Structure Matters: Sale of Real Property Subject to Illinois Replacement Tax

By: Jeff Glickman, SALT Partner

Long before states started enacting pass-through entity taxes, a number of states imposed business activity taxes directly on pass-through entities (PTE), some measured by income and some by gross receipts (or slight modifications thereof).  Examples include the Texas Franchise Tax, Washington Business & Occupation Tax, Ohio Commercial Activity Tax, and New Hampshire Business Profits Tax.

In 1979, Illinois enacted the Personal Property Replacement Tax (PPRT), when Illinois’ new Constitution (ratified in 1970) required the legislature to abolish personal property taxes and replace the revenue lost by local governments and school districts.  The PPRT is imposed directly on entities, including PTEs such as partnerships and S-corporations.  The rate for PTEs is 1.5% of Illinois net income, and the rate for C-corporations is 2.5% in addition to the state’s corporate income tax.

Therefore, individuals who conduct business through PTEs are subject to some double taxation since the PTE will pay PPRT and then the income of the PTE flows up to the individuals who will pay personal income tax with no credit for PPRT paid.   Taxpayers who are not advised properly may be surprised and frustrated by the Illinois tax consequences of their business structures, as illustrated by a recent Illinois General Information Letter.[1]

The taxpayer, an Illinois nonresident, wrote the ruling request himself, and his frustration (perhaps anger) is immediately apparent in the following opening statement:

First let me state that I am writing this on my own. . . .  I am not a lawyer or accountant.  I already spend plenty of money on lawyers and accountants and they did not advise me correctly.  They should have advised me to distribute the assets to the two partners before selling the family farm and avoid PPRT.  They did not.  I am in this mess because of lack of proper advice.

The taxpayer explained that he inherited an Illinois farm from his mother and was advised, for both legal liability protection and estate planning purposes, to place the farm in a partnership owned by him and a trust that was set up for his son.[2]  In a subsequent year, the farm was sold and it generated a significant capital gain for the partnership that was subject to the PPRT.  In addition, the gain was subject to income tax at the owner level.  As the taxpayer correctly pointed out, if the farm had first been distributed to the individual owners prior to the sale, the PPRT could have been avoided.

The taxpayer made a couple of very thin arguments, both of which the state dismissed.  His first argument was that the intent of the PPRT was to replace personal property taxes, and since he sold real estate, the PPRT should not apply to this income.  His second argument was that the gain should have been treated as non-business, capital gain income that should be reported exclusively on his Illinois personal income tax return, thereby avoiding PPRT.

Interestingly, the taxpayer noted in the ruling request that his neighbor “using a single-member LLC owned directly, avoided PPRT on a similar sale by reporting the gain personally, suggesting a potential inequity in the partnership structure’s tax treatment.”

The ruling stated:

The partnership cannot ignore its own structure and treat the gain as that of the partnership’s primary owner. . . .  The establishment of the partnership structure most likely resulted in some benefit to the partners.  The gain is the partnership’s gain and is subject to Illinois Personal Property Replacement Tax.

This case highlights two important planning points.  First, it is important for legal and tax advisors to consider all factors when recommending a structure and whether changes to a structure are beneficial as circumstances change.  In other words, while the partnership structure may have been the best one initially, perhaps it was no longer necessary once the taxpayer decided to sell the farm.

Second, structure matters.  In particular, owners of a PTE structure are often under the mistaken belief that if the PTE sells assets, the state tax treatment will be the same as if the individual owners sold the assets directly.  This is often not the case, and without proper advice and explanation, it can leave owners surprised and frustrated by the amount of state taxes they owe on the transaction.

[1] Illinois IT 25-0005-GIL (July 28, 2025).

[2] While a bit unclear, it appears that the asset may have been placed in a single member limited liability company (SMLLC) owned by the partnership, but since the SMLLC is disregarded for PPRT purposes, this article will just refer to the asset as being owned by the partnership for PPRT purposes.