Illinois Financial Services “Privilege” tax?

Jun, 29 2017

Turnkey’s very own Scott Kruse recently penned an article about Illinois’ planned financial services tax. His work was picked up and featured at the National Introducing Brokers Association (“NIBA”).  We’d encourage you to visit the NIBA article and to read more about the organization and what it does for the futures industry. To read Scott’s work you may do so below:

Illinois Financial Services – A “Privilege” Tax?

By: Scott Kruse – Turnkey Trading Partners

The State of Illinois is bankrupt. Whether anyone will acknowledge that or not is up for debate. Readers who are not familiar with the perilous state of financial affairs in Illinois need look no further than any major news publication over the last two weeks. The situation has gotten so dire that even the Chicago Tribune, Illinois’ very own reporting establishment, has gotten in on the action. Just this past week this tongue and cheek article about “Dissolving the Land of Lincoln” was run.  All of this would be funny if things in Illinois weren’t so serious.  So what’s a state in financial crisis to do? Raise Taxes. Except this time the taxes are intended to punish financial services firms still trying to make a buck in Illinois. That means the futures and securities industry are firmly in the State’s cross hairs.

Who does Illinois want to tax?

Illinois House Bill 3393 aims to tax partnerships and s-corporations engaged in investment management services by adding a first in the nation 20% tax on fees earned from investment strategies. Given the broad language in the proposal is there any doubt this tax could and likely will be applied to Commodity Trading Advisors (“CTA”) and Commodity Pool Operators (“CPO”)? Registered Investment Advisors (“RIA”)?  The real question is how far will they go? Will Illinois apply this to Futures Commission Merchants (“FCM”) and Introducing Brokers (“IB”) they deem to be assisting with or offering “investment strategies”? Will it apply to broker dealers (“BD”) of various types? What is the definition of “investment strategy” anyway? One thing is for certain the State wants financial services firms to pay more for the privilege of operating in Illinois.

What is Illinois saying it’s trying to accomplish?

Besides trying to generate more tax revenue articles published on this legislation suggest that Illinois is attempting to close the so called “carried interest” loophole. For those unfamiliar the carried interest loophole currently allows fund managers (that typically have an equity interest in the funds they operate) to consider incentive fees as “incentive allocations.” In so doing the incentive allocation then increases their share of fund equity rather than getting paid out as a fee for performance.  Over time, since the incentive allocations become equity, when they are withdrawn they are taxed at a lower rate than ordinary incentive fee income would have been. In this way the investment manager has “carried interest” in the fund rather than taking fees in the period they were earned. 

Is there more to the story?

It is worth noting that Illinois has a state legislature that loves to “tax the rich” to score political points. It is also a State that would rather play politics than to work on structural reform. Both of these items are easily evidenced by Illinois’ lack of a budget for the last 3 years.  According to a June 27, 2017 article in the Wall Street Journal the State now owes $14.6 billion to vendors it has not paid during the budget impasse. Illinois also has literal hundreds of billions in unfunded pension liabilities coming due, which as of now and probably into the future, it cannot pay. Given this situation one must wonder if the bill is actually an attempt to simply embarrass Republican Governor Bruce Rauner? For those who are unaware Rauner notoriously made his fortune in private equity and would have likely paid much more in taxes to the State had such a law been in place while he worked in the private sector.  So how does one come to the conclusion that HB 3393 is yet another political stunt that will not help the State of Illinois or its tax payers?

Practical Outcomes

Regardless of the State’s intent or individual political views, common sense says this bill will immediately hurt, and quite possibly decimate the futures and securities industry in Illinois.  Over time the large firms the bill targets will likely close locations that require them to pay Illinois’ investment strategy taxes. This will put further pressure on a State that is already bleeding people and businesses at an alarming rate.  If there is any doubt this will happen some readers will remember when Illinois threatened a transaction tax on Chicago based exchanges? The result? CME Group threatened to leave the state all together.

Perhaps worse the State already knows this! At the Illinois legislature’s website one can read the following when researching this bill:

“The Department of Revenue estimates that in the long-­run, this bill would raise no new revenue for the State. Due to the magnitude of the tax, this bill would elicit a strong behavioral response from would-be taxpayers. Taxpayers would be strongly incentivized to either reclassify fees so as not to be considered “investment strategy” or to relocate the taxable activity so that it is beyond the reach of the State.”

Turnkey Trading Partners works primarily with futures traders. At present there are roughly 537 registrants operating in the State of Illinois. We are well aware that most of these firms are smaller operations and not large industry participants. Certainly very few of them are significant hedge funds who would even have an opportunity to leverage the carried interest loop hole. Like most taxes the burden of the investment strategy tax will be carried on the backs of small businesses that can’t find a way to leave Illinois, reclassify fees, or change their organizational structure to avoid the tax. In fact such a tax may even produce further fallout if firms like Turnkey choose to also leave Illinois following their clients to more favorable business environments.

Conclusion

The financial services industry is facing the strongest headwinds in decades.  Asset managers are seeing fee compression like never before. Hedge funds are closing more readily than they are opening. Automated trading and robo-advisory firms are replacing human traders and managers.  While there are some shining stars left in Illinois and throughout the country the days of the Chicago Board of Trade (“CBOT”) and Chicago Mercantile Exchange (“CME”) floors producing millionaires are also over.  As usual Illinois has completely missed the mark with this legislation. In fact they know they have missed the mark in saying it will be ineffective at capturing new revenue! As usual in Illinois it’s politics before people.  The passage of such a bill will no doubt put further pressure on a struggling industry. It also will force the remaining financial services groups located primarily in Chicago to consider closing Illinois locations to continue doing business elsewhere. This bill should be alarming to any voter in Illinois, sane voters may want to contact their State representative to discuss it immediately.

To learn more about Turnkey Trading Partners services or to contact the author of this article please send all inquiries to Scott Kruse via info@turnkeytradingpartners.com or by calling (312) 324-0040.