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Summary Of Changes for Hedge Funds and Private Equity After Trump’s Tax Reform: State Changes


State Tax Implications Of federal Tax Reform

  1. It is a question of conformity with the IRC
    • Rolling
    • Fixed
    • Selective
  2. Some provisions broaden the federal income tax base (e.g. interest expense limitations, Sec. 965 repatriation) which will be a potential windfall for states.
  3. Some provisions allow deductions from the federal income tax base (e.g. bonus depreciation). Expect decoupling for state purposes.

Federal Reform Impact:

General

  1. Corporate rate deduction: No impact on states other than state rate becomes higher percentage of overall tax rate.
  2. Net operating loss deduction: Little impact since most states NOL provisions do not tie directly to the code.
  3. Business interest deduction limitation: Adopted by many states. The question is how the rule will be applied in separate filing states?  Interaction with related party intangible income adds back of applicable.

Domestic Provisions

  1. Full bonus depreciation deduction and increased 179 expense limitation
    • Majority of states have elected out of IRC section 168(k)
    • Adoption of IRC section 179 by states is mixed
    • Consider the effect on state investment tax credits when electing additional 179 expense
  2. Amortization of research and experimental expenditures
  • Adopted by most states
  1. Pass-through deduction
  • 20% deduction in computing taxable income
  • Will only flow through in a handful of states (NJ, Oregon have decoupled)
  1. Reactions to state tax $10,000 itemized deduction limitation
  • NYS – Employer Compensation Expense program & Charitable Contribution Trusty Fund
  • CT: Unincorporated Business Tax

Carried Interest

  1. Not addressed in federal tax reform
  2. States response
    • Carried interest fee (compensating state tax rate equal to federal ordinary income rate)
    • Proposed CA, CT, IL, NJ, RI
    • Condition that other states adopt except IL

State Tax Implications Of Federal Tax Reform

Potential Ripple Effects

  1. Potential Ripple Effects
    • Expansion of sales/use tax bases
    • Expansion of economic nexus caused by South Dakota v. Wayfair decision
    • Increased focus on state income tax rates
    • Imposition of new broad-based taxes
    • Intercompany transaction implications
    • Foreign entities and transactions\Choice of entity implications
    • M&A activity: new investment (credits & incentives)
    • Impact of the repeal of TEFRA partnership audit rules

Nonresident Back-up Withholding & Composite Returns

Pass-Through Entities Individuals Ownership Filing Requirements

  1. 41 States and D.C. impose an individual income tax
    • No individual income tax in AK; FL;NV;NH;SD;TN;TX;WA;WY
    • NH and TN don’t tax W-2 wages, but do tax interest and dividends
  2. How are individual owners of PTEs taxed by the states?
    • According to their share of income apportioned to a state
    • Income is apportioned to the states at the entity level
    • Income is reported to them on the states’ Schedule K-1 (or equivalent)
    • Nonresidents subject to back-up withholding at the entity level
  3. When does an individual owner have to file?
    • If a state K-1 is received the owner should file in that state if not included in a composite return filed by the entity
    • How to file varies by state – individually or included in a composite return filed by the entity

PTEs Composite Filing

  1. Composite filings enable the entity to file one return on behalf of its owners
  2. Simplifies owners’ filing requirements. It reduces filings and may eliminate need for back-up withholdings
  3. Mandatory in some states and in others the owner must elect to participate
  4. The owner cannot be included in a composite return if he/she has another income from the same state (other than an income from another PTE he/she is included in that entity’s composite filing.
  5. Composite filing enables the entity to file one return on behalf of its owners.
    1. States may include various types of owners to be included in a composite filing
      • Individuals
      • Estates
      • Trusts
      • C corps
    2. Often the state’s top tax rate will apply so it may not be the best option
    3. A minimum number of participants may be required
      • For example, in AZ=10 & in NY=11
    4. Some states require pass-through entities to file composite returns or withhold and remit tax on behalf of nonresident partners or shareholders – IL is one example

Re-evaluating Choice of Entity After Tax Reform

Pass-Through Entities

  1. Pass-through businesses are subject to a higher rate
  2. Do not face a second layer of tax

C Corporations

  1. Lower C corporation tax rates may facilitate retention of additional cash to drive business growth
  2. C corporations are subject to two levels of tax
  3. Hedge fund management fees
    • Better in a C corp?
    • Watch out for accumulated earnings tax personal holding company tax

State and Local Tax – Key Considerations

  1. State tax filing methodology implications
    • Potential combined reporting requirements for C corporations
    • Evaluating state specific S elections
    • Franchise and net worth taxes
  2. State tax rate differentials
    • Taxability in owner’s state of residence vs. C corporation structural planning
  3. State apportionment implications
  4. State tax base and modifications
  5. Sale of ownership interest

NYS and NYC S-Corps

SUBJECTNYS-Federal S-Corp/New York C-CorpNYS-Federal S Corp/New York S-CorpNYC-Federal S-Corp
Governing LawArt 9-A of NYS Tax LawArt(s) 9-A and 22Sub. 2 Admin. Code
Tax Base/RateHigher of business income base, capital base (phasing out) and fixed dollar minimum (250K cap)Not subject to business income or capital base. Only subject to a fixed dollar minimum ($4,500 cap)Computed under old GCT rules based on highest of four (entire net income, capital, income plus comp or fixed dollar min) plus tax on subsidiary capital
Rate6.5%N/A8.85%
Economic NexusYes, more than $1 M in salesYes. More than $1 M salesNo. Physical presence required
ApportionmentSingle salesSingle-salesThree factor (until 2018)
SourcingCustomer basedCustomer-basedLocation of performance
Investment IncomeNarrowly defined category of exempt incomeN/AAllocable to NYC using an IAP

NYS and NYC Partnerships

SUBJECTNEW YORK STATENEW YORK CITY
Governing LawArt. 22 of NYS Tax LawChap.5 of NYC Adm. Code
Tax base/rateNot subject to tax. Subject to an annual filing fee capped at $4,500Tax is computed on unincorporated income business taxable income at a 4% rate
Economic NexusNo. NY source income or at least one non-corporate resident partnerNo. Physical presence is required
ApportionmentThree-factor formula for individual partners. Corporate partners use single-sales factorThree factor formula with phase out to single sales by 2018
SourcingThree-factor formula for individual partners. Corporate partners use single-sales factor 

New York State

  1. Converting a partnership to a C Corp
    • Will trigger state entity level tax
  2. Corporations subject to tax
    • Section 1-3.2(a)(6)(I) OF THE Article 9-A Regulations states:
      1. A foreign corporation is doing business employing capital, owning or leasing property or maintaining an office in New York State if it is a limited partner of a partnership, other than a portfolio investment partnership which is doing business, employing capital, owning or leasing a property or maintaining an office in New York State and if it is engaged directly or indirectly in the participation in or the domination or control of all or any portion of the business activities or affairs of the partnership
  • Section 1-3.2(a)(6)(iii)(d) of the Article 9-A regulations states:
  1. [T]he term “portfolio investment partnership” means a limited partnership which meets the gross income requirement of section 851(b)(2) of the Internal Revenue Code… The term portfolio investment partnership shall not include a dealer (within the meaning of section 1236 of the Internal Revenue Code) in stocks or securities

Reviewing Yours Entities Choice

  1. If elections are made before March the 15th 2019, retroactive changes may be available, but later changes can be implemented on date of election
  2. Tax impacts of both near and long term should be modeled
  3. Hybrid structure may provide additional benefits so a simple conversion should not be the only option
  4. May impact:
    • Estate Planning
    • International Taxation
    • State and Local Taxes
    • Compensation Structures
    • And more. . .

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General State Income Tax Allocation & Apportionment Rules

State Apportionment: Background

  1. UDITPA (Uniform Division of Income for Tax Purposes Act)
    • Set of uniform standards for apportioning and allocating income amongst the states
    • Developed by the National Conference of Commissioners on Uniform State Laws in 1957
    • Approved by the American Bar Association in 1957
    • State were not quick to adopt the provisions
  2. In 1959 Congress enacted P.L. 86-272
    • Required that comprehensive study of state taxation be undertaken by the Wills Commission
    • Amongst other things, the Commission criticized the diversity amongst states with respect to their apportionment formulas
  3. Multistate Tax Compact/Commission
    • Developed in 1967 to counter the pressures to harmonize the state apportionment provisions
    • MTC incorporated most of the provisions found in UDITPA
      • Business income is apportioned while non-business income is allocated
  1. Equity weighted 3 factor (property, payroll, sales) apportionment formula
  2. Income producing/COP rule for sourcing of sales other than those of tangible personal property
  • There are 16 Compact member States, nearly all the others are sovereignty or associate members
  1. 3 Factor Formula
    • By 1978 43 of the 45 states that imposed a corporate income tax utilized and equally weighted 3 factor apportionment formulas (property, payroll & sales).
  2. Moorman Manufacturing Co. v. Bair (1978)
    • US Supreme Court sustains the constitutionality of Iowa’s single sales factor apportionment formula.
    • Since 1978 states have increasingly abandoned the equally weighted 3-factor formula in favor of formulas that give greater (and exclusive) weight to the sales factor.
  3. MTC Changes
    • In 2014/2015 the MTC approved certain changes to UDITPA including removing the equal weighting of the 3-factor apportionment formula and implementing market-based sourcing.

Tax Planning For U.S. Hedge and Private Equity Funds

State Market-Based Sourcing Update

  1. Market-based sourcing
    • The original UDITPA provisions = COP/income-producing activity
    • Since 2000,few states implemented market-based sourcing provisions (GA, IA, MD, MN).
    • Currently over 20 states have adopted some version of market-based sourcing
    • In 2017 the MTC approved the model market-based sourcing regulations
  2. Why the shift?
    • More reflective of taxpayer’s customer base
    • Reflective of modern economy
    • Political appeal – can benefit in-state service providers
    • Do away with ‘all/nothing’ traditional COP rules.
  3. MTC Model Rules
    • Receipts except those of the sale of tangible personal property are in the state if and as far as the taxpayer’s market for the sales is in the state.
    • Scenarios:
      1. Sales, rental, lease or license of real property
      2. Rental;, lease or license of tangible personal property
      3. Sale of a service
      4. License or lease of intangible property
      5. Sale of intangible property
    • Throwout rule for sales other than sales of TPP if taxpayer is not ‘taxable’ in the state to which receipts must be assigned
    • Sale of a service
      • MTC: Receipts are sourced to the state if and as far as the service is delivered to a location in the state.
  1. Some other states look at where the benefit is received by a taxpayer’s customer
  2. Other nuances:
    • If service is used at a location in the state (CT)
    • Where services are received (MN)
    • Market based approach in COP states (FL/IN)
  • Lack of uniformity amongst state rules
    • Leads to inconsistent results
  1. Makes it hard to comply to the letter of the law
  2. Can result in sourcing of the same revenue to more than one market-based states
  3. Regulations can help but cannot solve all the inconsistencies
  • EXAMPLE: Sale of a Service
    • X provides service to US federal government agency
  1. Service provided electronically
  2. Benefit received by hundreds of branches of the agency around the entire US
  3. Company X files tax returns in multiple market-based states
  • MA general rule: Receipts sourced to MA if and to the extent that the taxpayer’s customer receives the service in MA
  • Reasonable approximation
    • US population is used as the baseline
  1. MA population/US population × Total Revenue = MA revenue
  • For MA applied throwout provisions using same methodology
  • Same approach used for other market-based states
  1. What can we do as taxpayers?
    • Understand the applicable statutory provisions – – what is the critical inquiry?
    • Gather all the information available to your company
    • Understand who your customers really are
    • Pinpoint where the customers are actually receiving the benefit of services
      • The odds are high that the benefits are spread over multiple jurisdictions
    • Consider using the reasonable approximation tests
    • Consider industry specific provisions
  2. New Jersey Sourcing for years ending before December 31st 2018
    • Gross receipts of Personal Services that are provided in the state are attributable to the state
    • Services provided in and out of the state can be apportioned using cost performance, amount of time spent in the performance of the service or some other reasonable method
  3. Starting January 1st 2019 New Jersey enacted market-based sourcing for all taxpayers
    • Sourced to the state if the benefit of the service is received at a location in the state
  4. Connecticut Sourcing
    • Sourced to Connecticut if the taxpayer’s market for the sales is in the state
    • The market for the service is in the state if the service is used in the state
    • Before 2016 receipts from services had to be included in the receipts factor if the servicing was performed in Connecticut
  5. New York/City Corporations
    • Receipts from services are sourced to new York based upon the following:
      • Where is the benefit received?
  1. The delivery destination
  2. The apportionment fraction determined for the preceding taxable year for the receipts OR
  3. The fraction in the current taxable year for those receipts that can be sourced using the first two methods above
  • Taxpayer must use due diligence under each method before rejecting it and moving on to the next method in the hierarchy based on information the taxpayer knows.
  • Intangibles
    • Royalties from the use of patents, copyrights, trademarks and similar intangibles are sourced to New York if the intangibles are used in the state.
  • Digital Products
    • Receipts from the license to use (or granting remote access to) digital products are sourced to New York based on the following hierarchy
      • The customer’s primary use location
      • The location where the product is received
      • The apportionment fraction determined for the preceding taxable year for that digital product
      • Finally the fraction in the current taxable year for those digital products that can be sourced using the first two methods above
  1. New York State/City Partnerships, non-corporate Partner
    • Sales are allocated by the percentage of the cost of performance within NYS/NYC

Funding for Real Estate Projects

Factor-Presence nexus

  1. Attempt to quantify and standardize economic presence
  2. Factor presence is not necessarily limited to just economic presence
  3. Model: Doing business is satisfied for corporate income tax purposes if any of the following exist:
    • Sales sourced to the state exceed the lesser of $500,000 or 25% of the taxpayer’s total sales
    • Real and tangible property in the state exceed the lesser of $50,000 or 25% of the taxpayer’s total real and tangible personal property
    • The amount paid in the state by the taxpayer for compensation exceeds the lesser of $50,000 of the total compensation paid by the taxpayer
    • Actual thresholds may differ from state to state
    • Variations adopted by CA, CO, CT, MI, NY, OH, TN, WA

Factor Presence in Detail

ALTax years after December 31st 2014 – $500,000 or 25% of sales subject to PL86-272
CAThe lesser of $500,000 or 25% of total sales; $50,000 of property or 25% of average value of total property, $50,000 in payroll or 25% of total payroll – – 2016 Tax Year Adjustments: $547,711; $54,711; $54,771
COThe lesser of $500,000 or 25% of total sales; $50,000 or 25% of payroll; $ 50,000 or 25% of property
CTLesser of $500,000 or 25% of total sales
MIIf the taxpayer actively solicits sales in the state and has gross receipts of $350,000 or more sourced to this state
NYFor tax years beginning 2015, receipts of $ 1,000,000 or more
OHCommercial activity tax. Gross receipts in Ohio of at least $500,000
TNFrom January 1st 2016 receipts of greater than $500,000 or 25% of total receipts from sales, $50,000 or 25% of real tangible property, $50,000 or 25% payroll
WABusiness & Occupation Tax: receipts of greater than $267,000 or 25% of total receipts from sales, $53,000 or 25% of payroll; $53,000 or 25% of property

Financial services Industry Implications

  • There are potential implications to businesses in the financial services industry because of the shift to market-based sourcing in many states.
  • While it is still not completely clear where the market or benefit from financial service industry businesses such as hedge funds or management companies is received there exists the potential that such businesses may be exposed to or be required to file in factor presence jurisdictions.

Contact us for more info about tax strategies for Hedge Funds and Private Equity. 

Request a Confidential Consultation

FAS CPA & Consultants

9000 SW 137 AV Suite 224 Miami, FL 33186 T: 786-462-7899 E: support@fascpaconsultants.com

Fulton Abraham Sanchez, CPA

Fulton Abraham Sánchez, CPA is a Certified Public Accountant, specialized In Tax Planning, International Business, Wealth Management and Offshore Banking. You can email him to fa@fascpaconsultants.com or follow us on Facebook : FAS CPA & Consultants.

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