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Entity types and tax considerations

State tax considerations

State tax considerations

Federal tax gets most of the attention, but state tax can create unexpected obligations for both the ABF vehicle and its investors. Pass-through entities may trigger filing requirements in states where the vehicle has no presence, simply because of where underlying assets are located or where investors reside.

Delaware dominance

Why everyone forms in Delaware

Delaware is the default choice for ABF entities, and for good reason:

Developed law:

  • Delaware Statutory Trust Act written for securitizations
  • Extensive LLC case law
  • Chancery Court expertise in commercial disputes
  • Predictable outcomes, sophisticated judges

Favorable tax treatment:

  • No state income tax on entities with no Delaware operations
  • Entities conducting business outside Delaware: no Delaware income tax
  • Only franchise tax applies

Practical benefits:

  • Fast formation (same-day available)
  • Extensive service provider infrastructure
  • Familiarity to investors and counsel

Delaware franchise tax

Delaware entities pay annual franchise tax regardless of where they operate:

LLCs:

  • $300 flat annual fee
  • Due June 1
  • Simple, predictable

LPs:

  • $300 flat annual fee
  • Due June 1
  • Same as LLCs

Statutory trusts:

  • Typically no direct franchise tax
  • Owner trustee’s Delaware presence covers requirement
  • Included in owner trustee annual fee

Corporations:

  • Variable based on authorized shares or assumed par value method
  • Authorized shares method: Ranges from $175 (5,000 or fewer shares) to $200,000+ (large cap structures)
  • Assumed par value method: Can reduce tax for companies with many shares but low actual capitalization
  • Must calculate both ways and pay lower amount
  • Complex capital structures can result in surprisingly high franchise tax

When Delaware tax matters

For most ABF vehicles:

  • Only franchise tax applies
  • No income tax on out-of-state income
  • Costs are minimal and predictable

Delaware tax becomes more significant when:

  • Corporate blocker has large authorized shares
  • Entity has Delaware-based operations
  • Entity earns Delaware-source income

State withholding

Withholding on distributions

Some states require withholding when pass-through entities distribute to out-of-state investors:

California:

  • 7% withholding on distributions to non-resident members/partners
  • Form 592 for withholding, Form 593 for real estate
  • Can be waived with Form 588 (Nonresident Withholding Waiver)

New York:

  • Estimated tax payments required on behalf of non-resident partners
  • MCTMT (Metropolitan Commuter Transportation Mobility Tax) may apply for NYC

Other states:

  • Pennsylvania, Illinois, Minnesota have similar requirements
  • Rules vary significantly state to state
  • Must analyze based on entity’s state nexus

Impact on deal mechanics

Withholding creates operational issues:

  • Cash must be held back from distributions
  • Quarterly/annual withholding filings required
  • Investors may receive less cash than expected
  • Excess withholding requires investor refund claims

Best practices:

  • Identify withholding states before closing
  • Build withholding mechanics into distribution waterfall
  • Provide clear disclosure in offering documents
  • Budget for administrative costs

State nexus issues

When pass-through creates filing obligations

A pass-through entity can create state tax filing obligations for its investors in states where the entity has income or activities:

California:

  • Non-resident members/partners must file California returns
  • Share of California-source income is taxable
  • Even small allocations trigger filing requirement

New York:

  • Similar reach-through to non-resident partners
  • NYC allocates portion of partnership income to NYC if entity has NYC presence

Other states:

  • Most states with income tax assert similar rights
  • Rules for sourcing partnership income vary
  • Some states have de minimis exceptions

Sourcing partnership income

How states determine income source for pass-through entities:

Asset location:

  • Income from real property: sourced where property is located
  • Income from tangible personal property: sourced where property is used
  • Loans: often sourced to borrower location or where secured property is located

Market-based sourcing:

  • Some states source based on where customer/borrower is located
  • Creates issues for multi-state loan portfolios

Entity location:

  • Some income sourced to where entity conducts business
  • Relevant for management and servicing activities

Multi-state asset pools

For ABF vehicles with geographically diverse assets:

Example: National consumer loan portfolio

  • Loans to borrowers in 50 states
  • Entity may have sourcing nexus in all borrower states
  • Investors potentially have filing obligations in multiple states

Practical approach:

  • Understand where underlying assets are located
  • Analyze sourcing rules in material states
  • Disclose state tax exposure to investors
  • Some investors will accept; others will not
  • Consider blocker to contain state exposure

State tax planning

Using blockers for state issues

A corporate blocker can contain state tax exposure:

How it works:

  • Blocker corporation owns pass-through interest
  • State income stops at blocker level
  • Investors receive dividends from blocker
  • Dividends generally sourced to investor’s state (not underlying asset states)

When this makes sense:

  • Many states represented in asset pool
  • Investors unwilling to accept multi-state filing
  • Cost of blocker justified by administrative simplicity

Costs:

  • Entity-level tax at blocker (federal 21% plus state)
  • Formation and maintenance costs
  • Must weigh against administrative burden of pass-through

Entity placement

Where you form vs. where you operate:

Delaware formation:

  • Avoid Delaware income tax (only franchise tax)
  • Leverage Delaware law benefits
  • No state income tax implication for investors from formation state

Operations in other states:

  • Wherever business is conducted, that state may assert tax
  • Servicing location matters
  • Asset location matters
  • Management location matters

Example:

  • Delaware LLC holds loans to California borrowers
  • Servicing performed by California servicer
  • California may assert that income is California-source
  • Pass-through to investors creates California filing obligation

Common mistakes

Mistake 1: ignoring state withholding

LLC distributes to out-of-state members without withholding. State asserts deficiency plus penalties against LLC. LLC must pursue collection from members or absorb cost.

Fix: Identify withholding requirements before first distribution. Build withholding into distribution mechanics.

Mistake 2: not warning investors

Multi-state asset pool creates nexus in many states. Investors not warned. Investors surprised by filing obligations. Investor relations problem.

Fix: Disclose state tax exposure in offering documents. List material states where filing may be required.

Mistake 3: underestimating administrative burden

Fund has assets in 20 states. Each investor must file in multiple states. Administrative cost of providing state-specific information exceeds expectations.

Fix: Budget for multi-state reporting. Consider simplified structures or blockers for complex situations.

Mistake 4: Delaware corporation franchise tax surprise

Issuer forms Delaware corporation with 100 million authorized shares. Franchise tax bill exceeds $100,000. Not budgeted.

Fix: Calculate franchise tax before authorizing shares. Use assumed par value method. Minimize authorized shares.

Practical checklist

Before structuring

  • Identify states where underlying assets are located
  • Determine sourcing rules in material states
  • Understand withholding requirements
  • Evaluate pass-through vs. blocker economics

For Delaware entities

  • Calculate expected franchise tax
  • If corporation: compare authorized shares vs. assumed par value method
  • Budget for annual franchise tax
  • Calendar due dates (June 1 for most entities)

For multi-state exposure

  • List material states by asset concentration
  • Determine investor filing obligations by state
  • Build withholding mechanics into documents
  • Prepare state tax disclosure for offering memorandum

Ongoing administration

  • State withholding payments (quarterly/annual by state)
  • State information returns for pass-through entities
  • Investor state K-1 schedules
  • Delaware franchise tax (annual)

Working with state tax counsel

State tax is specialized:

  • Each state has its own rules
  • Rules change frequently
  • Nexus standards are often unclear
  • Sourcing methodologies vary

When to engage state tax counsel:

  • Multi-state asset pool
  • Significant non-resident investor base
  • Unusual structure or asset type
  • States with aggressive enforcement (California, New York)

What to expect:

  • State-by-state nexus analysis
  • Sourcing memorandum for material states
  • Withholding procedures
  • Ongoing compliance support

The cost of state tax counsel is generally justified when material state exposure exists. The cost of getting it wrong (penalties, investor dissatisfaction, administrative chaos) exceeds the cost of proper planning.

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