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.