California continues to assert a far-reaching and aggressive position when it comes to taxing private equity (PE) firms and asset managers. Through its application of market-based sourcing rules and specific treatment of carried interest, the state claims taxing rights over firms that may have no physical footprint within its borders. For General Partners (GPs) and asset managers based outside of California, understanding these rules is essential for managing compliance and exposure. This article explores how California sources revenue under its tax code and the circumstances under which carried interest becomes subject to state taxation.

Market-Based Sourcing: Service Revenue Follows the Customer

California applies a market-based sourcing framework for income derived from services. Under this approach, service revenue is sourced to the location where the benefit of the service is received, not where the service is performed. This has important implications for private equity firms providing fund management, advisory, or consulting services.

For example: if a General Partner based in New York provides asset management services to a Limited Partner domiciled in California, the associated management fees may be considered California-source income. This applies even if the GP performs all services from outside the state. What matters is that the economic benefit of the service is received within California.

Furthermore, California considers the underlying investors- the beneficial owners- when applying its sourcing rules. This can result in California claiming income even when the intermediary fund vehicle is domiciled elsewhere. If the investors receiving the benefit are located in California, the state asserts the right to source and tax the related revenue. Firms exceeding California’s economic nexus thresholds, such as a certain dollar amount of California-source revenue, may be required to file a return and pay tax, regardless of physical presence.

Carried Interest: Taxation Based on Value Creation

Carried interest, often representing a share of a fund’s profits allocated to the GP, is not treated the same way as management fees. Instead of following market-based sourcing rules, carried interest is sourced based on where the value is created.

Carried interest is classified as a distributive share of partnership income. For nonresident GPs, California taxes this income only to the extent that it is derived from California sources. The key determinant is where the business activity that generated the income took place.

If a fund’s value creation activities, such as operational oversight, restructuring, or management of a portfolio company- occur in California, then a portion of the carried interest earned by the GP may be subject to California tax. This is true even if the GP is based in another state.

On the other hand, if the GP manages only portfolio companies located outside of California, and there are no California-based business operations contributing to the value creation, then carried interest is not considered California-source income. The mere presence of a California LP or investor is not sufficient to trigger taxation of carried interest. There must be a clear connection between the income and business activities occurring within California.

Comparing the Two: Management Fees vs. Carried Interest

Implications for Private Equity and Asset Managers

• Firms operating outside of California should not assume they are beyond the reach of the state’s tax rules: If a firm has investors, customers, or operational ties within California, it may be subject to filing and tax obligations even in the absence of a physical presence.
• GPs should evaluate whether their services benefit California-based LPs or portfolio companies and whether any portion of their carried interest arises from value creation activities occurring in California.

In an era of increasingly complex multistate tax rules, taking a proactive approach to revenue sourcing and income allocation is critical. Proper documentation, analysis, and planning can help reduce compliance risk and unexpected tax liabilities.

Conclusion

California’s interpretation of its tax laws allows it to assert taxing authority over both service revenue and carried interest based on factors well beyond physical presence. Service income is taxed based on the location of the customer, while carried interest is taxed based on the location of value creation. For firms in the private equity space, this creates significant complexity and risk especially when managing multistate compliance, unexpected filing obligations, and state-issued tax notices.

That’s where Noticehub becomes essential. As a centralized tax notice tracker and notice management platform, Noticehub helps firms track and process tax notices across all jurisdictions- ensuring nothing slips through the cracks. Whether you’re responding to a California Franchise Tax Board inquiry or managing compliance across multiple states, Noticehub simplifies your workflow, reduces manual follow-up, and gives your team full visibility into every notice and deadline. In an era of expanding state tax enforcement, intelligent notice management is a necessity.

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