Illinois Launches 20% Privilege Tax at Financial Professionals

Perhaps a little more often lately, you come across pending legislation in which you can actually feel a politician stick his hand into your pocket and help himself to your wallet. Such a reaction is understandable after you read Illinois House Bill 3393, popularly called the “Illinois Privilege Tax” because it plans to charge investment professionals an extra 20% on their services rendered.

The specifics of the Illinois privilege tax contain the following provisions:

  • Partnerships and s-corporations that provide investment services would be subject to the tax.
  • The original bill stated that the privilege tax would be subject to repeal once the United States federal government removed the lower tax rate on carried interest, though the amended version contains no such expiration.
  • The test for whether a partnership or s-corporation is subject to the tax is whether it derives more than 40% of its income from “advising as to assets”, “managing or disposing of client assets”, “arranging financing or planning over public securities”, or “any any activity that supports the service of asset management.”
  • “Assets” are defined to mean real estate rental or ownership, publicly traded stocks, bonds issued from governments or any business, commodities, options, derivatives, or “any other financing that shares these characteristics.”
  • Partnerships and s-corporations are excluded from this bill if at least 80% of their income comes from the management of real estate.
  • This tax is in addition to all taxes that partnerships and s-corporations are already obligated to pay.
  • The original version stated that the law would not take effect until New York, New Jersey, and Connecticut all passed “substantially similar” legislation on financial professionals, but the amended version merely states that it will take effect on July 1, 2017 and there is no clause limiting when it takes effect or sets it for expiration.

The Illinois Privilege Tax aims to tax financial professionals at a rate of 20%. The definitions of the target audience is too overbroad and the tax hike is so extreme that it will need to a substantial counter-response from the business community if this legislation is enacted.

My takeaways:

#1. Specially targeted taxation generates a special kind of resentment. There is a reason why, when you visit a restaurant, the costs of your cheeseburger are not itemized. You don’t get charged $0.25 for ketchup, $.50 for a pickle, $0.25 for lettuce, $0.25 for tomato, and so on. That is the same reason why it is rare to see restaurants that charge $0.50 for a refill. Such targeting and nickeling and diming feels like extortion, even if the cumulative cost for the burger is the same as a place that just charges $10 regardless of your toppings.

When you see yourself especially targeted, your loyalty impulses to the community may dissipate. At first, that might translate into lower charitable giving in the community due to a sense that the community doesn’t love you back, and secondly, it can translate into an exodus from the community altogether.

#2. The politicians state that this is about the “carried interest loophole”, but the bill is written to cover a class of individuals more broad than that. If you are a financial advisor and you charge your clients a few hundred bucks per month to put them into shares of Colgate-Palmolive and Johnson & Johnson, you will fall within the realm of this tax. And yet, your business model has nothing to do with carried interest. You weren’t a beneficiary of advantageous tax rates in any way, and yet, you are now being asked to give up a fifth of your current disposable income. Even if you ideologically conclude that carried interest tax rates are a loophole that must be fixed, the staggering overbreadth of this rule will capture anyone in the investment industry even if they do not benefit from special taxation.

This is guilt and taxation by association without any of the benefits. To continue with the restaurant analogy, it is as if some hedge fund manager in New York gets to enjoy the free meal of claiming the carried interest loophole exception but then you’re asking some investment professional in Chicago to pay the tab even though he didn’t get to eat the meal. It is an example of populism waged against the wrong class of people in the hopes of scoring a cultural victory.

#3. This bill only covers partnership and s-corp entities, giving any advantage to large and well-established c-corporations. This is something that is aimed at harming small and medium-sized businesses. If you and several colleagues start a business, it is probably to your tax advantage to form a limited partnership. That advantage is now gone. Meanwhile, the largest businesses that tend to opt for c-corporation status, remain unaffected by this bill.

It is going to be like how the Master Settlement Agreement solidified the position of Altria, Lorillard, British American Tobacco, and Reynolds American because it made it impossible for new tobacco businesses to compete. Stultifying regulation can be a friend to Big Business because it wards off budding competition in the blizzard of regulatory paperwork and taxation that makes it quite difficult to get established.

Large businesses already have competitive advantages through lobbying arms, economies of scale, and the networking advantages that come with being an entrenched business. These advantages will now be compounded by more advantageous taxation as would-be competitors will be subject to an additional 20% tax. That is a perverse incentive. Or, an entrepreneurial investment professional will have to incorporate the business as a c-corporation from the get-go, subjecting the business to higher taxes and regulations during the formative years when the sustainability of the business model is in most doubt.

#4. This bill’s projected revenue of $473 million ignores human nature’s tendency to respond to incentives.

Remember in 2010 when New Jersey passed the millionaire’s tax that was intended to bolster state coffers? Well, enough New Jersey residents left for the neighboring states so that New Jersey actually collected lower revenues after passing the tax than before because the exodus was greater the extra amount of revenue collected by those that remained.

Initially, even Illinois politicians seemed aware of this economic principle because the original proposal limited implementation until several Northeastern states did likewise. Now, that provision is gone, and even states like Texas may be licking their chops to make overtures at Illinois’ financial industry.

Even if the bill has not yet passed, the planning has already begun to become either become a c-corporation or leave the state. I do not think the intended $473 million in revenue will be realized. A tax hike like this alters the status quo too dramatically, and causes so much resentment, that I don’t Illinois financial professionals will sit there like geese to be plucked. The rewards for changing corporate status or leaving are substantial, and the costs of doing nothing are notable. If this passes, you will see changes.

Conclusion: Right now, Illinois has unfunded pension liabilities in the $250-$300 billion range. It has no budget, and $15 billion in bills that they were obligated to pay by now but have not. The 2018 deficit is forecast to hit $10 billion. Chicago has been able to march on without feeling the full effects of this because interest rates have been low.

Politicians have been correct to realize that the gap between tax revenues and expenditures needs to tighten. But assuming that Illinois politicians want more than a PR victory, this Bill will not achieve their intended consequences. No class of people enjoys being singled out for taxation, and that initial resentment is heightened by the sheer enormity of the proposal. We are not talking about a 0.5% tax hike here; the current proposal that passed the house along party lines calls for a 20% hike.

Worse, many of the individuals captured by this tax are already overtaxed, or at the very least, not receiving the benefits of the lower carried interest tax rate that creates a gap this bill intends to close. And lastly, people respond to incentives. Illinois won’t get half to a billion dollars out of this—too many businesses will become c-corporations or leave the state of Illinois because the rewards for doing so are too great to ignore.