US capital firms adapt to state PTE taxes: PwC

Amy McAneny

PE Tax partner, PwC US

Many in the US recently witnessed a rare phenomenon - a full solar eclipse. A similarly rare tax event occurred over the last few years impacting private capital firms across the US - the enactment of elective pass-through entity (PTE) taxes in 36 states. Responding to the 2017 federal tax reform, state-level PTE taxes allow for income taxes on pass-through entities, which mitigate the effects of the $10K cap on individual owner’s state and local tax deduction for federal tax purposes. Seeing a majority of states act so quickly to enact these new taxes was unprecedented.

The benefits of electing into PTE taxes were too big to ignore. However, quickly assessing those benefits across several states and their impact on different stakeholders required tax departments to bring into alignment several factors. These factors include:

Building or acquiring agile technology to handle the additional compliance and administrative burden of the PTE tax regimes.
Monitoring the evolving guidance & legislative developments to quickly model the federal tax impact, as well as state tax considerations such as the impact to withholding taxes and composite elections.
Evaluating whether to make an election and for which entities, which was particularly challenging given the variation and complexity of the regimes among various states made certain elections more attractive than others.
Rebalancing and reprioritizing tax operations, possibly co-sourcing.
Executing a clear investor communication plan for each affected entity.
Utilizing a deep understanding of business operations and cash flows.

The implementation of these new state taxes exemplified the dynamic world that tax leaders in private capital must navigate to bring value to their organization and investors. Let's delve into some of the top challenges private capital tax leaders encounter.

Navigating the changing tax and regulatory environment

The global tax and regulatory landscape for private capital firms is in a constant state of flux, presenting a significant challenge for tax leaders. Keeping pace with new regulations such as Pillar Two, the Base Erosion and Profit Shifting (BEPS) initiatives, and changes in US federal and state tax requires a proactive approach. To manage these changes, tax leaders should:

Know your tax footprint: Understand the firm's current tax footprint to determine where potential changes in legislation would require you to take action to ensure compliance and manage risk arising from new tax developments.
Stay informed: Keep abreast of legislative and administrative developments, possibly leaning into your tax and legal advisors’ for tracking updates, so that you are able to anticipate and mitigate the impact of proposals as well as take immediate advantage of opportunities such as the state PTE elections.
Adapt strategies: Adjust tax planning strategies in response to tax changes to increase efficiency, meet compliance requirements and manage risk.

Considering impact of changes across all stakeholders

In order to keep pace with the changing landscape, a holistic view of tax across the entire private capital ecosystem is crucial. This includes understanding the tax considerations of new law changes — from portfolio companies to the management company, as well as individual investors before decisions are made. The elective state PTE taxes exemplified how this holistic approach is necessary to balance varying needs and expectations of all parties.

Whether a private capital firm is acquiring a new target, expanding its asset class, entering a new jurisdiction or navigating an entirely new tax across the several states, the private capital tax professional must:

Maintain stakeholder satisfaction: To balance the tax needs of all parties, it is critical to understand how perspectives differ among investors, business strategy, and portfolio companies.
Align growth with tax planning: Ensure that the firm's growth strategy is in harmony with tax considerations in order to decrease unexpected liabilities.
Focus on the tax audit environment: Maintain contemporaneous documentation so that you are prepared for audits that may target taxes or issues across the ecosystem such as self-employment taxes, airplane use, federal and state partnership audits. Leverage technology to track notices and the status of audit activities.

34%

"More than a third of CEOs say that the average competitor in their industry will be out of business within three years if it doesn’t change its business model."

Source: PwC 2024 Pulse Survey

Operational challenges and solutions

In addition to these primary challenges, private capital tax leaders face operational challenges. Fund managers are often reluctant to expand their tax departments due to cost concerns. Despite the limited resources, the tax team must navigate the ever-increasing tax and regulatory burdens. This means the tax team has to do more with less. The state PTE regimes illustrate the increasing data and administrative demands placed on tax departments. To determine where to make PTE elections, leaders worked with the finance and treasury functions to gather investor demographics, project realizations, and understand operating activity across several states. Given that the elections and payments are oftentimes required prior to year-end, it is critical that the tax teamwork with treasury to optimize efficiency from a cash flow perspective. Finally, proactive tax leaders considered structural changes to maximize the benefit of the state PTE regimes by:

Leveraging Technology: To maximize resources, ensure you are leveraging technology where possible to handle the more tedious aspects of the tax function so that your tax department can focus on driving value and navigating the complexity of the ever-changing tax landscape.
Balancing priorities: High-priority tax department activities may need to be weighed against the return on investment and expenditure.
Benchmarking against peers: Tax departments compare their strategy against the benchmark set by peers in terms of technology, utilizing alternative compliance staffing models to allow employees to focus on high value activities.

Aligning the stars

By leveraging technology, considering outsourcing, and maintaining a strategic focus on high-value activities, tax leaders will be well prepared for the next full eclipse-level event at the end of 2025, when the 2017 individual tax reforms are set to expire. Among the many decisions to be made by the US Congress will be whether to extend or modify the federal SALT cap. Tax leaders will want to be ready to respond to potential law changes by the US Congress as well as actions that state governments may take in response.