In recent years partnership compliance has become increasingly complex at both a federal and state level. Federal changes have given rise to conformity challenges as economic turbulence has driven state governments to become aggressive in pursuing tax dollars. This has led to increased scrutiny on the taxation of pass-through entities. With reliance on tiered partnership structures, the financial services industry faces unique challenges navigating the often gray area of partnership taxation at the state level. A few key areas of concern for the industry include the following:

• Sales of partnership interest; 
• Management fees; 
• Pass-through entity tax (PTET) elections; and 
• Treatment of underlying partnership income. 

Sales of partnership interests

Typically, a sale of partnership interest is treated as a sale of an intangible. Some states will source and allocate any gain to an investors’ state of domicile, akin to the sale of corporate stock. Other states may require the gain to be apportioned by applying the apportionment factors of the underlying partnership. If the partnership has historically apportioned all underlying partnership income this could open the door for the gain to also be apportioned. The proper treatment will depend on a variety of factors as the unitary determination (i.e., the active vs. passive nature of the selling partner’s involvement in the underlying partnership’s operations) often plays a critical role in many states. 
If the gain is determined to be apportionable, how the gain is apportioned can be nuanced. Some states vary treatment based on the balance sheet of the sold partnership, timing of the sale, or number of years the interest was held. Each transaction should be separately analyzed to mitigate risk. Treatment should also be evaluated as it moves up the tiered chain of ownership. While the gain may not be apportionable at the upper tier non-corporate partner level, select states may assert it should be subject to apportionment when it reaches a corporate partner. 

How the gain is sourced could have a significant impact on income tax withholding obligations at the partnership level. It is imperative to capture any nonresident withholding requirements, so the necessary cash is available at the time of filing to alleviate the need to claw back distributions after closing of the sale from investors for failing to take this into consideration.

Management fees

Management fees can also pose sourcing challenges for financial services taxpayers. Most states now use market-based sourcing which typically looks to where the customer is located to source income derived from services provided. A commonly used structure includes a fund paying the management fee to a management company. In this scenario who is the customer? Is it the fund (i.e., sourcing based on known delivery location of services) or the investors in the fund (i.e., ultimate beneficiaries of the services received by the fund? Who is truly benefiting from the service.?

States vary on the answer, and many do not offer clear guidance.

States like Connecticut would look through the fund to the investor while Massachusetts would look to where the contract is managed. Partnership and corporate rules can also differ. For example, New York would look to where services are performed at the partnership level but to where the customer is for corporate partners. Partnerships are generally required to track and disclose apportionment under both sets of rules.  

Treatment can also vary depending on the exact nature of the services. An understanding of the rules both where the entity operates and where there are potential customers of the fund receiving such services is recommended to help ensure accurate reporting on state income tax filings. If the management company is profitable, a state nexus study should be considered to understand exposure. 

PTET elections

The $10,000 federal cap on state and local tax deductions imposed by the 2017 Tax Cuts and Jobs Act significantly impacted those in the financial services industry. As a workaround, most states have created optional PTETs which allow partnerships to take the deduction at the federal level where there is no cap. The One Big Beautiful Bill Act (OBBB) has raised the cap to $40,000 for individual taxpayers that itemize on their tax returns but includes a phaseout for taxpayers with adjusted gross income over $500,000. As a result, taxpayers with high incomes may see little to no change resulting from this OBBB provision. In contrast, the enacted OBBB continues allowing for such federal deduction for state taxes incurred by PTET electing partnerships on behalf of its partners.

The eligibility rules and credit treatment for PTETs vary widely by state. Management companies see the greatest benefit when the entity is primarily comprised of individuals in concentrated states offering this elective treatment. 

Treatment of underlying partnership income

In preparing their income tax returns, the taxpayer must first determine how partnership income from an underlying partnership investment should be treated at the taxpayer partner’s level. What appears to be a straightforward question can be quite complex depending on the fact pattern. As noted above, how income is treated historically can set precedence in impacting future events such as a sale of a partnership interest as well other Schedule K-1 income items from operations and investment activities. Most states offer clear guidance on how to treat corporate partners, but less clarity exists when partners are themselves partnerships. States will generally treat the income in one of two ways.  

• Blended apportionment, where the pro-rata apportionment factors from the lower tier partnership are combined with the partners entity level factors. 
• Direct allocation of income, where income is directly sourced to a state as reported on the state K-1 received. 

Most states will require blended apportionment when a unitary relationship exists with a corporate partner. The unitary determination is driven by facts and circumstances and is a complex topic worthy of a separate discussion. How states treat non-corporate partners is less clear and practical applications vary by industry. In an ideal world, every partnership would provide investors with their pro-rata share of state modifications and apportionment factors to appropriately tier up to the ultimate taxpayer. Reality is far from ideal as in practice, tax compliance is a marriage between the technical rules and practical solutions. Understanding the state’s expectations is essential to effectively manage risk in striking that balance. 

What does CohnReznick think?

The above is only a sampling of the issues impacting the financial services industry. It is critical to understand the taxpayer’s structure and revenue streams to determine appropriate treatment. Taxpayers should review the state rules and document any filing positions taken to mitigate risk and preserve an audit trail. The reality of tiered partnerships is that taxpayers are often running up against the deadlines with incomplete information. Having a plan well ahead of the filing deadline is key to a high-quality deliverable despite the necessary tight turnaround.