Fund Managers May Be Taxable in California, Even if the Manager Has No Property or Payroll in California and All of the Management Services Are Performed Outside of the State.

Several recent law changes in California, when taken together, may make fund managers taxable in California, even though the manager has no property or payroll in California and all of the management services are performed outside of California. Potential taxes impacted by these changes are the California LLC-based taxes and fees (including the fee based on the manager’s gross receipts), as well as potential withholding obligations for the income sourced to California and allocated to the members of the LLC (or partners in a limited partnership, if that is the entity of choice for the manager).

Economic Nexus

The first change that may have tremendous impact on fund managers is California’s switch to an economic nexus standard. Prior to 2011, the term "doing business" in California meant actively engaging in any transaction for profit within the state. However, as of January 1, 2011, the law changed to an economic nexus threshold, whereby any taxpayer was considered to be doing business in California if its California-sourced gross receipts exceeded $500,000 (with provisions that index this threshold for inflation) or 25 percent of the entity’s gross receipts. As a result, a fund manager operating in New York, with no physical presence in California, could nonetheless find itself with a California tax obligation if its California-sourced gross receipts exceed $500,000.

Market Sourcing

This leads to an obvious question: What constitutes a California-sourced gross receipt? Prior to 2011, like many states, California subscribed to the "cost of performance" rule — a receipt was sourced for income tax purposes to the location where the service was performed (technically, where the costs for performing the service were incurred). Under a specific rule for fund managers, this was measured based on the ratio of time spent providing services in California compared to the time spent in all jurisdictions performing services. For fund managers outside of California who never performed services within California, this meant that zero receipts were sourced to California for income tax purposes.

However, like many states, on January 1, 2011, California switched to market sourcing. Market sourcing recognizes the loss of tax revenue brought about by the reality that modern technology allows taxpayers to reach other states’ markets without necessarily having to travel there. Under market sourcing, receipts are sourced to California to the extent that the purchaser receives the benefit of the service in California.

This creates a particularly thorny issue for fund managers. If, for example, the fund it manages either is formed under the laws of California or has a California mailing address, the risk is obviously that all of the receipts received from that fund as a customer could be considered California receipts. Alternatively, California could look through the fund to its investors in order to determine where the benefit was received.

Recently passed California sales sourcing regulations applicable to mutual fund service providers allowed these taxpayers to use such a "look through" approach. Thus, mutual fund managers providing services to a fund look at the percentage of investors located in California to determine California sourcing. Under this rule, a mutual fund management company that earns $2,000,000 annually in fees from a mutual fund with 50 percent of its investors in California would have $1,000,000 in California gross receipts. Under such a scenario, the amount of gross receipts would exceed the $500,000 gross receipts threshold for economic nexus, and the manager would have to file a California return.

A proposed amendment to the applicable regulation would extend the mutual fund rules to fees earned by asset managers who are providing similar services to entities other than mutual funds, such as private equity funds or hedge funds. The California Franchise Tax Board, which administers these taxes, expressed support for this position in 2013, and it is likely to be finalized soon.

Pepper Perspective

Given the inherent logic behind the rule, as well as the similarities in services offered by mutual fund managers and other asset managers, it seems likely that the mutual fund manager rule will be extended to all managers. As a result, it will require tax preparers for management companies to actively inquire as to the fund’s shareholder makeup in order to make nexus determinations and file returns as necessary. Such returns (and liabilities) would include the minimum $800 LLC tax and the LLC fee calculated based on gross receipts capping at slightly less than $12,000. Managers may also have to withhold and remit California tax for its members if the California receipts exceed the economic nexus thresholds. Managers may wish to explore the possibility of filing a composite return for their members in such a situation.