Do deferred retirement payments made to retired partners of a professional-services LLC out of current partnership earnings qualify for Illinois's retirement-income subtraction modification?

Plain-English summary

A company wrote to the Illinois Department of Revenue on behalf of a professional engineering-services firm organized as an LLC taxed as a partnership. The firm has both active and retired members. When a member retires, they are paid the full value of their LLC capital account, cease providing services, and thereafter receive only annual payments under the firm's retirement plan for the rest of their life. Because those payments are actually an allocation of the LLC's current-year income (not a separately funded pension), the retired partners keep being taxed on their distributive share in the year the LLC earns the income, even though the cash is often not actually paid out to them until a later year - sometimes not until the beginning of the second year after it was earned.

The company asked the Department to confirm that these deferred, income-based retirement payments still qualify for the Illinois subtraction modification in 35 ILCS 5/203(a)(2)(F), which allows taxpayers to subtract from Illinois base income retirement payments to retired partners that are excluded from "net earnings from self-employment" under IRC Section 1402(a)(10). To qualify under Section 1402(a)(10), the payments must be made under a written retirement plan, continue until the partner's death, and the partner must (A) render no more services, (B) have no obligations owed by other partners except retirement payments, and (C) have already been paid their capital account in full.

The Department walked through each requirement using the facts submitted. It found that the retired members render no services after retirement, that no other obligations exist besides the retirement-plan payments, and that their capital accounts were paid in full at retirement (with the ongoing K-1 capital entries relating only to the deferred retirement income itself). Relying on IRS Revenue Ruling 79-34 - which held that payments from current partnership earnings can qualify under Section 1402(a)(10) even if actual receipt is deferred until shortly after year-end - and noting that neither the Ruling nor General Counsel Memorandum 37701 defines how much delay is too much, the Department concluded it would respect the taxpayer's federal position on this point absent a "federal change" as defined in IITA Section 506(b).

The bottom line: the Department agreed that the retired members' distributive shares qualify for the Illinois subtraction modification under 35 ILCS 5/203(a)(2)(F), because the payments meet the IRC Section 1402(a)(10) exclusion from self-employment tax, even though some of the payments are not physically distributed until well into the following year (or later).

What this means for you

If you are a retired partner in a professional-services LLC or partnership

If your former firm continues to pay you a share of its ongoing profits after you retire - under a written retirement plan, with no more services rendered by you, no other outstanding obligations to you, and your capital account already paid in full - those payments may qualify for Illinois's retirement-income subtraction, even if the cash isn't actually paid to you until the following year or later. The key is that the payments must be excluded from "net earnings from self-employment" for federal purposes under IRC Section 1402(a)(10).

If you are a partnership or LLC administering a retirement plan for former partners

Structure and document your retirement arrangement as a written plan that pays retired partners only retirement income (no other obligations), pays out capital accounts in full at retirement, and requires no further services from the retired member. This letter shows the Department will look to how the arrangement is treated for federal self-employment tax purposes (Section 1402(a)(10)) as the touchstone for whether the Illinois subtraction applies, per the Department's own statement that it will "respect the taxpayer's federal position as correct" absent a later federal change.

Limits on relying on this letter

This is a General Information Letter (GIL), not a Private Letter Ruling. It is not binding on the Department and does not constitute a statement of Department policy. It applies to the specific facts described by this particular taxpayer, and the Department expressly noted uncertainty about how much payment delay would be too "significant" to still qualify - so this letter does not guarantee the same result for materially different facts or longer payment delays.

Common questions

Q: What Illinois subtraction is at issue in this ruling?
A: The subtraction modification under 35 ILCS 5/203(a)(2)(F), which lets a taxpayer subtract from Illinois base income "retirement payments to retired partners, which payments are excluded in computing net earnings from self-employment by Section 1402 of the Internal Revenue Code."

Q: Why were the payments in this case not simply guaranteed payments or wages?
A: The retiring members' payments were an allocation of the LLC's actual income, deductions, and credits (not a fixed guaranteed payment), and the retired partners continued to be treated as partners under federal and Illinois tax law for as long as they received these payments.

Q: Does it matter that some payments weren't distributed until the following year?
A: The Department said no, relying on Revenue Ruling 79-34, which held that payments from current partnership earnings can qualify under IRC Section 1402(a)(10) even if actual receipt is deferred until shortly after the beginning of the following year. The Department noted it was not entirely clear how much delay would become a "significant delay," but it agreed to respect the taxpayer's federal position on these facts.

Q: Is this ruling legally binding on the Department for other taxpayers?
A: No. It is a GIL, issued under 86 Ill. Adm. Code 1200.120(b) and (c) (referenced in the letter) and 2 Ill. Adm. Code 1200.120 (referenced in the Department's disclaimer). A GIL merely provides general information and is not a statement of Department policy or binding on the Department.

Citations and references

• 35 ILCS 5/203(a)(2)(F) - Illinois subtraction modification for retirement payments to retired partners
• IITA Section 506(b) - defines "federal change," referenced regarding when the Department would revisit its position
• 86 Ill. Adm. Code 1200.120(b) and (c) - governs GILs, cited in the taxpayer's request letter
• 2 Ill. Adm. Code 1200.120 - GIL authority, cited in the Department's disclaimer
• IRC Section 1402(a) - defines net earnings from self-employment
• IRC Section 1402(a)(10) - excludes certain retired-partner payments from net earnings from self-employment
• IRC Section 736(a)(1) - treatment of retirement income paid out of current partnership earnings
• Treasury Regulations Section 1.1402(a)-17(b) - bona fide retirement income requirement
• Treas. Reg. Section 1.6662-4(d)(3)(iii) - substantial-authority status of Revenue Rulings
• IRS Revenue Ruling 79-34 - deferred payment from current earnings still qualifies under IRC Section 1402(a)(10)
• General Counsel Memorandum (GCM) 37701 (1978) - IRS internal guidance preceding Revenue Ruling 79-34

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/income-tax/2016.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/income-tax/2016/it-16-0004-gil.pdf

Original ruling text

IT 16-0004-GIL 09/02/2016

SUBTRACTION MODIFICATION-PENSIONS

Subtraction modification for retirement payments to retired partners applies only to
payments described in IRC Section 1402(a)(10).

September 2, 2016

Re:

COMPANY
FEIN: #####

Dear Xxxxx:
This is in response to your letter dated July 25, 2016, in which you request a general information
letter (GIL) on behalf of the above-named taxpayer. A GIL is designed to provide general
information, is not a statement of Department policy and is not binding on the Department, See
86 Ill. Adm. Code 1200.120(b) and (c), which may be accessed at www.tax.illinois.gov.
In your letter you state the following:
COMPANY (“COMPANY” or “We” or “Our”) is submitting this request for a General
Information Letter (“GIL”), pursuant to the provisions of 2 Ill. Adm. Code Sec. 1200.120
on behalf of our CLIENT (“CLIENT”) and its retired members seeking written confirmation
from the Illinois Department of Revenue (“Department”) upon which our client and its
retired member may affirmatively rely that, as described below, payments to retired
members qualify for the subtraction modification in 35 ILCS 5/203(a)(2)(F). A copy of said
written confirmation will be attached to annual Illinois individual income tax returns for
each CLIENT retired member in an effort to provide clarity and prevent notices from the
Department. To the best of CLIENT’s and our knowledge, neither CLIENT nor any of its
affiliated companies is subject to any pending audit or litigation in Illinois involving the
issues raised in this GIL request. Additionally, neither CLIENT nor COMPANY is aware
of any contrary rulings, cases, statutes, or regulations to the position requested in this
letter. A power of attorney authorizing our representation of CLIENT is attached.
Relevant Facts
CLIENT is a professional services firm that provides engineering services to the power
industry. CLIENT is a limited liability company treated as a partnership for federal and
Illinois income tax purposes. CLIENT has two types of members: active and retired. Each
type of member includes both Illinois residents and non-residents for income tax
purposes. The active members provide services to CLIENT on a full-time basis. The
active members also pay self-employment tax on income earned from the LLC. Pursuant
to the LLC operating agreement, upon retirement a retired member of CLIENT ceases to

be a member and ceases to provide services to CLIENT. On the last day of the tax year
during which a member retires, the retiring member is paid an amount equal to his full
value of the LLC units. In other words, all of his capital as determined under the LLC
operating agreement is paid to the retiring partner. The partner ceases to be a state law
member. The only amounts to be paid to such retired member are those determined under
the retirement plan.
Pursuant to the LLC operating agreement, the retired members receive payments from
CLIENT on an annual basis for the remainder of their lives. The income earned by the
retired members is not a guaranteed payment but is instead an allocation of all types of
income, deductions and credits earned by the LLC. For federal and Illinois income tax
purposes, the retired partners continue to be treated as partners for as long as they are
receiving these payments. After retirement the member is allocated and taxed on
retirement income in the same year in which the income is generated by the LLC even if
the amount has not been paid to the member in the year it was earned. Historically the
retirement income is paid to the member in subsequent years after it was earned and
taxed. The retirement income earned and taxed in one year that is paid to retired
members in the subsequent years is accounted for as an obligation of the LLC. As the
retired members are treated as partners for federal income tax purposes these obligations
from the LLC are reported as capital on the retired partner’s federal K-1.
Following is an example of the earnings and payments made to a retired member:
On December 31, 2013, the member (who retired on December 31, 2010 is owed $$$ of
retirement income from CLIENT. The $$$ that the member is owed will be paid to the
member in 2012 and 2013 and is also reported as distributive share because the income
is paid out of current net profits of the company. Thus, it is reflected in the capital account
of the retired partner. Because it is not paid before the end of the year, it is also reflected
in ending capital on his federal K-1. Of this amount $$$ was earned in 2012 and $$$ was
earned in 2013. The retired member included these amounts in federal taxable income in
2012 and 2013, respectively.
The amounts were earned and paid to the retired member as follows:
Date of
Payment

Year Retirement
Income Earned

January 14, 2014
2012
April 15, 2014
2013
June 15, 2014
2013
September 15, 2014
2013
January 15, 2015
2013
Total due as of December 31. 2013

% of Retirement
Income Paid

Retirement
Income

100%
40%
20%
20%
20%

$$$
$$$
$$$
$$$
$$$
$$$

For Federal and Illinois income tax purposes, the retired members continue to be
allocated taxable income, deductions and credits, because, as noted above, retirement
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amounts are paid out
of net current profits of the company. Therefore, these
amounts are reported to the retired members on a federal Schedule K-1 and Illinois
Schedule K-1-P and is subject to federal income tax but not subject to self-employment
tax under section 1402(a)(10). It is CLIENT’s understanding that the members are not
subject to Illinois Individual Income Tax on these retirement payments because they
qualify for the subtraction modification in 35 ILCS 5/203(a)(2)(F).
Legal Analysis and Authorities
In computing an individual’s base income subject to Illinois Individual Income Tax, under
35 ILCS 5/203(a)(2)(F), Illinois provides a subtraction for retirement payments that are
excluded from net earnings from self-employment under the Internal Revenue Code
(hereinafter “IRC”). Section 1402(a) defines net earnings from self-employment as:
[T]he gross income derived by an individual from any trade or business carried on by such
individual, less the deductions allowed by this subtitle [IRC Sections 1 et. seq.] which are
attributable to such trade or business, plus his distributive share (whether or not
distributed) of income or loss described in section 702(a)(8) from any trade or business
carried on by a partnership of which he is a member.
Section 1402(a)(10) provides an exception to the general definition of net earnings from
self-employment, which reads in whole:
[T]here shall be excluded amounts received by a partner pursuant to a written plan of the
partnership, which meets such requirements as are prescribed by the Secretary, and
which provides for payments on account of retirement, on a periodic basis, to partners
generally or to a class or classes of partners, such payments to continue at least until
such partner’s death, if—
(A) such partner rendered no services with respect to any trade or business carried on by
such partnership (or its successors) during the taxable year of such partnership (or its
successors), ending within or with his taxable year, in which such amounts were received,
and
(B) no obligation exists (as of the close of the partnership’s taxable year referred to in
subparagraph (A)) from the other partners to such partner except with respect to
retirement payments under such plan, and
(C) such partner’s share, if any, of the capital of the partnership has been paid to him in
full before the close of the partnership’s taxable year referred to in subparagraph (A).
Application of Section 1402(a)(10)
Section 1402(a)(10)(A)
Income earned by CLIENTS retired members meet the requirements of section
1402(a)(10)(A) – (C) to be excluded from net earnings from self-employment. First of all,
retired members cease rendering services to CLIENT upon retirement in compliance with
section 1402(a)(10)(A). In the present case, the Member retired in 2010. He ceased
providing services under state law during 2010. Any payments made during 2014 and
2015 were not made in years during which he provided services to the company. Thus
section 1402(a)(10)(A) is met.

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Section 1402(a)(10)(B)
Secondly, all obligations to the retired members outside the scope of section 1402 have
been paid to them prior to December 31, 2011. There is no definition under section
1402(a)(10) for obligations. As a general matter, this amount should include any loans
that the company may have made to the members. However, no such obligations exist.
The only obligation is to pay amounts to the retired member earned under the retirement
plan, which is allowed by statute. Thus the taxpayer meets the requirement of section
1402(a)(10)(B).
Section 1402(a)(10)(C)
Finally, retired members were paid in full for their capital accounts in the year in which
they retired. The Schedules K-1 currently reflect a capital account for such partners. This
is because the terms of the retirement plan are such that the income is paid out of current
earnings pursuant to section 736(a)(1), which is discussed below. Because the capital
balance relates solely to the retirement income, this meets the requirements of section
1402(a)(10)(C).
Revenue Ruling 79-34
Because of the lack of clarity of definitions in the statute, one might ask if retirement
income earned but treated as distributive share could fall within the provisions of
paragraphs (B) and (C) discussed above. The Ruling does not specifically cover
paragraph (C) however, the facts are such that the retirement income is paid out of current
earnings pursuant to section 736(a)(1). The Ruling never concludes that the income
violates the requirements of paragraph (C). This was discussed in more detail in GCM
37701, discussed below.
Paragraph (B) is specifically addressed in Revenue Ruling 79-34, which provides:
Payments made by a partnership retirement plan to a retired partner from current
partnership earnings are excepted from “net earnings from self-employment” for purposes
of section 1402 of the Code even though receipt of part of the payments is deferred until
shortly after the beginning of the following year. Rev. Rul. 79-34.
Revenue Ruling 79-34 states that “dollars unpaid at the close of the partnership’s taxable
year [are] an integral part of the partnership’s retirement plan. Despite deferral of its
payment for a short time after year end, the … dollars [are] not an obligation within the
intent of section 1402(a)(10)(B) of the Code, but [are] a retirement payment.” Revenue
Ruling 79-34 then clarifies that for purposes of section 1402(a)(10), the payments are
considered to be made during the year in which the earnings facilitating the retirement
payments were earned, regardless of whether a portion of those periodic retirement
payments were distributed during the following year.
General Counsel Memorandum 37701
This was released in 1978. It also included a proposed revenue ruling that ultimately
would be released as Revenue Ruling 79-34. This internal IRS guidance specifically
discussed the fact that retirement income can be paid out of current profits and thus affect
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the member’s capital account; and still qualify under Paragraph (C). The IRS concluded,
“Thus, Congress intended that retirement payments under section 1402(a)(10) can be
payable out of the current income of the partnership.” In a footnote it also suggests that
payments of income subject to significant delay can become an interest in capital. It is
important to note that the footnote nor the subject of the footnote were not incorporated
into the published Revenue Ruling 79-34. Thus, retirement payment that is allocated out
of current profits under section 736(a)(1) qualifies as retirement payment under section
1402(a)(10) even though the amounts are not paid before the close of the taxable year in
which it was allocated.
Reliance on Authorities
Revenue Rulings are substantial authority that must be followed by revenue agents.
Treas. Reg. §1.6662-4(d)(3)(iii). GCMs are not authority, need not be followed by revenue
agents, and merely express the opinion of the author. This is important because of the
footnote in GCM 37701 noted above implies that if the cash payment of the retirement
income is not paid by year end or within a reasonable time following year end, that the
payment might be considered an obligation other than an obligation solely under the
retirement plan. As noted above, this footnote appeared only in the GCM, which is not
authoritative. It also did not appear in the issued Revenue Ruling, which is authoritative.
Further, the income in this case was paid out within a reasonable period of time and the
retired partners received only the amount owed under the retirement plan.
Conclusion
For the reasons stated above, we believe that income and payments made to the
CLIENTS retired members meet the exception under section 1402(a)(10), thereby
qualifying for the subtraction in 35 ILCS 5/203(a)(2)(F) and respectfully request that the
Department provide the general information letter requested. In addition, we request that
the identity of CLIENT and the other parties described herein be redacted from any
published version of a GIL that the Department does issue to CLIENT.

RULING
IITA Section 203(a)(2)(F) sets forth the following subtraction modification in the computation of
Illinois base income:
An amount equal to all amounts included in such total pursuant to the provisions of
Sections 402(a), 402(c), 403(a), 403(b), 406(a), 407(a), and 408 of the Internal Revenue
Code, or included in such total as distributions under the provisions of any retirement or
disability plan for employees of any governmental agency or unit, or retirement payments
to retired partners, which payments are excluded in computing net earnings from self
employment by Section 1402 of the Internal Revenue Code and regulations adopted
pursuant thereto.

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The subtraction for retirement payments to retired partners applies only to payments described
in Internal Revenue Code (IRC) Section 1402(a)(10) and Treasury Regulations Section
1.1402(a)-17.
IRC Section 1402(a)(10) excludes from the definition of net earnings from self-employment:
(10) [A]mounts received by a partner pursuant to a written plan of the partnership, which
meets such requirements as are prescribed by the Secretary, and which provides for
payments on account of retirement, on a periodic basis, to partners generally or to a class
or classes of partners, such payments to continue at least until such partner’s death, if –
(A) such partner rendered no services with respect to any trade or business carried
on by such partnership (or its successors), ending within or with his taxable year,
in which such amounts were received, and
(B) no obligation exists (as of the close of the partnership’s taxable year referred
to in subparagraph (A)) from the other partners to such partner except with respect
to retirement payments under such plan, and
(C) such partner’s share, if any, of the capital of the partnership has been paid to
him in full before the close of the partnership’s taxable year referred to in
subparagraph (A).
Treasury Regulations Section 1.1402(a)-17(b) states that to qualify as payments on account of
retirement, the payments must constitute bona fide retirement income. For purposes of this
ruling, it is assumed that the S&L retirement plan meets the requirements of Treasury
Regulations Section 1.1402(a)-17(b).
Your letter indicates that upon retirement, the partner ceases to be a member and ceases to
provide services to CLIENT. Further, your letter indicates that the income paid to the retired
member is considered under IRC Section 736(a)(1) as a distributive share of partnership income,
and that historically the income is actually paid to the member in years subsequent to the year
the retired partner must take into account the distributive share of partnership income. The
retirement income earned and taxed in one year that is paid to retired members in subsequent
years is accounted for as an obligation of the LLC. Your letter provides an example in which the
retired member’s distributive share for the 2012 taxable year of the partnership is not actually
paid to the retired member until January 14, 2014, and in which the distributive share for the
2013 taxable year of the partnership is actually paid to the retired member in installments
between April 14, 2014 and January 15, 2015. You have indicated that the retired members of
CLIENT have taken the position on their federal income tax returns that the payments are
excluded from net earnings from self-employment under IRC Section 1402(a)(10).
In Revenue Ruling 79-34, the IRS determined that payments made to a retired partner from
current partnership earnings satisfy the exclusion under IRC Section 1402(a)(10) where
payment is deferred until shortly after the beginning of the following year. General Counsel
Memorandum (GCM) 37701 (1978) included a proposed revenue ruling subsequently released
as Revenue Ruling 79-34. In the GCM, the IRS noted, “[w]e believe it is critical that there is no
significant delay between the time the distributive share is determined and the time any excess
distributive share is distributed. If any amount is retained by the partnership, it may be an

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obligation under section 1402(a)(10)(B) or a share in partnership capital under section
1402(a)(10)(C).”
Neither the GCM nor the revenue ruling indicate what period of delay would be considered a
“significant delay.” Revenue Ruling 79-34 indicates only that a distribution shortly after the
beginning of the following year does not cause the distributive share to fail to satisfy the exclusion
under IRC Section 1402(a)(10). It is therefore not clear whether the amounts retained in this
case, some of which were retained until the beginning of the second succeeding year, constitutes
a “significant delay” that may result in a disallowed obligation or disallowed share in partnership
capital. Accordingly, absent a federal change, as defined under IITA Section 506(b), with respect
to the treatment of the retired member’s share of CLIENT’s income for federal self-employment
tax purposes, the Department will respect the taxpayer’s federal position as correct.
Consequently, the distributive shares of the retired members of CLIENT will qualify for the
subtraction modification under IITA Section 203(a)(2)(F).
As stated above, this is a GIL. A GIL does not constitute a statement of policy that applies,
interprets or prescribes the tax laws, and it is not binding on the Department. If you have further
questions regarding this GIL, please call (217) 782-2844. If you have additional questions
regarding Illinois income tax laws, please visit the Department’s web site at www.tax.illinois.gov.

Sincerely,

Brian L. Stocker
Associate Counsel (Income Tax)

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