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Top State and Local Tax Issues for Private Equity Firms

By: Matthew John McNally |

Private equity firms face an increasingly complex tax environment. The combination of the 2017 Tax Cuts and Job Act, the historic U.S. Supreme Court Wayfair ruling last summer, and the growing trend of states adopting market-based sourcing, have put many new rules and regulations on the table.

As these changes take effect, it’s more important than ever for firms to be up-to-date from a tax perspective. Here’s a brief look at the top state and local tax issues facing private equity firms today.

  1. Nexus complexity. As mentioned earlier, the Wayfair decision has definitely added complexity to the tax environment, specifically nexus. To understand the Wayfair decision, it’s important to remember that nexus determines when a taxpayer has to file sales and/or income tax returns in a state based on the activities conducted in the state. Prior to this SCOTUS ruling, nexus was based solely on physical presence. Now it can be based on economic activity as well.

That means if a private equity firm buys a partnership, the firm will then have the same nexus as that partnership and must file state taxes wherever the partnership is required to file. It now becomes a very cumbersome process as one nexus can create multiple state tax filings, and the firm must have a system capable of tracking everything.

Companies that do not register and file state and local taxes in the proper jurisdictions can incur substantial penalties and interest. Therefore, it’s important to determine where your firm has nexus and track it accordingly.

  1. Audit readiness. More state and local filings result in more exposure to possible audit. Additionally, many states are becoming increasingly strict with heavier policing of non-compliance, more aggressive tax collection, and higher penalties. Private equity firms need to be prepared to successfully withstand this scrutiny.
  2. Market-based sourcing. Over the last few years, a transformation has been taking place in state and local income taxes—the shift to market-based sourcing for services income. In short, market-based sourcing is based not on where the service is performed, but where the benefit of the service is received by the customer. This method drastically changes the way service-providers are taxed.

Consequently, private equity firms may be required to allocate management fees to where the fund’s investors reside rather than where the firm is doing business. And because state laws vary, a firm may be required to source the sale to both states—potentially paying taxes on over 100% of income. For example, if a private equity firm in Connecticut is managing investments for a client in California, Connecticut could tax 100% of the income and California could tax 20% resulting in a tax on 120% of income. For more information on this topic see our blog on What Market-based Sourcing Rules Mean for Private Equity Firms.”

  1. Cost burden. Finally, the three issues mentioned above all come together to create higher costs. Sophisticated tracking systems to account for a more complex nexus, thorough audit preparation, and more state and local tax filings all require additional funds. Private equity firms have to take this into account as part of the cost of doing business in an increasingly complicated tax environment.

The experienced tax professionals at True Partners Consulting can help you stay on top of state and local tax issues. To learn more about the impact of these issues on private equity firms, contact Matthew McNally at Matthew.McNally@TPCtax.com.