O Tax Revenue, Where Art Thou?

Keith Staats, JD Special Counsel, Duane Morris LLP
Deciphering Today's State & Federal Tax Law

Even though the Illinois General Assembly’s spring legislative session has only recently concluded, and the budget for fiscal year 2025 began on July 1, there’s already talk of a need for additional tax revenues for the fiscal year 2026 budget.

For example, the Chicago area’s transit agencies—including the Regional Transportation Authority (RTA) and Chicago Transportation Authority—have already announced their intentions to seek additional funding from the state. For background, these transit agencies have been receiving a significant amount of federal funding since the pandemic, and that funding runs out at the end of the year. In fact, beginning in 2026, the RTA system is facing a projected $730 million annual budget gap.

Of course, the state doesn’t have an extra $730 million to give, and the City of Chicago is facing its own unique fiscal challenges, with Mayor Brandon Johnson already looking at several different revenue sources. Because the City of Chicago doesn’t want to raise additional revenue by increasing property taxes, there’s been talk of taxing services at both the state and city levels.

While my focus for this column isn’t to give my opinion on the merit or lack of merit of taxing services, I will provide some historic context on prior attempts to tax services in the state and City of Chicago and why legislative leaders will face challenges if they steer in this direction.

THE HISTORY OF ILLINOIS’ SERVICE TAXES

Illinois has a Service Occupation Tax, and like most things that are sales tax related in the state, this tax is unique. Despite its name, the Service Occupation Tax doesn’t tax services. Instead, it’s a tax imposed on tangible personal property (TPP) transferred to a purchaser in the course of providing a service—the service itself isn’t taxed.

So, how did Illinois end up with a “service” tax that doesn’t tax services? The answer lies in the restrictions on taxation that were included in the 1870 Illinois Constitution that was in effect when Illinois enacted its sales taxes, as well as political inertia that prevented Illinois from revamping its sales tax laws since the enactment of the 1970 Constitution.

As I’ve shared in previous columns, Illinois’ sales tax is actually four separate taxes: the Retailers’ Occupation Tax, the Use Tax, the Service Occupation Tax, and the Service Use Tax.

• Retailers’ Occupation Tax and Use Tax: In 1933, Illinois enacted the Retailers’ Occupation Tax, which is a tax on the sale of TPP imposed on a retailer. However, the tax had a major loophole—purchasers could make purchases tax-free from out-of-state sellers who weren’t located in Illinois. To close that loophole, Illinois enacted the Use Tax in 1955. The Use Tax is imposed on purchases of TPP and gives Illinois the authority to collect tax from purchasers when they made purchases from retailers that aren’t subject to the Retailers’ Occupation Tax.
• Service Occupation Tax and Service Use Tax: In 1961, Illinois enacted the Service Occupation Tax and the Service Use Tax. These taxes are imposed on the selling price of TPP transferred (sold) to an end user in the course of providing a service. A classic example is automobile repair: The tax is imposed on the selling price of the repair part(s), but the charge for the mechanic’s service in repairing the automobile isn’t taxed. (There are arcane and, in some instances, virtually incomprehensible rules about how a bill from a service provider can be divided up to properly allocate charges between taxable and nontaxable aspects of the service transaction—but that’s a whole other column in itself.)

SERVICE TAX PUSHBACK

In 1967, the Illinois General Assembly passed, and the governor signed, legislation to impose a true tax on certain services. The tax base of the Service Occupation Tax was expanded to include the charges for these services. This expansion was limited to four types of services:

1. Selling certain tools and equipment.
2. Printing graphic arts (not taxable under the Retailers’ Occupation Tax).
3. Repairing, renovating, or reconditioning TPP.
4. Selling prescription drugs or medicines.

However, a group of service providers and customers challenged the validity of this legislation, and in 1968, the Illinois Supreme court ruled in Fiorito v. Jones that the amendments to the Service Occupation Tax were unconstitutional, as they limited taxed services to the four types of services. If the tax was deemed to be levied on the performance of a service, the court concluded that it was unreasonable to exclude transactions in which no personal property was transferred. Also, if the tax was deemed to be levied on the TPP transferred by a service provider, the court concluded it was unreasonable to measure the tax by the gross receipts of the entire transaction.

Another example that was challenged was in 1981 when the City of Chicago enacted an ordinance that imposed a 1% tax on purchases of services in the city. In 1982, the Illinois Supreme Court ruled in Commercial National Bank of Chicago v. City of Chicago that the city’s services tax was unconstitutional on two grounds:

1. It violated a provision of the Illinois Constitution requiring approval by the General Assembly for the imposition of occupation taxes by home rule units.
2. It violated the Illinois Constitution’s uniformity clause by taxing certain businesses and transactions and exempting others.

Needless to say, if the General Assembly attempts to craft legislation that taxes services next year, these are some of the challenges they’ll be up against again. After all, Supreme Court precedent will make it difficult, if not impossible, to pick and choose which services can be taxed.

If Chicago pushes forward with its proposal to tax services, it’ll face challenges because Supreme Court precedent and Illinois law restricts Chicago from imposing a local services tax without specific authority from the General Assembly. Of course, even if such authority were granted, uniformity principles will limit the ability of the city to pick and choose which services are taxable.

That said, if state and city leaders go looking for additional tax revenues for the years ahead in the form of services taxation, in my opinion, both the city and state will be unlikely to craft taxes on services that are both politically viable and legally defensible.

Related Content:

• Illinois’ Sales Taxes: A Deeper Dive on Exclusions and Exemptions: Exclusions and exemptions may sound the same, but when it comes to Illinois’ sales taxes, they’re actually quite different.
• Illinois’ Corporate Income Tax: Never-Ending Complexity: Having the state’s income tax mirror the federal tax base seems simple enough, but decoupling from federal tax treatment makes it anything but.