Does a trust or a REIT owe Illinois replacement tax?

Why this tax exists, and who it reaches by its terms

The replacement tax traces to the 1970 Illinois Constitution, which directed the General Assembly to abolish the ad valorem personal property tax on businesses by January 1, 1979, and to replace the revenue local governments and school districts had relied on with a statewide tax that was not itself a real estate tax (Ill. Const. art. IX, section 5(c)). The General Assembly did so effective July 1, 1979, adding the replacement tax as a second, separate tax layered on top of the regular Illinois income tax rather than folded into it (35 ILCS 5/201(c)). That structure still matters procedurally: replacement tax has its own imposition subsection, its own rate subsection, and its own exemptions, so a conclusion about whether an entity owes the regular income tax does not automatically answer whether it owes replacement tax, and the two questions are worked separately below.

By its terms, section 201(c) imposes the tax on "every corporation (including Subchapter S corporations), partnership and trust" for taxable years ending after June 30, 1979. Individuals and estates are not on that list, and replacement tax is not imposed on either. Partnerships and S corporations do not pay the regular income tax under section 201(a) and (b), because that income passes through to partners and shareholders, but both are expressly carved back into replacement tax liability at the entity level (35 ILCS 5/205(b), (c)). The rate for corporations, other than S corporations, is 2.5% of net income, reduced from an original 2.85% effective January 1, 1981; the rate for partnerships, trusts, and S corporations is 1.5% (35 ILCS 5/201(d)). Every entity question that follows is a question of which side of that corporation-versus-trust-versus-partnership line a given entity falls on, and whether it is a legal entity in the first place.

Trusts: the grantor question is the whole question

A non-grantor trust, sometimes called a complex trust in this context, is a separate taxpayer under Illinois law, as it is federally. It files its own Illinois fiduciary return, computes its own net income, and owes replacement tax at 1.5% on income attributable to Illinois, just as a partnership or an S corporation does. Nothing about being a trust rather than a business entity removes it from section 201(c)'s reach; the statute lists "trust" alongside "corporation" and "partnership" without qualification.

A grantor trust is a different animal, and the difference is not a rate reduction but a threshold classification question. Under the federal grantor trust rules, a trust whose assets, activities, and income are treated as belonging to its grantor, most commonly a revocable living trust or an intentionally defective grantor trust used in estate planning, is disregarded for federal income tax purposes; all of its income is reported on the grantor's own return. Illinois follows that federal disregard directly. The statute exempts common trust funds under IRC section 584 and any trust to the extent its grantor is treated as owner under IRC sections 671 through 678 from "the tax imposed by this Act" (35 ILCS 5/205(e)). That language reaches the whole Act, replacement tax included, unlike the partnership and S corporation exemptions in 205(b) and (c), which reach only the regular tax under 201(a) and (b) and expressly leave those entities subject to replacement tax under 201(c) and (d). Illinois regulation adds that a trust so disregarded federally "is not treated as a trust for Illinois income tax purposes" (86 Ill. Adm. Code 100.9750(e)). Put those together with the imposition rule: section 201(c) reaches entities, and a wholly grantor trust is not, for Illinois purposes, an entity separate from its grantor. If the grantor is an individual, and most grantor trusts have individual grantors, then the trust's income is the individual's income, and individuals are outside the replacement tax's reach, since only 201(a) and (b) apply to them and replacement tax is imposed only under 201(c) and (d).

The practical trap sits at the margins of that clean rule. A trust that is a grantor trust as to only part of its income, one that becomes irrevocable and stops being a grantor trust partway through a year, or one whose grantor status depends on a specific retained power that is itself contestable, does not resolve neatly into either category. A fund or entity with a mix of trust investors, some wholly grantor, some non-grantor, some mixed, cannot treat "trust" as a single reporting category on its own returns; each trust partner's status has to be determined and supported on its own facts, and that determination should be documented and revisited if the trust's terms or the grantor's circumstances change, rather than carried forward unexamined from a prior year's filing.

REITs are corporations, not trusts, for this purpose

The word "trust" in real estate investment trust describes its organizational form, not its Illinois tax classification. Illinois treats any entity treated as a corporation for federal income tax purposes as a corporation for all purposes of the Illinois Income Tax Act (86 Ill. Adm. Code 100.9750(b)(1)), and the regulation addresses REITs by name: an eligible entity that elects to be treated as a REIT is deemed to have elected to be treated as a corporation (86 Ill. Adm. Code 100.9750(b)(1)(B)). That makes a REIT a corporation for Illinois purposes, subject to the 2.5% corporate replacement tax rate rather than the 1.5% rate that applies to trusts, notwithstanding the name. The same regulation treats a REIT and its qualified REIT subsidiaries, the kind disregarded federally under IRC section 856(i), as a single corporation for all Illinois Income Tax Act purposes, consistent with the federal disregard (86 Ill. Adm. Code 100.9750(b)(1)(B)).

Because Illinois' base income starts from federal taxable income, and a REIT's federal taxable income is typically reduced close to zero by the dividends-paid deduction under IRC section 857(b)(2)(B), a REIT that distributes substantially all of its income and is not otherwise limited often owes little Illinois income or replacement tax on the income it passes through as dividends. That is where the captive REIT rule changes the calculus. Illinois requires a captive REIT to add back the federal dividends-paid deduction in computing Illinois base income, for taxable years beginning after December 31, 2008 (35 ILCS 5/203(b)(2)(E-15)). A captive REIT, for this purpose, is a REIT whose shares or beneficial interests are not regularly traded on an established securities market and that is more than 50% owned, by vote or value, directly, indirectly, or constructively, by a single corporation at any time during the last half of the taxable year (35 ILCS 5/1501(a)(1.5)(A)). The statute exempts a REIT from captive status where the controlling owner is itself a non-captive REIT, a person exempt from federal tax under Internal Revenue Code section 501 (subject to conditions on unrelated business taxable income), a listed Australian property trust or a trust such a listed trust controls at the 75 percent level, or a qualifying foreign entity that independently satisfies REIT-like tests: a real estate, cash, and government securities asset composition, no entity-level tax on amounts it distributes, an 85% or greater annual distribution requirement, either public trading or no single owner of more than 10%, and organization in a treaty country (35 ILCS 5/1501(a)(1.5)(B)(i)). A REIT is also excluded for its first taxable year as a REIT if its shares become regularly traded on an established securities market before the earlier of the due date, including extensions, of its return for that year or the date it files that return (35 ILCS 5/1501(a)(1.5)(B)(ii)). The Illinois Department of Revenue has applied that framework in at least one letter ruling addressing a REIT with a foreign parent seeking confirmation that the qualifying-foreign-entity exception, rather than captive status, applied to its structure (IT 20-0001-PLR, Jan. 24, 2020). That ruling is not precedential and binds only the taxpayer that requested it, but it illustrates the Department's approach to the ownership and trading tests in a real fact pattern, and any structure resting on the exception rather than on public trading should expect the same factual analysis if it is examined.

The captive REIT question is not a one-time determination. Ownership concentration, trading status, and the identity of a controlling owner can all shift year to year, particularly in privately held real estate structures where a REIT's shares are not publicly traded to begin with, and a REIT that was outside the captive definition in one year is not guaranteed to stay there.

The taxable REIT subsidiary is an ordinary corporation

A taxable REIT subsidiary, elected jointly by a REIT and the subsidiary under IRC section 856(l), is not disregarded federally and is not treated as part of the REIT for Illinois purposes either. It is, for Illinois classification purposes, what it is federally: a C corporation, classified as a corporation under 86 Ill. Adm. Code 100.9750(b)(1) on the same federal-conformity basis that classifies the REIT itself. The Department's regulation addresses REITs by name, deeming an entity that elects REIT status to have elected corporate treatment (86 Ill. Adm. Code 100.9750(b)(1)(B)); it does not address taxable REIT subsidiaries separately, so the subsidiary's classification rests on the general rule of 100.9750(b)(1) and the combination conclusion on the absence of contrary authority. It files its own Illinois return, computes its own apportioned net income, and owes both the regular 7% corporate income tax and the 2.5% replacement tax on that income, with no REIT-derived exemption or reduced rate of its own.

Nothing in the REIT provisions of the Illinois Income Tax Act either requires or forbids combining a REIT and its taxable REIT subsidiary on a single Illinois return. That question is answered, as it is for any other pair of related corporations, by the general unitary business group definition: a group of persons related through common ownership whose business activities are integrated with, dependent upon, and contribute to one another (35 ILCS 5/1501(a)(27)(A)). Where a REIT and a taxable REIT subsidiary meet that test on their actual facts, most often because the subsidiary provides services to the REIT's tenants or manages activities the REIT cannot conduct directly without jeopardizing its REIT status, combination in Illinois is mandatory rather than elective. The statute's former exclusion of members that apportion income under different subsections of section 304, which separated out financial organizations, insurance companies, and transportation companies, applies only to taxable years ending before December 31, 2017 (35 ILCS 5/1501(a)(27)); for later years such members stay in the group and apportion by subgroup, and in either period nothing in the exclusion reaches REITs or their subsidiaries, so a REIT and TRS are not excluded from combination on that basis. The right question is not whether combination is permitted; it is whether the unitary test is met on the specific relationship between the REIT and that particular subsidiary, tested the same way any other affiliated group is tested, and documented as such.

Practice notes

The recurring error in practice is reading entity labels as tax outcomes: assuming a trust on a K-1 means replacement tax applies, or that a REIT's name means it is taxed as a trust, or that a REIT and its subsidiary either must or cannot combine because one is called a REIT and the other its subsidiary. Every one of those questions turns on a classification rule, grantor status for trusts, federal entity classification for REITs, and the ordinary unitary test for combination, none of which is visible from an entity's name or its federal information return alone. The discipline that avoids the error is the same across all three: identify what the entity is, and re-confirm it rather than carrying a prior year's classification forward, since grantor status, ownership concentration, and trading status are all facts that can change. Replacement tax is deductible in arriving at federal taxable income, but Illinois requires a corporation to add back the amount of tax imposed by the Illinois Income Tax Act, replacement tax included, to the extent it was deducted (35 ILCS 5/203(b)(2)(B)), so the deduction does not reduce Illinois base income. A written analysis at the entity level, trust by trust and REIT structure by REIT structure, made in the year the facts are current rather than reconstructed later during an audit, is the difference between a defensible position and a guess. G&G State Tax Group provides Illinois entity classification and replacement tax analysis for trusts, REITs, and their affiliates alongside its state and local tax practice.