the Department use to determine what "direct costs of performance" are with respect to the performance of a service?

b.If a seller of a service owns a disregarded entity, e.g., a single member limited liability company, and an employee of the SMLLC contributes to the performance of the service, is the SMLLC's employee's wages considered a "direct cost"?

a.   A "direct cost" of a service is a cost that is incurred only in the provision of a particular service, in comparison to an "indirect cost" that is incurred in support of more than one activity. For example, labor of an employee in providing the service and materials actually consumed in providing the service are direct costs. The time spent by a company president supervising the general affairs of the business, on the other hand, even when it is attributable in part to services provided, would be an indirect cost. The Department is not aware of any authoritative guidance for distinguishing direct from indirect costs in any particular setting.

b.   Any entity that has elected to be disregarded is treated as part of its owner for all purposes. See proposed regulation Section 100.9750. Accordingly, the single member limited liability company's employee is an employee of the seller.

Income Tax - Enterprise Zone Dividend Subtraction. The Illinois Income Tax Act, 35 ILCS 5/203(a)(2)(J) provides a subtraction for individuals in computing their Illinois adjusted gross income in an amount equal to those dividends included in such total which were paid by a corporation which conducts business operations in an Enterprise Zone or Zones created under the Illinois Enterprise Zone Act, and conducts substantially all of its operations in an Enterprise Zone or Zones. Illinois statutes also provide such dividend subtractions for recipient corporations (35 ILCS 5/203(b)(2)(K)) and partnerships (35 ILCS 5/203(d)(2)(K)). None of those statutory provisions distinguish between dividends paid by a regular corporation and those paid by a corporation which has elected subchapter S status under the Internal Revenue Code. Nevertheless, in 86 Ill. Admin. Code 100.2480, Enterprise Zone Dividend Subtraction, an example is provided in paragraph (d)(2) which provides that a taxpayer is not entitled to subtract distributions from an S corporation which conducts substantially all of its business in an Enterprise Zone "since a distribution by an S corporation is generally not characterized as a dividend. See Section 1368 of the Internal Revenue Code."

The regulation cites Section 1368 of the Internal Revenue Code as authority for the conclusion that S corporation distributions are generally not characterized as dividends. However, Section 1368 only determines the federal income tax treatment of S corporation distributions - e.g., whether a distribution will be treated for federal income tax purposes as a dividend (ordinary income), return of basis, or a capital gain (if distribution exceeds basis). Since an S corporation is still a corporation under the state's corporation law, any distributions or payments to its shareholders are dividends under such corporation laws. The statutory provisions cited above which allow for the Enterprise Zone Dividend Subtract make no distinctions between dividends, as that term is used in the corporate context to mean the distribution of profits by a corporation to its shareholders, and the tax treatment of certain corporate distributions to shareholders as dividends for federal income tax purposes. Furthermore, such statutory provisions do not distinguish between dividends paid by a C corporation and dividends paid by a corporation which has elected subchapter S treatment.

Is the treatment of S corporation distributions by the above-cited regulation consistent with the intent of the statute and the applicable legislative history? Why should there be disparate treatment between C corporations and S corporations where the intent is to encourage business development and activity in an Enterprise Zone? If the regulation is valid, are there any instances where a distribution from an S corporation can qualify for the dividend subtraction?