Does an accelerated lump-sum pension payment stay exempt from Illinois income tax after a company sale triggers plan termination?

Plain-English summary

A husband and wife who file jointly asked the Illinois Department of Revenue to confirm, in what they framed as a request for a Private Letter Ruling, that a lump-sum pension payout would stay exempt from Illinois income tax. The husband had retired from his employer and, on the return currently being prepared, had reported a qualified retirement benefit payment on line 5 of Form IL-1040 as exempt "per Section 1402 of the Illinois Code." Shortly after, the former employer notified him it was being sold, and that as a result of the resulting change in control it intended to terminate the retirement plan and pay out all of his remaining scheduled payments as a single lump sum in one calendar year. The company pointed to two federal Treasury regulations -- one on plan termination and liquidation, one on payment acceleration triggered by a change in control -- as its basis for telling him the lump sum would remain Illinois tax-exempt.

The Department did not simply agree. It responded as a GIL rather than a binding PLR, and its answer had two parts. First, it corrected the taxpayer's own legal citation: Section 1402 of the Illinois Income Tax Act (35 ILCS 5/1402) covers the Department's own notice requirements and does not appear to have anything to do with taxing retirement income. Second, it explained that the real retirement-income subtraction lives in Section 203(a)(2)(F) of the IITA, which exempts amounts includable in federal adjusted gross income under specific Internal Revenue Code sections covering qualified employee trusts, qualified annuities, and IRAs -- but the two federal regulations the company cited both relate to nonqualified deferred compensation plans. Based on what the taxpayer had described, the Department said it could not tell whether the husband's plan was qualified or nonqualified, and therefore could not tell whether the Section 203(a)(2)(F) subtraction applied to these particular payments at all. It left that question unresolved and instead stated the general federal-conformity rule that governs the answer either way.

What this means for you

Retirees receiving an accelerated or lump-sum payout

Do not assume a pension or deferred-compensation payout stays state-tax-exempt just because your regular distributions were exempt in prior years. Illinois's subtraction under Section 203(a)(2)(F) hinges on whether your plan falls under specific IRC provisions (Sections 402(a), 402(c), 403(a), 403(b), 406(a), 407(a), or 408) or is a retired-partner payment under IRC Section 1402 -- not on whether the payment happens to be labeled "retirement income" or is paid as one lump sum instead of many. If your employer's plan is being terminated and cashed out because of a company sale, find out whether the plan is a qualified plan (like a pension trust or 401(a) plan) or a nonqualified deferred compensation arrangement, because that classification controls the Illinois tax result.

HR and benefits professionals handling plan terminations

If a change-in-control event is forcing your organization to terminate a retirement plan and accelerate payouts under Treas. Reg. 1.409A-3(j)(4)(ix)(b) or 1.409A-1(c)(2), be aware those two regulations are markers of a nonqualified deferred compensation plan under IRC Section 409A. That federal characterization matters a great deal to affected employees' Illinois taxes: nonqualified deferred compensation is generally not covered by the specific IRC sections Illinois cross-references in Section 203(a)(2)(F). Citing Section 409A relief for federal tax-timing purposes does not, by itself, establish state tax-exempt treatment, and communications to retirees claiming otherwise should be reviewed by tax counsel.

Tax preparers working with retiree clients

Watch for clients whose return previously excluded retirement income "per Section 1402 of the Illinois Code" -- that citation does not govern the taxability of retirement income and is not the correct authority for the subtraction. The correct citation is IITA Section 203(a)(2)(F), and eligibility depends on which IRC section the distribution falls under, which in turn depends on whether the plan is qualified or nonqualified. When a client's lump sum results from a 409A-driven plan termination, confirm the plan's qualified/nonqualified status before assuming the subtraction carries forward from prior years.

Common questions

Q: Did the Department rule that the lump-sum payment is tax-exempt in Illinois?
A: No. The Department declined to confirm exemption. It stated the general rule that governs the outcome, but said it could not determine from the facts provided whether this specific plan is qualified or nonqualified -- and that determination decides whether the subtraction applies.

Q: Was the taxpayer's original citation to Section 1402 of the Illinois Code correct?
A: No. The Department pointed out that Section 1402 of the Illinois Income Tax Act (35 ILCS 5/1402) addresses the Department's own notice requirements and does not appear to apply to the taxation of retirement income at all. The taxpayer's return had used the wrong provision to justify the earlier exempt treatment.

Q: Does paying retirement benefits as a lump sum instead of regular installments change whether the subtraction applies?
A: No. The Department said Illinois follows federal treatment regardless of whether retirement income is paid as a lump sum or in regular distributions. What matters is whether the income is included in gross income under one of the specific IRC sections listed in Section 203(a)(2)(F) (402(a), 402(c), 403(a), 403(b), 406(a), 407(a), or 408) or is a retired-partner payment excluded from self-employment earnings under IRC Section 1402.

Q: Do the Treasury regulations the company cited (1.409A-3(j)(4)(ix)(b) and 1.409A-1(c)(2)) guarantee the Illinois subtraction applies?
A: No. The Department noted those two regulations appear to relate to nonqualified deferred compensation plans, which are generally not among the specific IRC provisions Section 203(a)(2)(F) cross-references. If the underlying plan turns out to be nonqualified, the lump sum would likely not qualify for the Illinois subtraction, though the Department did not make that final determination in this letter.

Q: Why did the Department issue a GIL instead of the Private Letter Ruling the taxpayer requested?
A: The Department found that the nature of the inquiry and the information provided required a General Information Letter response rather than a binding PLR. A GIL directs a taxpayer to relevant regulations and information but is not a statement of Department policy and is not binding on the Department.

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/income-tax/2023.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/income-tax/2023/it23-0006-gil.pdf

Original ruling text

IT-23-0006-GIL 05/31/2023 SUBTRACTIONS
Retirement income, including lump sum payment, is eligible for subtraction
modification under Section 203(a)(2)(F) of the IITA if it is included in federal
adjusted gross income pursuant to the provisions of the Internal Revenue Code
cited in Section 203(a)(2)(F).

NAME/ADDRESS

May 31, 2023

Dear NAME:
This letter is in response to your letter dated March 20, 2023, in which you
requested information. The Department issues two types of letter rulings. Private Letter
Rulings (“PLRs”) are issued by the Department in response to specific taxpayer
inquiries concerning the application of a tax statute or rule to a particular fact situation.
A PLR is binding on the Department, but only as to the taxpayer who is the subject of
the request for ruling and only to the extent the facts recited in the PLR are correct and
complete. Persons seeking PLRs must comply with the procedures for PLRs found in
the Department’s regulations at 2 Ill. Adm. Code 1200.110. The purpose of a General
Information Letter (“GIL”) is to direct taxpayers to Department regulations or other
sources of information regarding the topic about which they have inquired. A GIL is not
a statement of Department policy and is not binding on the Department. See 2 Ill. Adm.
Code 1200.120. You may access our website at www.tax.illinois.gov to review
regulations, letter rulings and other types of information relevant to your inquiry.
The nature of your inquiry and the information you have provided require that we
respond with a GIL. In your letter you have stated and made inquiry as follows:
The purpose of this letter is to request a Private Letter Ruling
pursuant to I.A.C. Title 2, Chapter 1200.110 - Private Letter Rulings. The
request seeks a determination as to whether termination/ retirement
benefits scheduled over a number of years remain exempt from Illinois
Income Tax per Section 1402 of Illinois Code if they are accelerated to a
lump sum payment within a single tax year as the result of plan
termination due to a change in control of the company due to a sale.
Statement of Facts:

1. The parties of interest with respect to this request are
   HUSBAND and WIFE, husband, and wife, who file jointly with
   the Illinois Department of Revenue.
2. HUSBAND was formerly employed by COMPANY1 and retired
   as of MONTH DAY, YEAR.
3. As part of the filings for tax year YEAR, which is currently being
   prepared, income from a qualified retirement benefit payment

NAME
Page 2
May 31, 2023
from COMPANY1 is noted on line 5 of the IL-1040 and is not
subject to Illinois Income Tax per Section 1402 of the Illinois
Code.
Material Issues:

1. COMPANY1 has notified HUSBAND, retiree, that the company
   has entered into a Letter of Intent to sell the company.
2. COMPANY1 has notified HUSBAND, retiree, of their intent to
   terminate the retirement plan and accelerate plan payments due
   to the change in control /ownership.
3. COMPANY1 has notified HUSBAND, retiree, of their intent to
   pay all remaining scheduled payments with a single lump sum
   payment in calendar year YEAR.
4. COMPANY1 has cited U.S. Treas. Reg. l.409A-3(j)(4)(ix)(b) as
   the regulation that allows termination and liquidation and U.S.
   Treas. Reg.1.409A-1(c)(2) allowing payment acceleration due to
   a change in control event.
5. COMPANY1 has stated to HUSBAND, retiree, that the citation
   above in Item 4 substantiates that a lump sum payment of
   remaining scheduled benefits will remain exempt from Illinois
   Income Tax provided the plan is terminated and lump sum
   payment is made as a result of the change in ownership control
   due to a sale.
   Subject of Request:
6. HUSBAND, retiree, is requesting a Private Letter Ruling from
   IDOR that a lump sum payment, if made in the YEAR tax year,
   of the remaining scheduled retirement benefits would remain
   exempt from Illinois Income Tax if the plan is terminated under
   the terms outlined.
   Statements:
7. There is currently no pending audit or litigation associated with
   the taxpayer, HUSBAND.
8. The Department has not previously ruled on the same or a
   similar issue for the taxpayer, and taxpayer has not previously

NAME
Page 3
May 31, 2023
submitted the same or similar issue to the Department and
withdrew it before a letter ruling was issued.

3. COMPANY2 has stated that the accounting firm providing
   services to COMPANY1 has provided them with the opinions
   listed under 4 and 5 of Material Issues above. Taxpayer is not
   aware of any other authority supporting those views.
4. Taxpayer has not been able to locate any authority/authorities
   contrary to those views.
5. Taxpayer is not requesting any specific trade secret information
   be deleted from the publicly disseminated version of the Private
   Letter Ruling.
   DEPARTMENT’S RESPONSE:
   Section 203(a)(2)(F) of the Illinois Income Tax Act (“IITA”, 35 ILCS
   5/203(a)(2)(F)) provides the following deduction in the computation of an individual’s
   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.
   Section 402 of the Internal Revenue Code deals with distributions from employee
   trusts exempt under Section 401(a) of the Internal Revenue Code, which provides an
   exemption for certain employee trusts “created or organized in the United States.”
   Section 403(a) of the Internal Revenue Code deals with annuities described in
   Section 402(a)(2) of the Internal Revenue Code, which describes certain annuities
   purchased by employee trusts exempt under Section 401(a) of the Internal Revenue
   Code.
   Section 403(b) of the Internal Revenue Code deals with annuities for employees
   of exempt organizations.
   Sections 406 and 407 of the Internal Revenue Code deal with employee benefit
   plans under Section 401 that cover overseas employees of affiliates of the employer
   that created the plan.

NAME
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May 31, 2023
Section 408 of the Internal Revenue Code deals with individual retirement
accounts.
In paragraph 3 of your Statement of Facts, you state that “…income from a
qualified retirement benefit payment from COMPANY1 is noted on line 5 of the IL-1040
and is not subject to Illinois Income Tax per Section 1402 of the Illinois Code.” Section
1402 of the Illinois Income Tax Act, 35 ILCS 5/1402, addresses the Department’s notice
requirements and does not appear to apply to the treatment of retirement income. In
paragraph 4 of your Material Issues section, you refer to U.S. Treas. Reg. l.409A3(j)(4)(ix)(b) and U.S. Treas. Reg.1.409A-1(c)(2) which appear to apply to nonqualified
deferred compensation plans. Based on the information that you have provided, it is
unclear whether you are a member of a qualified or nonqualified plan or if any of the
provisions cited in Section 203(a)(2)(F) of the IITA apply to the retirement benefits at
issue.
That being said, the Department follows the federal treatment when determining
whether retirement income, whether it is made in a lump sum or as regular distributions,
is subject to the subtraction modification under Section 203(a)(2)(F). If the income is
included in gross income under Internal Revenue Code Sections 402(a), 402(c), 403(a),
403(b), 406(a), 407(a), or 408, or because it is a retirement payment to a retired partner,
which is excluded in computing net earnings from self employment by Section 1402 of
the Internal Revenue Code and regulations adopted pursuant thereto, then the income
qualifies for the Section 203(a)(2)(F) deduction.
I hope this information is helpful. If you require additional information, please
visit our website at www.tax.illinois.gov or contact the Department’s Taxpayer
Information Division at (217) 782-3336.
Very truly yours,
Michael D. Mankowski
Associate Counsel
MDM:CB-C