New Jersey's sourcing rule for gain on dispositions of interests in flowthrough entities can be a real deal-killer.

• Author: Kwiatek, Harlan

Private-equity groups (PEGs) have historically invested in portfolio companies treated as corporations for state income tax purposes, limiting the state income tax impact of portfolio company operations and asset liquidations at the PEG and owner levels. However, as portfolio company investments have shifted from the corporate form to flowthrough and disregarded entities, such as partnerships and limited liability companies (LLCs), the PEG space has become inundated with state income tax issues and traps for the unwary, triggered by complex state-to-state variations in the treatment of tiered flowthrough entities and fundamental differences between the state income tax treatment of flowthrough entities and corporations.

Stress points that often produce significant difficulties include apportionment issues stemming from the mixed entity and aggregate treatment of flowthrough entities, the attribution of nexus up and down tiered flowthrough structures, and the impact on individual owners of residency rules and unusable credits for taxes paid to other states. At no point are these items brought into greater magnification, both in their separate capacities and as a tangled whole, than when a PEG enters into a deal to sell a portfolio company.

Consider the following example, which illustrates a fairly common scenario:

Example: Company A is a PEG legally and commercially domiciled in New Jersey. Individual A, a New Jersey resident, owns 20% of Company A. In 2010, Company A purchased 100% of Company Y, an LLC legally and commercially domiciled in New Jersey with activities conducted wholly within the state. Company A successfully operated Company Y and expanded its business operations to a number of other states. In 2015, A, whose personal tax adviser suggested that he move to a warmer climate, became a resident of Florida. In late 2015, Company A entered into a deal closing in mid-January 2016 to sell to a third party substantially all of Company Y's assets, the vast majority of the value of which is tied up in zero-basis goodwill and customer lists. In the few weeks of 2016 before the sale, Company Yhad a relatively small amount of apportionable income from operations in New Jersey and the other states in which it did business.

In this scenario, Individual A would have a significant state income tax problem. Company X would be required to remit to New Jersey a withholding tax on behalf of A for A's 20% share of Company X's income, including...