State sourcing income rules and considerations for hedge and private equity funds

State sourcing income rules and considerations for hedge and private equity funds

Sourcing rules in general, nexus

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.

State guide

What follows is a tax guide of some states that have many hedge and private equity managers. As you read on, you’ll notice how no state conforms to the next and many complexities arise.


California uses a single factor formula for investment partnerships. On January 1, 2011, California adopted an economic nexus standard for purposes of allocating sales based on market-sourcing. Based on examples that were withdrawn and then reinstated in January of 2017, when California gross receipts exceed $500,000 or 25 percent of the total, the entity receiving the management fee would have to allocate income to California even if the fund had no physical presence in the state. A “look-through” approach is taken to determine the residence of the ultimate investors, even in cases where the investors are trusts or pension plans.

So if a New York based management company were to receive $2,000,000 in fees during the year and 25 percent of its investors lived in California, the New York based management company would be subject to California income tax. There has been some back and forth on this as the regulation is written for mutual funds and particularly hedge or private equity funds, but it seems the Franchise Tax Board is going to be aggressive on funds not apportioning sales to the state.

For “qualifying investment partnerships” (those with 90 percent of their assets in liquid type investments such as stocks, bonds, etc.), income from the partnership is still sourced to the state of residence. Therefore, on the incentive only, a New York based manager receiving the “carry” from a California-based investor could probably avoid California taxation on that “carry.” This also allows Iowa-based investors to invest in a California-based qualifying investment partnership without paying California taxes.

California imposes an $800 minimum franchise tax on limited partnerships or LLCs registered to do business in California or with California sourced income. In addition for LLCs, a tiered gross receipts fee is imposed with a maximum of $11,790 if California based receipts are $5,000,000 or more. Distributions of California-based income to California non-residents must be withheld on at 7 percent for domestic partners and higher rates for foreigners (8.84 percent for corporations, 10.84 percent for banks and financial institutions and 12.3 percent for everyone else). Since this withholding is on distributions and not on income, the confusion of the timing issue mentioned above can come into play. California provides for the filing of a composite return, but only for individual partners and at the highest tax rate of 12.3 percent. Obviously, if the amount is large enough, the individual partners may want to file in California to take advantage of their own itemized deductions (unless the Trump administration’s proposal to eliminate most itemized deductions is eventually passed).

California has a use tax. (Note, electronically downloaded software is exempt.)


Colorado is a cost of performance proportionate state which essentially uses a single sales apportionment factor for the management investment partnership entities. If one of a hedge fund’s four managers is located in Colorado and three are located in New York, Colorado is going to want 25 percent of the management fee income allocated to it. If nonresident members sign a Form DR 0107 saying they will file in Colorado if necessary, no withholding need be done.

Colorado has a use tax.


With Senate Bill #502, Connecticut has changed to a single sales apportionment factor and market based sourcing for 2017. The state charges a $250 business entity tax every two years and requires withholding at the rate of 6.99 percent on Connecticut based income in excess of $1,000 allocable to a nonresident non-corporate pass-through entity member.

Connecticut has a use tax.


Florida has no personal income tax, but it does have a use tax. Downloaded software is not subject to tax.


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.


Massachusetts utilizes the traditional three factor apportionment – sales, payroll and property (unless the entity happens to be a mutual fund service corporation – then it just uses sales – this might be a precursor of changes to come to investment partnership rules). Double weighted sales are market-sourced. A composite return can be filed for an electing full-year nonresident individual or the estate or trust of someone who passed away. Withholding on sourced income allocable to nonresidents must be withheld but are exclusions for Qualified Securities Partnerships and tiered structures when the lower tier has already done the necessary withholding (no need to double up). On amounts going to individuals the rate is 5.1 percent.

There is a use tax.


Minnesota uses a single factor market-based sourcing sales apportionment (though, if the method can be argued successfully that it does fairly reflect net income, another apportionment method can be used – many states have similar clauses) and has a use tax. It imposes a minimum fee if source sales, payroll and property is a certain level – topping out at $9,690 in 2016 – each year it is adjusted upwards for inflation. Unless a composite return is filed (only individuals and grantor trusts can be included), if a nonresident partner receives more than $1,000 in distributive income, withholding is due and is paid on a quarterly basis. Prewritten software is taxable.

New Jersey

Despite some proposals over the years, New Jersey is still cost of performance proportionate for partnerships. The state imposes a $150 fee per resident partner that is apportioned for non-residents on any partnership with New Jersey sourced income. Though corporations use a single sales factor for apportionment, partnerships still use the standard three factor formula – sales, payroll and property.  Withholding is required for non-residents receiving New Jersey sourced income – 6.37 percent for individuals, trusts and estates and 9 percent for corporations or other partnerships. Composite returns can be filed, but only on behalf of individuals.

There is a New Jersey use tax. Business software is generally exempt.

New York and New York City 

New York imposes an annual filing fee based on New York sourced gross income remitted by March 15 for calendar year entities. It’s paid on Form IT-204-LL and goes from a minimum of $25 to $4,500 for entities with income over $25 million. New York City imposes an Unincorporated Business Tax (UBT) of 4 percent on non-corporate entities with New York City based net income. (Investment income can be excluded from income subject to the tax but generally not if the funds used to invest are working capital of the business.) Despite New York City having a trading for your account exception, most hedge and private equity managers have the incentive reallocation flow to a separate entity than the one receiving the management fee to avoid paying New York City UBT on the incentive and only pay it on the management company. For each active partner, an exemption is given.  If the management fee receiving entity is a single member LLC disregarded for federal tax purposes, the owner still must pay New York City UBT on the net profit. New York City also imposes a commercial rent tax on annual rent of $250,000 or higher.

There is a New York use tax. Software as a service and prewritten software are taxable.

Everything changed for corporations in New York starting in 2015 with regards to market-based sourcing of sales, but for partnerships everything pretty much has stayed the same with a cost of performance proportionate approach to the sales factor and still having a three factor formula. For New York City, apportionment is also done using a three factor formula, but sales are heavily weighted and will soon be the only factor, making payroll and property much less relevant.

New York allows filing of a group return, but a request must be made beforehand and there must be at least 11 nonresident individuals who want to be included so it’s rarely done in the investment partnership world. New York partnerships are required to withhold taxes on income allocable to the state, but if the partner completes a Form IT-2658-E saying they will fulfill their New York State filing obligation, that requirement is waived. This form currently must be renewed every two years and is only kept in the records of the partnership and not remitted to the Tax Department.


Oregon apportions using a single sales cost of performance all or nothing factor – meaning if a management company earns the fee from a Montana investor 60 percent in Portland and 40 percent in Seattle, the fee will be allocated to Oregon for Oregon purposes. Oregon requires pass-through entity returns, but does not require withholding on nonresidents. Local income taxes may apply (e.g., Multnomah County).

Oregon has neither a sales nor a use tax.


The presentation of Pennsylvania Schedule K-1s for partnerships differs slightly than other states and has given computer programmers issues for years. The software for preparing Pennsylvania partnership returns for out of state entities has always been a labor intensive endeavor, adding another wrinkle to the whole process and often causing frustration with delays and interpreting the forms.

Pennsylvania has a use tax and still retains the traditional three factor formula of sales, payroll and property for partnerships unless a separate accounting for each location is able to be used (however, services across locations could not be shared and this obviously would be rare for most hedge and private equity type managers). Sales are market-based sourced for corporations and cost-of-performance for individuals. Individuals in certain cases can elect to be part of a composite return. Withholding on Pennsylvania sourced income to nonresident individuals, trusts and estates must be done on a quarterly basis at the rate of 3.07 percent for 2016.

Prewritten software and cloud-computing are taxable.


Texas does not have a personal income tax, but has a use tax. It has an annual franchise tax due May 15 that limited partnerships or LLCs either organized in Texas or those doing there have to pay. Generally, the rate is 0.75 percent for investment partnership type vehicles unless it qualifies for an EZ Computation Report (annualized total revenue is less than $20,000,000) and then the tax drops to 0.331 percent. It’s based on margin which is calculated one of four ways, but all starting with revenue. Revenue is allocated to the state based on a single sales cost of performance all or nothing factor. If the margin is less than $1,110,000, no tax is due.

Data processing services, including software as a service, are subject to sales/use tax.


Washington has no personal income tax, but does have a use tax and a Business and Occupation tax which is based on gross receipts. If an asset manager has investors in Washington, such as the Washington State Investment Board pension fund, those fees earned may be subject to the tax under the adopted economic nexus standard the state had adopted.

Software, including software as a service, is subject to both taxes.

Washington, D.C.

Washington, D.C. imposes a hefty 9.2 percent unincorporated business franchise tax on profit, but there are exceptions when 80 percent of the revenue is earned by personal services actually rendered by owners or members of the business. Revenue is allocated using a single sales factor formula. A minimum tax of $250 or $1,000 could be due based on different thresholds. There are exclusions from the franchise tax for trading for one’s account so that generally the entity receiving the carry would be excluded from the tax.

The jurisdiction also has a use tax. Software, including software as a service, is taxable.


Wisconsin also apportions sales according to market-based sourcing and sales is the sole factor used. Pass-through entities must withhold tax on nonresident individuals or entities. It is reported on an annual basis using Form PW-1. Quarterly estimated payment are required. If the partner has made the required Wisconsin estimated quarterly tax payments, the partnership may not have to withhold if the partner has properly filed a Form PW-2 Affidavit with Wisconsin and had it approved. Composite returns are permitted.

Wisconsin has a use tax. Prewritten software is taxable, but software as a service is exempt.

Wisconsin also imposes an economic development surcharge ranging from the minimum of $25 to $9,800 for corporations, including S, that have $4 million or more of gross receipts.


We highly recommend that entities faced with state sourced income issues discuss their specific situation with a qualified tax advisor. As noted previously, each state has varied rules and situations can be extremely complex.

For more information on state sourced income, or to learn how Baker Tilly's asset management industry tax specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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