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IMA Tax Policy Blog

State Sourcing Income Rules and Considerations for Hedge and Private Equity Funds

by Gregory Kastner

Baker Tilly is an IMA member certified public accounting and consulting firm…

As if the Internal Revenue Code, Treasury Regulations and various federal courts didn’t make taxes complicated and confusing enough, hedge fund and private equity managers must also contend with the varied, and often contradictory, state laws regarding sourcing of income. No unifying principle seems to translate from one jurisdiction to the next with one exception: all states seem to be saying we want more.

There are two key concepts that govern state income taxes. The first is nexus which is the legal or economic connection that permits a state to require a business like an investment advisor to file an income tax return. Once nexus is established, the second concept – sourcing comes into play. Sourcing rules determine the methods used by a business to assign income to the states in which it has taxable activities. Whether a business has nexus in a state depends on the amount and type of business activity present there. Physical presence in a state can be established through having employees, partners or other agents there (be sure to keep in mind telecommuters either in management or traders), owning or leasing property there, or investing in and actively managing a partnership or other pass-through type entity that has its own sourced income in that state.

Of course, each state has its own interpretation of these rules, can and sometimes does apply them to corporations or partnerships differently, and so each must be considered separately. Traps to watch out for are registering to do business in a state and then never actually doing business there or failing to file the proper dissolution papers if your business is permanently leaving that state – California is particularly aggressive in collecting its minimum franchise tax in such instances.

Movement from three factor apportionment formula to just sales

Historically and still in some states, income was apportioned among states using a variation of a three factor formula – sales, payroll and property.  Some states equally weighted each factor. Other more heavily weighted sales. The property factor usually included rent expense multiplied by a factor of 8 to substitute for property leased in that state. However, in recent years, many jurisdictions have transitioned to a single factor formula – sales.

Apportioning sales has grown in complexity as the way businesses conduct their operations has changed with the expansion of e-commerce and telecommuting. In the past, most states apportioned sales using the cost-of-performance method, meaning revenue was sourced to where the work that earned that revenue was based. This method was further refined as either cost of performance proportionate (meaning if work was done 40 percent in one state to earn the sale and 60 percent in another, sales would be apportioned accordingly) or cost of performance all or nothing (in the previous example, the sale would be sourced to the 60 percent state). Under both cost-of-performance approaches, the assignment of revenue occurs on a “transaction by transaction” basis. For a hedge or private equity fund cost of performance meant the management fee was generally sourced to where the traders and management were located. If a hedge fund had Minnesota investors, but was run out of an office in Manhattan, the management fee income was sourced to New York City and a tax return in Minnesota may not have been filed.

Then came market-based sourcing rules.

Cost of performance versus market-based sourcing rules

As of 2016, 24 states had adopted market-based sourcing rules in a myriad of forms and often applying different methods to corporate versus personal income tax. All of these various methods can lead to entities allocating more than 100 percent of taxable income among states where returns are filed. The difference between market-based sourcing and cost-of-performance is that market-based may allocate the management fee to where the fund’s investors reside.

This can get especially tricky when the addresses of trusts are located one place and the beneficiaries in another. The problem gets worse with fund of funds as some states also have “look-through” provisions. Funds with numerous investors, some of which might be partnerships or limited liability companies being taxed as pass-through entities, could face a nightmare trying to determine where to market-source all of its income. This is aside from the extra cost of compliance that can come along with this in the form of accounting fees and, perhaps, state entity level taxes.

Non-business income

Non-business (or non-unitary) income, however, is usually not apportioned but rather allocated. Non-business in the investment partnership world generally refers to income passed through from another partnership where such determinations as to apportionment are done at that level. This type of income may be from oil and gas properties, real estate partnerships and patents. If a hedge or private equity fund received this allocated sort of income, the income would generally retain its state sourcing. Required withholding, if any, would probably be done at the upper level, but if it wasn’t, responsibility may fall to hedge or private equity fund depending on what information was disclosed to the upper level partnership regarding domicile and partner residency.

Relief for the carry/incentive/carve-out (while it lasts)

While the fixed fee hedge and private equity funds charge based on net assets under management is subject to state sourcing rules, the profit reallocation (also known as the carry, incentive or carve-out) often is specifically excluded under a trading for its own account exclusion many states offer. To take advantage of this exclusion, generally most hedge and private equity funds have the profit reallocation be given to a separate limited liability entity than the one receiving the management fee to preserve this exclusion and keep the income free of any state sourcing taint. Generally, this income ends up being taxed by wherever the managers of the fund reside.

However, this exclusion only applies to income from securities and does not apply to income that might be sourced to a particular state because of what it is.  Loan origination fees, real estate income or oil and gas royalties are all types of income that would retain their sourcing to their original states even when passed through as a profit allocation to a manager. Often, these are passed through other partnerships into the fund. When deciding on investments to be made, state sourcing should be considered. If the federal administration ever gets around to changing how the profit reallocation is currently taxed and the states follow suit, expect this exclusion to disappear.

This exclusion for trading for its account is what also allows a California resident to invest in a New York City based hedge or private equity fund without necessarily paying any New York based income taxes. Nearly every state has a form of this exclusion.

Compliance issues and common state tax differences

When preparing state income tax returns, there are often federal to state taxable income differences.  Many states do not conform to the federal bonus depreciation. Most do not allow the deduction of taxes based on profit but do allow fees (such as secretary of state filing fees). There are also currently eight states that require filing in that state if a partner resides there even if no income is sourced there: California, Georgia, Missouri, New York, New Jersey, Oregon, Pennsylvania and Utah. Before accepting investors in any of these states, hedge and private equity managers should consider the cost of additional compliance for taxes.

Impact of partnership having state sourced income and solutions

So what happens if a partnership has state sourced income?

Some states have income thresholds, which may be as small as one dollar, that once passed require filing. In addition to the filing, many states also require the entity to withhold state income taxes on the income sourced to nonresident partners, whether foreign or domestic. These are generally done at a fixed rate, sometimes different depending on the partner’s structure (individual, corporation, foreigner), and sometimes on income, sometimes on distributions. Obviously, if the withholding is required only on distributions as opposed to state K-1 amounts, this can cause a headache as the state apportionment percentage might change year to year and the distribution could be of prior allocable income.

To alleviate the need for the individual partner to also file in the state (as in cases of states that require filing if even one dollar of income is sourced there), some states offer the partnership the option to file a composite return. In a composite return, the partnership pays the partners state income tax liability on their behalf. However, the composite return’s tax rate is generally the highest marginal tax rate imposed by the state and the partners are not able to take advantage of itemized deductions or perhaps other sourced losses attributable to the state. This advantage may be offset by the cost of paying someone to prepare these additional tax returns at the partner level.

Failure to properly withhold can expose the partnership to a liability for state taxes. This can also lead to a FAS 5 / ASC 450 issue and possibly be an Uncertain Tax Position. In most cases, the statute of limitations would not start unless a filing was done in that state (and, generally, it doesn’t count if it’s completely or willfully erroneous) and so exposure wouldn’t necessarily end after a certain number of years had passed. Not withholding payroll taxes as necessary or remitting the amounts to both states (state sponsored disability insurance) and the federally based Social Security administration can have dire consequences as well, as traditionally enforcement of these payments are much more doggedly guarded. Knowing the rules determining when a service provider is an outside contractor versus an employee is imperative.

Sales and use tax: Computers, research services and art

Despite not usually having to collect sales tax for their services, hedge and private equity managers may be subject to use tax on equipment or services they did not pay sales tax on. Examples include purchasing a computer free of sales tax over the internet and having it shipped to the manager’s office or purchasing research services or security services and, again, not paying sales tax. Renovations of office space should also be considered. Purchases of art for the office also can fall under this purview. States like New York have been especially aggressive in recent times in arguing that expensive pieces of art displayed in offices enhance the company’s image of success and, therefore, are being used by the business and subject to the use tax. Claims that the art was purchased for resale and that the manager is an art dealer can be contested.


Partnerships must pay a 1.5 percent personal property replacement tax on income (no estimates are required). Qualified investment partnerships are excluded from the tax but must have 90 percent of their assets be stocks, bonds, etc. and have 90 percent of their income derived from such assets. Therefore, the entity receiving the management fee income would not qualify generally and entities holding more complex investments would need to look closely at the definition.

Illinois utilizes a single sales factor for apportioning sales based on market-based sourcing. Composite returns cannot be filed. Withholding is due on nonresidents’ share of Illinois based income.

Illinois has a use tax. Illinois does not generally tax licensed software or software as a services. City of Chicago does tax both licensed software and software as a service.


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