Tax Obligations & Strategies for Funds Lending in Multiple States was originally published in AAPL’s Spring Edition 2023 Private Lender Magazine.
Filing, withholding, and composite regulations can change from year to year, and state to state. Fund managers need to understand the tax impacts, and filing requirements of conducting business or owning property in multiple states.A private lending fund is generally set up as a limited liability company (LLC) or limited partnership (LP), and its tax-related responsibilities vary by state.
Besides the entity’s filing requirements and withholding obligations, each investor (also referred to as partner throughout this article) in an LLC or LP may also have tax-related responsibilities in those states. Entities can alleviate some of their investors’ state obligations, however. Two of the methods we’ll discuss here are composite returns and subsidiary real estate investment trusts (REITs). It’s important to have a general understanding of each method’s implications in order to approach a fund’s short- and long-term objectives strategically.
State Filings and Apportionment
Each state has the right to tax a business that earned revenue within the state. When a business operates in more than one state, the allocation of the taxable income in each state is determined using the “apportionment” method rather than the exact income earned or deductions. Apportionment requires assigning a percentage of a company’s gross revenues and specific expenses to each state in which it operates in order to determine the company’s income tax in each state.
The three apportionment factors used to determine the percentage of taxable income reportable to each state are:
- Revenue (sales) considers gross revenue (sales) within the state, also known as total gross revenue.
- Payroll uses payroll within the state, also referred to as total payroll.
- Property assesses property owned within the state, known as total property.
Understand, however, that use of the apportionment method varies by state, as does the definition of the three factors.
In the private lending space, revenue would generally be interest income, fee income, and servicing income, essentially what the entity shows as gross income by state before any expenses. Most funds are set up on an accrual basis, so receivables recorded as income (e.g., accrued interest receivable) are included as gross income.
For foreclosed real property, there is the possibility of income at the time of foreclosure. It would be the difference between the fair value of the property and amount of the note and accrued interest, and it would be included in gross income for that state at the date of foreclosure. Second, if the property sells subsequently for an additional gain, the gain amount would be included in the revenue factor amount.
The payroll factor is based on wages; it does not include guaranteed payments or independent contractors. This factor is strictly based on the state in which an employee works, not the state in which the entity operates. An entity with remote employees working outside the entity’s home state pays wages to the employee in the employee’s state, giving rise to the payroll factor in multistate tax returns.
Some states “weight” each apportionment factor equally. Often, however, greater weighting is given to revenue because sales are likely to be more prevalent. Certain states may double the weighting factor for sales, or perhaps consider only the sales factor. Note that many states have thresholds regarding minimum sales amounts that must be met in the state in order for a filing requirement to exist. Because of the minimum filing requirement, in some states you may not have to file if you don’t meet their minimum, despite having revenues.
Because of states’ differing definitions, weightings, and filing thresholds for the three apportionment factors, the total apportionment percentages may not equal 100%. Net losses are also apportioned across different states in the same manner as net income. However, the application of losses, either carrying back or forward, is determined by each state.
If you have multistate activities, one approach is to schedule the apportionment factors by state and then do an analysis to determine which states have required filings. Once you establish that, you can determine composite or withholding requirements (discussed later in this article).
Six states—Georgia, Missouri, New Jersey, New York, Oregon, and Pennsylvania—impose a filing requirement without regard to revenue, payroll, or property amounts. Instead, the entity has a tax filing requirement if there are any investors living in those states.
One common misconception about state filing obligations exists for states that do not have income tax. Forming an entity in a state that does not impose income tax (e.g., Delaware) alleviates the filing requirement in the state (or states) where business is conducted, including the entity’s home state. But, as previously stated, other states can tax an entity if it generated revenues in the state, regardless of the income tax status of the entity’s state of formation. Failure to timely file and pay tax at the entity level comes with penalties and interest, some of which can be steep, depending on the state and the number of investors.
For an LLC or LP, the term “withholding” is typically an annual payment made at year-end versus the traditional pay-as-you-go tax collection method. Withholding requirements can be complex, varying by state and by classification of the partner (corporation, individual, etc.). Although many states require withholding on behalf of nonresident partners, some states impose an entity withholding requirement for resident partners. Conversely, when certain minimum distributive shares of income or tax thresholds are not met, some states do not subject the entity or a partner to withholding.
Exemption waivers are one way to mitigate withholding obligations and, therefore, can be appealing to nonresident partners. Many, but not all, states allow nonresident, non-tax-exempt partners to be treated as withholding-exempt, provided the entity maintains a completed waiver. Such waivers are essentially an agreement by the partner to timely pay and file tax obligations. Besides maintaining the waiver, it is best practice for the entity to procure a separate agreement from each nonresident partner. Because ownership interests have the tendency to shift among different partners, it can be an administrative challenge for an entity to accurately track and maintain such waivers and agreements.
Practically speaking, most funds are single-state initially. As they grow and potentially lend in more states, they transition to multistate. Entities with activities in multiple states will first turn to composite tax filings to avoid the withholding for investors. For states that do not allow a composite filing or for an entity with investors whose state prohibits them from being included in a composite return, a withholding for the investors may be an option. The fund pays the withholding with the state partnership return and reports the amount on the investors’ Schedule K-1 for their individual tax filing.
Withholding amounts can vary from minimal to quite large, depending on the amount of business an entity does in a particular state. Overall, business activities outside an entity’s home state tend to be small, and the withholding amounts reflect this.
Are there ways to relieve investors of having to file in all the states in which the fund conducts operations?
Yes. There are several feasible solutions for fund managers to research and evaluate with the help and guidance of a professional adviser.
Composite Tax Returns
A state composite return is one that a pass-through entity files. It reports the state income of all nonresident partners as a single group. This means the nonresident partners do not have to file an individual tax return.
It is important to be aware of each state’s tax laws. Each state has its own rules around eligibility and the availability of filing a composite tax return. Nebraska, Oklahoma, Tennessee, and Utah currently do not allow composite tax filings. Arizona, New York, and Vermont have restrictions around which companies may use the composite method.
The greatest benefit of filing a composite state tax return is the convenience of filing only one return at the entity level rather than filing individual returns for each nonresident partner. Not having to file multiple returns will result in lower tax preparation fees. Another advantage is the responsibility of tax notices and assessments is diverted away from the nonresident partner; the entity handles them instead.
Although these benefits can make the fund more attractive to investors, the convenience of filing a composite return can be offset by certain disadvantages, including:
- Tax rate. Most states have their tax rate for composite tax filings set at the highest marginal rate, which means higher taxes compared to filing an individual tax return in that state.
- Deductibility. The tax payment made on behalf of the nonresident partners is not deductible at the entity level; instead it is treated as a distribution and payment on behalf of the nonresident partner.
Composite tax returns are elective each year, so it is necessary to assess the filing benefits annually. Although you file a composite tax return in one year, doing so in the subsequent tax year may not be advantageous. The entity must inform the non-resident partners accordingly to ensure they meet their individual filing requirements.
It is important to emphasize that filing a composite tax return does not replace a state filing requirement at the entity level. State composite and state income tax are two separate filings.
Subsidiary Real Estate Investment Trusts
Another option for keeping nonresident partners from needing to file in multiple states is to set up a subsidiary REIT. A REIT is considered to be the entity conducting business activities in the multiple states instead of the fund and its investors. REITs, taxed as a C corporation, can deduct dividend distributions, avoiding double taxation at both the corporate and the personal income tax levels. The REIT files in all the states in which there is business activity, not the investors.
Since a REIT is eligible to develop and own most real estate property types, this may be a viable option for fund managers to consider. REITs have other benefits as well. A REIT pays passive income as dividends to its investors who get taxed in their state of residence only, which can produce higher yields and increase the deductibility of dividends the investors earn. Other advantages (and disadvantages) are associated with REITs; you should discuss them with a professional adviser as you evaluate whether to form a REIT.
Seek Professional Advice
Private lenders face complex tax and withholding rules for multistate activities.
Consulting with an experienced accounting professional with multistate tax expertise helps ensure a private lending fund:
- Complies with the various state withholding and filing requirements at the entity and partner levels.
- Takes advantage of potential tax-saving strategies that may be appealing to its investors.
- Reduces its exposure to examination by state taxing authorities.
iling, withholding, and composite regulations can change from year to year—and from state to state. Both established fund managers and those new to the industry should secure the services of an accounting professional who specializes in multistate tax preparation.
Author, Jeff Spiegel, CPA
Author, Dyan Cole
Director of Operations
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.