PRIVATE EQUITY TRANSACTIONS STATE AND LOCAL TAX ISSUES

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1 PRIVATE EQUITY TRANSACTIONS STATE AND LOCAL TAX ISSUES Peter L. Faber McDermott Will & Emery LLP 340 Madison Avenue New York, NY Jeffrey B. Gotlinger Ernst & Young LLP 5 Times Square New York, NY Jeffrey.gotlinger@ey.com

2 PRIVATE EQUITY TRANSACTIONS STATE AND LOCAL TAX ISSUES I. Introduction. A. State and local tax issues are often overlooked in planning private equity structures. B. This can be a mistake. State and local tax issues can be important for the funds, their managers, and their investors. C. Common structures. II. Taxation of the fund. A. Most states follow the federal check-the-tax regulations. An entity that is taxed on a flow-through basis for federal tax purposes will be similarly treated for state tax purposes. B. Some states do not disregard single-member LLCs (e.g., New Hampshire, Tennessee, Texas). C. Some states impose an entity-level tax on partnerships and LLCs (e.g., New Hampshire, D.C., New York City, Texas, Washington). 1. Some of the impetus for these rules was the desire to tax nonresident partners, particularly limited partners. 2. New York City s unincorporated business income tax does not allow a deduction for reasonable compensation paid to owners for services. In a service partnership this comes close to a tax on gross receipts since compensation paid to partners may be the principal expense. D. States have experimented with a variety of fees imposed on pass-through entities. 1. Basis for fees a. Dollar amount per member New York, Florida, Illinois, and Texas impose per-partner or per-member annual filing fees on pass-throughs b. Percentage of income or assets Alabama, Kansas, West Virginia, and Wyoming impose net worth based franchise taxes on LLCs and certain types of partnerships. c. Simple annual fee for the privilege of being. 1

3 2. Constitutional infirmity E. Series LLCs. Fees have been successfully challenged as not sufficiently coordinated with state activity to withstand constitutional muster. For example, a California Court of Appeal held that California violated the U.S. Constitution s fair apportionment standards. Ventas Finance I, LLC v. Cal Franchise Tax Board, 165 Cal. App. 4th 1207 (2008). 1. Some states allow an entity to have internal funds or divisions, each of which may have different members, managers, assets, and liabilities. 2. The federal tax status of series LLCs is unclear, although it is generally believed that they will be treated as separate entities. 3. The state treatment of series LLCs is also unclear. The California Franchise Tax Board treats them as separate entities, each of which must file tax returns and pay tax. Delaware seems to treat them as one entity. F. In general, the fund is treated as a separate taxpayer for purposes of taxes other than income taxes (e.g., sales and use taxes, real estate transfer taxes, employment taxes). 1. Some states treat income-tax pass-through entities as taxpayers without regard to their tax-free classification under income tax principles. a. Minnesota treats SMLLCs as a separate legal entity for sales tax purposes. Minn. Rev. Notice (July 8, 2002). b. Contrast this result with the Alabama Department of Revenue s ruling that, because a SMLLC is disregarded for federal tax purposes, it is to be disregarded for sales/use tax purposes. Al. Rev. Ruling (Oct. 29, 2002). c. A Pennsylvania court held that a transfer from an individual to an entity owned entirely by an individual to an entity owned entirely by the individual was subject to realty transfer tax. Penn Tower Assocs. V. Commonwealth of Pa., No. 225 F.R (2005). d. Contrast this result with a Florida court decision that held that a transfer from a parent partnership to a newly created LLC was not subject to documentary stamp tax because the transfer lacked both consideration and a purchaser. Crescent Miami Center LLC v. Dept. of Rev., 903 So. 2d 913 (2005). 2

4 III. Taxation of the members/partners. A. Managing partners. 1. In general, managing partners are taxed on their shares of fund income as are other partners. 2. Amounts paid to managing partners as compensation are typically taxed as compensation. 3. Income from carried interests. a. A carried interest is that part of a managing partner s interest in a fund that is disproportionate to the partner s capital contribution. In a typical arrangement, the managing partner would contribute 1% of a partnership s capital and receive 20% of the partnership s profits (often only after the investors had received distributions equal to their capital contributions). b. The issue is whether the share of the partnership s investment income that the managing partner receives with respect to the carried interest is investment income (on a flow-through basis) or business income. Proponents of treating it as business income argue that it is a form of compensation for services. Opponents argue that it simply reflects a business deal with the investors. This can affect the applicable tax rates (e.g., are capital gains flowed through). This can affect whether the income is subject to special taxes on business income such as New York City s unincorporated business income tax. c. Congressman Rangel and Senator Levin have proposed treating income from carried interests as business income. d. The issue in New York City. In the early 1990s the New York City Department of Finance took the position that income from a carried interest was compensation that was subject to the unincorporated business income tax, even though it 3

5 represented the manager s share of the fund s investment income. The Department agreed to support legislation that would exempt carried interest income attributable to partnership investment income from the UBT. Legislation so providing was enacted. Certain union-affiliated groups have supported legislation that would reverse that decision and subject all carried interest income to the UBT. Their proposals have not been supported by the City Department of Finance. B. Investors. 1. Are investors taxable? a. In general, general partners of a partnership are deemed to be doing business in states in which the partnership does business. b. Limited partners and LLC members. An argument can be made that, because of limited liability and the lack of a general agency relationship between the individual and the entity, a limited partner cannot constitutionally be taxed by a state just because the partnership has nexus in the state. (a) (b) (c) (d) The limited partner s situation is similar to that of a corporation s shareholder, and none would suggest that a corporation s presence in a state confers nexus on its shareholders. A limited partner was held not to be taxable in Alabama merely because the partnership had nexus in the state. Lanzi v. Ala. Dep t of Rev., Ala. Ct. Civ. App. 2006, cert. cen. (Ala. Sup. Ct. 2007). The non-tax law in many states provides that a partnership or an LLC is distinct from its members (e.g., California, Minnesota, New York). The states are not in agreement as to whether a limited partner in a partnership or an LLC member has taxable nexus in states where the entity has nexus. For example: 4

6 (1) Yes: Georgia, Missouri, North Carolina, New York, Oregon. This appears to be the majority rule among state revenue departments. (2) No: California, Tennessee, Texas. (e) Despite the aggressive approach that state revenue departments have taken in asserting nexus, it is not at all clear that they are correct as a matter of constitutional law. This is an issue that may be worth litigating in appropriate circumstances. Exemptions. (a) Income from qualified investment partnerships. (1) A number of states have exemptions for members of qualified investment partnerships or LLCs (e.g. Arkansas, California, Georgia, Illinois, New Jersey). (2) Qualification rules vary, but typically the entity must have diversified investments, primarily in securities, and must not be a dealer. (3) The exemption generally does not apply to an investor who has other income from the state besides income from the partnership. (b) Trading for the taxpayer s own account. (1) Some states have exemptions for investment-type activities of individuals that are not related to qualified investment partnerships. These may be in addition to exemptions for members of qualified investment partnerships. (2) Typically, the exemption requires that the person s activities in the state not rise to the level of an active business. (3) States with such exemptions include California, Georgia, Massachusetts, and New Mexico. 5

7 (c) Exemptions for foreign corporations. (1) Connecticut, New York State, and New York City have exemptions for foreign corporations whose activities in the jurisdiction are limited to investing or trading in securities or commodities for their own account within the meaning of section 864(b) of the Internal Revenue Code. (2) The performance of administrative functions by agents will not result in a loss of the exemption. 2. Taxation of investors. a. Generally, each investor is taxed on his or her share of the fund s net income and certain items that are specifically allocated among the partners. b. Apportionment of income for corporate partners. (iv) A multistate corporation is taxed by each state only on its share of the corporation s income. Business income is apportioned among the states based on some combination of property, payroll, and sales. Nonbusiness income is typically allocated to only one state, usually the state of commercial domicile, in case of income from securities and other intangible property, and the state of location, in case of tangible property. Business income is apportioned based on the fund s apportionment factors or it flows through to the partner and is apportioned based on the partner s factors, taking the partnership s factors into account. The states vary in their approach. In some states (e.g., California, Indiana), the partnership s factors are used only if the partner and the partnership are engaged in a unitary business. New York State has detailed regulations incorporating this concept. Most states have not addressed the question of whether the status of income as business or nonbusiness income is determined at the partnership level or at the partner level. Those that have addressed the issue have divided. At the 6

8 partnership level: California, Illinois. At the partner level: Indiana, Pennsylvania. c. Withholding or other entity-level enforcement. In an effort to compel compliance by nonresident partners (over whom they might not otherwise have jurisdiction), many states require a partnership to withhold income tax on the income allocated to nonresident partners, even if it is not distributed to them, typically at the highest individual tax rate (e.g., Arkansas, Maine, New York). In Alabama, a nonresident partner may agree in writing to pay the tax on his or her share of the partnership s income. If no such agreement is signed, the partnership must pay the tax on demand by the Department of Revenue. Connecticut requires a partnership to file a composite return on behalf to its nonresident partners and pay the taxes due at the highest marginal rate. d. Composite returns. (iv) Many states permit the filing of composite returns on behalf of nonresident partners. Typically, a partner can be included in a composite return only if he or she has no other income from the state. A partner s liability on a composite return may be higher than it would be if he or she filed a separate nonresident return. Often, deductions and exemptions are not allowed and the highest marginal tax rate must be used. This must be balanced against the administrative convenience of not having to file a separate return in states where participation in a composite return is at the partner s election. Several states do not allow a partner to claim a refund with respect to taxes paid on a composite return (e.g., Oregon). e. Sale of a partnership interest. It is not clear whether authorities dealing with whether gains and losses on the sale of corporate stock are business or nonbusiness will apply with respect to sales of partnership interests. 7

9 (iv) (v) If the partner and the partnership are engaged in a unitary business, the right answer seems to be to treat gain or loss as business income or loss and to apportion it in accordance with the partnership s apportionment factors. If the partner and the partnership are not engaged in a unitary business, the right answer seems to be to treat the gain or loss as nonbusiness and to allocate it based on the law applicable to the partners. Maine applies a look-through approach based on the location of the partnership s property with intangible property being sourced based on the receipts factor in the apportionment formula. Most states have not addressed these issues, leaving it up to the taxpayer to choose (and defend) any reasonable method. f. Credits for taxes paid to other states. (iv) Most states allow a credit on a resident s personal income tax return for taxes paid to a state of which the person is a nonresident. Some states, by agreement with other states, provide for the credit to be claimed on the nonresident return. A credit may not be available if a person is a resident of two or more states, which can happen if the states have different definitions of residence or if the tax authorities of more than one state, applying the same definition, determine that a person is a resident of their state. If issues are raised on audit involving the tax liability to one state and a credit may be available in another state for any increased tax resulting from the audit, file a protective claim for a refund based on the credit in the other state. Otherwise, the claim, if filed after the conclusion of the audit, may be barred by the statute of limitations. 8