S-Corp taxes recently changed in Illinois. The state legislature recently passed SB 2351, a corporate tax reform law, that has significant ramifications for S-Corporations (“S-Corps”). Before diving into the law and why it matters, we should cover some background information.
What Is An S-Corp?
An S-Corp is a sub-type of the classic corporate entity structure, often referred to as a C-Corp. The IRS created the S-Corp as a special designation that allows a company to take advantage of corporate protections, like limited liability protection, without being subject to some other corporate requirements. For instance, an S-Corp does not need a board of directors and there are fewer record-keeping requirements.
Why Would Someone Choose An S-Corp?
First, investors like S-Corps more than sole proprietorships or regular partnerships. While S-Corps have fewer requirements than C-Corps, they still have more than a sole proprietorship or partnership. For example, an S-Corp must pay reasonable compensation to its shareholders and file its own entity tax return. This means there will be a longer paper trail for investors to examine when deciding whether to put money into the entity.
Second, the S-Corp’s most attractive feature is best introduced with the million-dollar question: What will its taxes be?
S-Corps are pass-through entities, meaning that the individual shareholders pay taxes on earned income on their individual tax returns as partnerships do. Thus, the S-Corp avoids the dreaded “double taxation” problem associated with regular corporations because the entity itself does not pay tax on the income earned. This is especially helpful for companies generating a lot of income. Shareholders can potentially save big money when paying taxes on corporate earnings only once instead of twice.
New Illinois S-Corp Tax Law
The Illinois House and Senate unanimously passed SB 2351, which changes how an S-Corp can choose to be taxed. Governor JB Pritzker signed the bill into law on August 27, 2021, so businesses should be aware that the law is currently active. The law provides an alternative way around a recent corporate tax problem: the SALT Cap.
What Is The SALT Cap?
The term SALT Cap is actually relatively new, as long as we aren’t talking about rations on tableside seasonings. “SALT” simply stands for “State And Local Taxes.” Explaining the “Cap” requires a bit more work. In 2017, President Donald Trump enacted the Tax Cuts and Jobs Act. This Act made several significant changes to the Internal Revenue Code of 1986, which governs the taxation of businesses and individuals. Most relevant to SB 2351, it limited the amount of paid state and local taxes an individual could deduct on their federal tax returns. It capped state and local income tax deductions at $10,000, resulting in significantly higher federal tax bills for those paying high state income taxes. Shareholders of an S-Corporation are subject to the same restriction when reporting S-Corp income on their individual tax returns, potentially making them liable for thousands of more dollars in federal taxes.
The SALT Cap’s Significance
Two main reasons, one practical and one political, have been cited as the motivation behind the SALT Cap. Practically, the Republicans needed to raise massive revenue to offset costs stemming from the tax overhaul. Specifically, they needed to compensate for corporate tax cuts and the lowering of the top individual income tax rate. The SALT Cap may produce an estimated $170 billion in additional federal tax revenue. Politically, the bill arguably reflects President Trump’s and the Republican party’s ire towards notably blue, Democratic states as tax havens for rich individuals, where unlimited deductions allow those persons to dramatically decrease their federal tax bill.
Regardless of the motivations behind the Tax Cuts and Jobs Acts, the bill certainly disproportionally affected heavily blue states. States like New York, Illinois, and California have substantially higher state and local taxes than most other states. In fact, several historically Republican states, like Texas, Florida, and Tennessee, have no state income taxes at all. The SALT Cap predictably caused outrage amongst Democratic lawmakers, with some demanding its abolition. Conversely, some progressive Democrats denounced complete repeals in favor of other reforms. They cited that top earners would receive over half of the individual tax dollars saved by a repeal.
However, Illinois has taken a more innovative approach to deal with the SALT Cap. Even though the Cap will expire in 2025, a unanimous vote of Illinois legislators evidence their preference for immediate action.
How Does SB 2351 Tackle The SALT Cap?
Basically, the Illinois law lets an S-Corp’s shareholders claim the state taxes they would have paid as a business expense. Effectively, the company pays the shareholders’ state taxes for them. There is no cap on the amount of individual state income tax that can be claimed as a business expense. Paying state taxes at the corporate level reduces the net income that passes to shareholders individually on their federal tax return.
Before, a shareholder could only deduct up to $10,000 on their federal income tax return, even if they paid more in state and local income taxes. Now, if the S-Corp elects to pay the Pass-Through Entity (PTE) tax, it can deduct the taxes paid as an expense on its federal income tax return. If the shareholder has no other income source, they may get to take a credit on their individual state income tax return. They may not even need to file one at all. The net income that the shareholder needs to report on their federal income tax return is also reduced. This effectively gives them back the reduction that the SALT Cap took away.
Should I Form A Single-Member S-Corp?
The decision between forming a sole proprietorship, S-Corp, or another entity generally comes down to taxes and total costs of maintaining the entity. Before SB 2351 was enacted, the decision was relatively easy. An S-Corp only made sense if you bought in a lot of income; the costs of an S-Corp would outweigh any potential tax benefits.
The new law does not change much when making this decision for many small businesses. Remember, the federal deduction still applies for state taxes paid up to $10,000, so the benefits from SB 2351 do not apply unless you pay more than $10,000 in state income tax. Illinois has a flat income tax rate of 4.95%, so you would need make over $200,000 before SB 2351 will make a difference. Be aware, though, that S-Corps can provide other benefits as well. As another factor, SB 2351 might not apply to S-Corp with shareholders that are not residents of Illinois.
Because SB 2351 affects an individual’s tax return, there are several other non-business factors at play, such as:
- Income from outside the business
- Filing status (joint or single)
- Spouse’s income (if filing jointly)
- Individual tax bracket
You should address all of the factors above when deciding whether an S-Corp makes sense for you. Ultimately, this decision depends on the owners’ goals and situation. Talk with your accountant or tax attorney to evaluate other factors, like whether the business is eligible for other tax credits.
Can I Elect To Be Taxed Under SB 2351 Right Now?
Yes. The law went into effect on August 27, 2021. Illinois waived all late penalties for quarterly estimated tax payments for companies that elect for the 2021 tax year. Businesses do have to affirmatively make the election each year, which you can do online here. Either the owner of an S-Corp or their accountant should have login details to your Illinois online tax account. After you login, you should see announcements about making an election under SB 2351.
Of course, first you need to form a business. Is that starting as an LLC? Or forming a PLLC? If you’re considering filing an election under SB 2351, deciding whether an S-Corp makes sense for you, or have any other questions about starting your business, don’t hesitate to get in touch!