Feb 17, 2025
A few things cause more frustration in the business world than taxes. While federal tax compliance is usually top-of-mind for most corporations and investment partnerships, state and local taxes (SALT) often sneak in layers of complexity and, unfortunately, cost.
Investment partnerships, particularly those in private equity, operate under pass-through tax rules, which means income flows directly to the partners’ returns. But, when operating across multiple states, the SALT landscape becomes 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-income partnerships, closing loopholes, and increasing audits. For investment partnerships, this means strategic tax planning 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 partnership tax rules, while others tweak them to fit local needs. This inconsistency creates challenges for investment partnerships that operate 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 multistate partnerships, this can lead to double taxation, where multiple states tax the same income.
State tax authorities are no longer passive observers. They’re actively auditing partnerships, enforcing withholding requirements, 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 nexus comes into play. Some states claim you owe taxes based on economic presence, not just physical presence. Once nexus 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) apply if your partnership holds U.S. real estate. Also, Effectively Connected Income (ECI) rules 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 Taxes (PTET). 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 rules surrounding PTETs vary by state. Each state has its own requirements and structures for participation, including specific eligibility criteria, income thresholds, and tax rates. So, understanding where PTET is beneficial is key.
The IRS has stepped up its auditing of partnerships considerably. They have even established a new audit group focused on intricate partnership arrangements, indicating a more aggressive enforcement approach. Not just the IRS is observing these days. State tax officials are doing the same, concentrating on typical audit triggers such as incorrect income distribution, noncompliance with withholding regulations, and mistakes in Section 754 elections, which modify the basis of partnership assets following a change in ownership.
How states handle their tax investment income differs, such as capital gains, interest, and dividends. Some states may treat income from carried interest as ordinary income rather than capital gains. This impacts the tax burden for fund managers. Additionally, debt-financed investments can 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 tactics used by partnerships. They are particular about “basis-shifting” transactions 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 partnership guidance. 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 tax arrangements to prepare for this increased scrutiny. To handle changing circumstances, they must make sure that state and federal tax regulations are followed and consult with experienced tax consultants.
Compliance with state and local taxes is more than simply a box to be checked; it’s an essential component of managing the financial performance of an investment partnership, especially those that operate in several jurisdictions. Partnerships must proactively prepare their approaches to guarantee they have the finest tax positions, from comprehending nexus and apportionment regulations to adhering to withholding requirements and PTET elections.
With the IRS ramping up enforcement efforts and states tightening their tax regulations, investment partnerships cannot afford to overlook the importance of strategic tax planning.
Engaging with knowledgeable tax advisors and staying informed about the latest developments in partnership taxation will be key to maintaining compliance and achieving long-term success in the evolving SALT landscape.
At Noticehub, we help companies and professional investors streamline their 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
