Feb 17, 2025
A few things cause more frustration in the business world than taxes. While federal tax compliance for investment partnerships is usually top-of-mind for most corporations and investment partnerships, state and local tax (SALT) compliance for private equity firms often sneaks in layers of complexity and, unfortunately, cost.
Investment partnerships, particularly those in private equity, operate under pass-through entity taxation rules, which means income flows directly to the partners’ returns. But, when operating across multiple states, the SALT tax implications for investment partnerships become a minefield of regulations and hidden pitfalls.
To complicate matters further, the IRS is stepping up its enforcement game. New initiatives fuelled by the Inflation Reduction Act are targeting high-net-worth partnerships for tax audits, closing loopholes, and increasing audits. For investment partnerships, this means strategic tax planning for multistate businesses isn’t just a good idea; it’s essential.
Think of federal tax rules as a blueprint. But here’s the catch: not every state follows that blueprint. Some states mirror federal tax laws for investment partnerships, while others tweak them to fit local needs. This inconsistency creates challenges for private equity fund taxation that operates across state lines. For example, while a deduction might be perfectly valid federally, it could be disallowed at the state level, leaving partnerships vulnerable to unexpected tax bills as outlined in the MTC White Paper.
Imagine trying to split a pie between guests who all claim they deserve a bigger slice. That’s what it feels like when states decide how to apportion a partnership’s income. Some states focus on where sales happen, others on where property or employees are located. For investment partnerships managing multistate operations, this can lead to double taxation of partnership income, where multiple states tax the same income.
State tax authorities are no longer passive observers. They’re actively auditing partnerships, enforcing withholding tax requirements for non-resident partners, and imposing stiff penalties for non-compliance. This means partnerships must track income sources meticulously and ensure withholding taxes are paid correctly for non-resident partners.
If you have an office or employees in a state, you probably expect to pay taxes there. But what if you just earn income from clients in that state? That’s where economic nexus rules for partnerships come into play. Some states claim you owe taxes based on economic presence in a state, not just physical presence. Once state tax nexus for investment funds is established, these states then use different formulas to apportion income, which can lead to overlapping tax obligations.
If your partnership includes out-of-state or foreign partners, there are chances that you need to withhold income taxes on their behalf. Failure to do so can lead to severe penalties. Special rules like the Foreign Investment in Real Property Tax Act (FIRPTA) compliance apply if your partnership holds U.S. real estate. Also, Effectively Connected Income (ECI) tax rules for foreign investors govern foreign investors in U.S. partnerships. The IRS Withholding Guidelines provide more insights into this.
To combat the federal $10,000 SALT deduction cap, many states introduced Pass-Through Entity Tax (PTET) elections. This allows partnerships to pay state taxes at the entity level, bypassing the cap and maximizing deductions for partners. But not all states offer PTET, and the state-by-state PTET tax rules vary. Each state has its own requirements and structures for participation, including specific eligibility criteria, income thresholds, and tax rates. So, understanding where PTET elections benefit private equity firms is key.
The IRS has stepped up its auditing of partnerships considerably. They have even established a new audit group focused on IRS partnership tax audits for high-income filers, indicating a more aggressive enforcement approach. Not just the IRS is observing these days. State tax officials are doing the same, concentrating on typical state tax audit triggers for partnerships, such as incorrect income distribution, noncompliance with withholding regulations, and mistakes in Section 754 election tax compliance.
How states handle state taxation of investment income differs, such as capital gains, interest, and dividends. Some states may treat carried interest taxation for private equity as ordinary income rather than capital gains. This impacts the tax burden for fund managers. Additionally, UBTI tax implications for pension fund investments arise when debt-financed investments create Unrelated Business Taxable Income (UBTI) for tax-exempt investors like pension funds, leading to unexpected tax liabilities.
The IRS has announced a number of initiatives to combat abusive tax avoidance strategies for partnerships. They are particular about basis-shifting transactions in private equity funds that unfairly reduce taxable income. A new dedicated group within the IRS’s Office of Chief Counsel is focused on closing these loopholes and developing more thorough IRS enforcement of partnership tax compliance. These efforts are a component of a larger plan to ensure high-income partnerships pay their fair share of taxes by stepping up audits and enforcement directed at them.
Investment partnerships should assess their state and local tax compliance strategies to prepare for this increased scrutiny. To handle changing circumstances, they must ensure that multistate tax obligations for investment firms are met and consult with experienced tax consultants.
Compliance with state and local taxes for investment partnerships is more than simply a box to be checked; it’s an essential component of managing the tax efficiency of private equity funds, especially those that operate in several jurisdictions. Partnerships must proactively prepare their approaches to guarantee they have the finest tax positions, from comprehending multistate tax nexus rules to adhering to withholding tax requirements for out-of-state partners and Pass-Through Entity Tax (PTET) elections.
With the IRS ramping up enforcement efforts and states tightening their tax regulations, investment partnerships must develop proactive tax planning strategies.
Engaging with knowledgeable tax advisors and staying informed about new tax laws for private equity firms will be key to maintaining compliance and achieving long-term success in the evolving SALT tax landscape for investment funds.
At Noticehub, we help companies and professional investors streamline their state tax notice management and processing, helping them stay compliant and reduce penalties and interest across all jurisdictions.
Experience the full potential of Noticehub through a virtual demo.
Jeroen van der Wal
Business Development Representative
