Tax planning season is almost here. Private equity and venture capital firms will have a lot to sift through but one element that should not be overlooked are funds’ state and local income tax obligations. The following are four state and local income tax topics that should be on the minds of all private equity and venture capital (PE/VC) management teams, particularly because some of these provisions may affect PE/VC investors.

State Nexus

Nexus is the minimum connection that a taxpayer must have with a state or local jurisdiction before becoming subject to that jurisdiction’s tax laws. Nexus can refer to any type of tax—income, payroll, sales, property, etc. In 2018’s groundbreaking court case South Dakota v. Wayfair, the federal government ruled that a taxpayer’s physical presence was not required to generate nexus. While many states apply various thresholds that would have to be met, any kind of purposefully directed activity could be enough to trigger nexus in a particular state.

Post-Wayfair, states have been tweaking their tax laws to take advantage of this “economic nexus” standard and more easily tax out-of-state sellers. Considering private equity firms will be assumed to have nexus in the same states as their investments, this change will hit PE/VC firms especially hard.  Cost of compliance will increase if funds have to file in additional states that they were not previously filing in. PE/VC firms should pay close attention to the activities of their target entities before finalizing acquisitions so they know how the transaction could affect filing responsibilities.

State Allocation and Apportionment

An entity’s income will be taxed at both federal and state levels. There are two methods by which income gets divided among the states:

Allocation: Nonbusiness income (which is everything but business income) is allocated based on each states’ statutes for particular types of income-generating property.

The question that PE/VC firms must ask themselves is: Should my investment income be apportioned or allocated? Most states allow firms to allocate their pass-through income from their investments in operating partnerships. Partnerships that have reportable activity in multiple states will provide State K-1s or footnotes in their K-1s that show state-specific information. The state income shown in those K-1s or footnotes will be taxable to the private investor. Unfortunately, this may impose a state filing responsibility onto the PE/VC investor. If they had not already been filing in those states and the state does not allow the partnership to file and pay taxes on their behalf, they may be required to file in each and every state in which the partnership does business. PE/VC firms should note which states do not allow the partnership to file and pay taxes on the partners’ behalf and communicate with their investors about their potential tax filing responsibilities.

Another area that adds an additional layer of complexity to determining state sourced income is the sourcing of gains from sales of partnership interests.  States may apply different rules regarding the classification of this type of income.  As mentioned previously, states’ statutes will determine the types of income that are classified as business or non-business income.  PE/VC firms will have to consider factors such as their business activities, the type of sale, whether they are active or passive in the business, as well as many other considerations to determine if the state will treat the gain as business income subject to apportionment or nonbusiness income subject to allocation.

Nonresident Withholding and Composite Returns

More than half of all states require pass-through entities to withhold tax on behalf of their nonresident owners. This ensures states receive the taxes that are rightfully theirs without having to pursue each individual taxpayer through audits or assessments. Investors may still have to file a state tax return to report the income allocated to them, and can take a credit for the withholding paid on their behalf.  Investors can also opt to provide the fund with a state waiver, certifying that they will make their own state estimated payments, and relieving the fund from making the payments on their behalf.

Nonresident withholding may also be required on gains from the sale of a partnership interest.  It is important that prior to distributing  the proceeds from the sale, the PE/VC fund does the necessary calculations to determine the amount of withholding related to the sale that will be required to be remitted to the states on behalf of its investors.  Doing so will help to ensure the fund holds back sufficient cash from the distribution to cover the taxes owed.

In tandem, many states allow pass-through entities to file composite tax returns on behalf of their nonresident partners, if those partners have no other income sourced to that state. A composite return could save PE/VC investors almost all state compliance burdens. However, investors may pay more taxes as a result. Many states apply the highest marginal tax rates to composite return income, deductions may be limited, and NOL carryforwards are disallowed, which could result in tax well above what they would have paid by filing on their own.  PE/VC funds should work with tax professionals to determine if composite returns will benefit the fund and the individual investors in the long run.  The cost of compliance at the fund will have to be weighed against the convenience provided to the investors through reduced compliance on their end.

Some firms opt to send an annual questionnaire to its investors to determine each owner’s domicile, existing filing responsibilities, tax-exempt status, and interest in participating in a composite return. In many instances, participation is optional. Taxpayers can sign an affidavit either opting out or opting in to inclusion in a composite return.  The annual questionnaire can include state waivers that will allow investors to also opt out of nonresident withholding, as mentioned above.  

Market-Based Sourcing for Management Companies

Service-based revenue has always been difficult to source.  Should the resulting income be assigned to the state in which the service was performed, or should it be assigned to the state where the customer receives the most benefit? More and more states are choosing to shift away from performance-based sourcing methods to market-based, which may prove difficult for PE/VC firms. They may now be required to allocate management fees to the home states of their investors rather than where they conduct business. 

If all states used market-based sourcing, this may not be an issue. However, when some states use performance-based sourcing methods and others use market-based, income has the potential to be taxed twice. States have become increasingly aggressive in tax collection in recent years, so there may not be an easy way out of this conundrum.  Furthermore, PE/VC firms will also have to consider how market-based sourcing will interact with new economic nexus rules since Wayfair.  The fund may be considered to have economic nexus in a state where its investors are located if management fees are allocated to those states, and as such, could have filing requirements in states that they are not physically conducting business in.

For More Information

Noncompliance with state and local taxes can be damaging to even the most successful PE/VC firms. To ensure your firm (and you as an individual) are compliant with state and local taxes, contact a member of our team.

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Published on September 24, 2019