State Withholding vs. Composite Filing: What’s the Difference?

Fund managers have many decisions to make when deploying their capital. A leading yet often overlooked factor is the state tax consideration for the potential investment. Amid questions around future valuations and current profitability, it’s important to keep in mind that each state has different filing requirements and tax calculations which can impact a fund’s limited partners.

State Withholdings and Composite Filings

A key decision around state filing requirements for fund managers is whether to elect a composite filing or withholding on behalf of investors. What exactly is the difference between the two? State withholding is when the partnership remits state tax payments on behalf of nonresident partners. A composite filing remits state tax payments on behalf of the nonresident partners and satisfies the partner’s filing requirement in the state. In theory, a composite filing is the obvious choice, but there are some potential drawbacks.

Considerations Before Selecting a Composite Filing

• Not all states provide composite filings as an option.
• Composite filings are taxed at the highest marginal tax rate, so the rate may be higher than nonresident partners withholding.
• State rules vary regarding which investors can participate in a composite filing. For instance, some states may not allow investors that are partnerships or corporations to participate in the filing. Additionally, some states disallow participation in a composite filing if an investor has income or losses attributable to the state from other sources.
• Since not all investors may be able to participate, this could result in filing two separate state returns for those who participate and those unable to participate. The additional filing will increase compliance costs for the fund.
• Limited partners may also be required to submit an election form notifying the fund that they wish to participate in the composite filing which can require additional record keeping and an increased administrative burden for the fund as these elections may need to be collected and/or reviewed each year to determine they are still valid.

Understanding Compliance and Beyond

The tax return compliance process will undoubtedly be more complex given these varying factors even if it eases the burden on the limited partners.

Fund managers evaluating state withholding versus composite filings should discuss these considerations with a tax advisor to understand their particular tax footprints and options available. Please reach out to a Weaver tax professional with any questions related to this topic.

Authored by Conner Walker

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