New Withholding Obligations for Illinois Trusts

April 22, 2009

Effective January 23, 2009, the Illinois Department of Revenue imposed new tax withholding obligations on Illinois trustees when making certain distributions to nonresident trust beneficiaries. Under Illinois Department of Revenue Regulation (“Regulation”) section 100.7035, every Illinois pass-through entity, which is defined as a partnership, subchapter S corporation, or a trust, must withhold from each nonresident owner/beneficiary the Illinois tax on the distributable share under sections 702 and 704 and subchapter S of the Internal Revenue Code for any business income of the pass-through entity that is apportionable to Illinois. This withholding requirement applies whether or not the business income is distributed to the owner. An “owner” is defined as a partner of a partnership, a shareholder of an S corporation, or a beneficiary of a trust. These rules apply to tax years beginning in 2009 and the years following.

If a composite tax return is filed, Illinois trustees may be able to avoid the new withholding requirement. Partnerships and S corporations are permitted to report a nonresident owners’ share of income and taxes on a composite return. Therefore, if a partnership or S corporation includes nonresident owners on a composite return, then the new withholding requirement will not apply to a passthrough entity, such as a trust, that receives distributions from the partnership or S corporation. Generally, an Illinois trust will not be included on such a composite return; however, a trustee of an Illinois trust may petition the Illinois Department of Revenue to be permitted to be included on a partnership’s or S corporation’s composite return. Specifics for petitioning the Illinois Department of Revenue can be found in Regulation section 100.5100(c).

A nonresident trust beneficiary who had Illinois income tax withheld from their trust distributions would need to file an Illinois income tax return in order to obtain a state income tax refund which may be owed to the beneficiary. Similarly, in the event that a nonresident owner is included on a composite return, the nonresident “may claim a credit against their Illinois income tax liability for their share of the tax paid on their behalf on the composite return” under section 100.5100(e) of the Regulations. When distributing annual K-1s to nonresident trust beneficiaries, it may be prudent for the fiduciary to inform nonresident beneficiaries of their rights to file an Illinois income tax return and to claim applicable state exemptions and tax refunds.

The agent responsible for reporting Illinois income tax withholding on a composite return is not required to make estimated tax payments. In the event the agent filing the composite return makes an overpayment or underpayment, then the agent is required to “file an amended return to correct the error and claim a refund or credit, or pay the liability, for any person included on the composite return” under Regulation section 100.5180(a).

Beginning in 2009, an underlying partnership or S corporation is permitted to report changes in liabilities of the reporting entity’s owners and to make payments on behalf of any owner, regardless of whether a composite return was filed or whether a specific owner was included on that composite return. Failure to timely report and pay tax due on a composite return may result in the issuance of a notice of deficiency by the Illinois Department of Revenue to the agent responsible for the return, which may also include applicable interests and penalties.

The rules affected by the amendments were published on February 6, 2009 in the Illinois Register and are found in Illinois Regulations, Sections 100.5100, 100.5140, 100.5160, 100.5180 and 100.7035. Illinois’ new withholding requirements are not unique among the states. The current list of states with similar withholding requirements include: California, Colorado, Georgia, Indiana, Kansas, Kentucky, Massachusetts, Michigan, Minnesota, Missouri, Nebraska, New Jersey, New Mexico, New York, North Carolina, North Dakota, Oklahoma, Oregon, Pennsylvania, South Carolina, Virginia, and Wisconsin.

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Our Fiduciary Advisory Services assists financial institutions in a wide array of areas in which questions or concerns may arise. For further information on the private letter rulings discussed above or our practice, please contact the authors.

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