State Compliance Considerations for Investment Funds

Wouldn’t it be nice if state tax laws could conform to a uniform standard? Unfortunately, this is not the case, and investment funds — particularly private equity funds — need to look at withholding obligations on a state-by-state basis each year to determine withholding requirements, among other things, on behalf of nonresident investors.

Quite often, funds invest in pass-through entities with operations in various states. When this state source income is passed through to the fund, several determinations need to be made. Does a state income tax return need to be filed? Does tax need to be withheld on behalf of nonresident investors? This can create a compliance nightmare for the fund, and it can be very time consuming and costly depending on the number of states and investors involved.

Keep in mind that operating income — ordinary income of an active trade or business, for example — is the main sticking point. Passive investment income, including interest, dividends and capital gains, is generally sourced to an investor’s state of domicile.

There are various mechanisms used by state tax authorities to collect tax from pass-through entities:

• Nonresident withholding
• Composite tax filings
• Entity level taxes and fees (like California’s $800 minimum franchise tax)
• Pass-through entity level tax elections (to avoid the $10K cap on the state and local tax deduction under the Tax Cuts and Jobs Act)

While rules vary from state to state, some states have an option for an exemption from withholding on nonresidents. In these situations, the partners of the fund can sign a waiver form effectively stating the partner agrees to file a state tax return in a particular state and pay any tax due. This relieves the fund of the withholding requirement in most situations which may be helpful from a cash flow and administrative perspective. However, depending on the number of investors in the fund, the process to obtain these exemptions can also be very time consuming and administratively burdensome.

However you slice it, the burden on multistate partnerships can be cumbersome, especially when a fund has several tiers involved.

Regardless of the choice made, it is important for funds to report to investors how much state tax has been remitted and/or withheld on their behalf, as this can impact both federal deductions and state nonresident returns at the investor level. State filing requirements and reporting obligations should be reviewed in depth with your tax advisor. Contact us to learn more about state compliance considerations for investment funds. We are here to help.

Authored by Meghan Matthews

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