Overview:
One particularly annoying feature of investing directly into private equity funds and real estate operating as partnerships is the exposure to multistate taxation. Income from portfolio companies and real estate is generally sourced to the state where the portfolio company operates or the real estate is located. Thus, a non-resident investor is subject to income tax in those states even though the non-resident investor does not reside there.
Blockers and Composite Tax Returns:
What do private equity funds and real estate funds do to minimize multistate taxation and perhaps more importantly, mask the identity of the non-resident investors? They often use corporate blockers which mask the identities of the investors, but do not eliminate the economic effect of multistate tax. The corporation still pays the state income tax to the states where the portfolio companies operate, or the real estate is located. In an attempt to create greater tax efficiency, the funds will often use complex tax planning involving a combination of loans and equity capital to minimize the multistate tax effect. However, the plan will never be totally tax efficient and the investors will ultimately bear the administrative costs of the corporate blocker planning.
Private equity funds and real estate funds will often choose to file composite tax returns which relieve the non-resident investors from filing multistate tax returns. The tax is paid by the fund with the filing of the composite return. The investor still bears the economic burden of the non-resident state taxes and the identity of the non-resident investor is revealed to the state in the composite tax return. In some cases, certain investors will not be eligible to participate in a composite return (e.g., corporations and other partnerships). Finally, there may be a higher overall state tax cost for the non-resident investor since the tax rate on the composite return is often the highest marginalstate tax rate.
Avoiding the Complexities of Multistate Taxation
Regulated Investment Companies (RICs) and REITS provide a solution to the multistate tax concerns of investors. RICs and REITS are taxed as corporations and investors receive a Form 1099 reporting only dividends to them. Dividends are only taxed in the state of residency. Thus, an investor in RICs and REITS need not worry about state taxation of RIC or REIT income outside of the investor’s state of residency and the administrative costs and tax planning complexities should be less. RICs that qualify as Business Development Companies provide an opportunity for investors to participate in investments similar to private equity funds and REITS provide access to a diverse group of real estate investments.
Disclosures
Past Performance is not indicative of future results Institutional Use Only Prospect Capital Management L.P. (“Prospect”) is an SEC registered investment adviser that was founded in 1988 (along with its predecessors). Prospect invests across the United States in diversified portfolios by industry, company, and situation, and its proprietary underwriting process and metrics have been developed over more than 30 years and through multiple economic cycles. Prospect has over 140 employees and $9.4 billion** of assets under management as of March 31, 2026. With a buy-and-hold mentality, Prospect’s objectives are to preserve capital by making credit and equity-focused investments at reasonable multiples of recurring cash flow, earn attractive current cash yields and long-term capital appreciation while achieving consistent low-volatility returns. For more information, call 212.448.0702 or visit prospectcap.com
**The $9.4 billion of Assets Under Management (“AUM”) refers to the assets managed by Prospect and its affiliated registered investment advisors. AUM equals the sum of: (i) the gross assets of (a) Prospect Capital Corporation (“PSEC”), Priority Income Fund, Inc. (“PRIS”), Prospect Floating Rate and Alternative Income Fund, Inc. (“PFLOAT”), Prospect Credit REIT, LLC (“PCRED”), and Prospect Enhanced Yield Fund (“PENF”), and (b) pooled investment vehicles with respect to discrete assets for which Prospect has non-discretionary authority, (ii) any amounts available to be borrowed under certain credit facilities of the investment companies, (iii) total managed assets for real estate and structured credit investments, and (iv) uncalled capital commitments. Prospect’s AUM measure includes assets under management for which Prospect charges either nominal or zero fees.
Prospect’s definition of AUM is not based on any definition of assets under management contained in any management agreements of the investment companies Prospect manages. Given the differences in the investment strategies and structures among other investment advisors, Prospect’s calculation of AUM may differ from the calculations employed by other investment managers and, as a result, this measure may not be directly comparable to similar measures presented by other investment managers. Prospect’s calculation also differs from the manner in which Prospect and its affiliates registered with the SEC report “Regulatory Assets Under Management” ($6.9 billion) on Form ADV.
This information is educational in nature and does not constitute an offer to sell or the solicitation of an offer to buy any securities. Prospect is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. All investing is subject to risk, including the possible loss of principal. Prospect cannot guarantee that the information herein is accurate, complete or timely.
We make no representation or warranty in respect of any information derived from the third-party sources which has not been independently verified. Prospect and its affiliates do not provide tax, legal or accounting advice. This material is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
