California’s New Sourcing Rules for 2026: Risks and Opportunities for Asset Managers

California has finalized long-anticipated changes to its market-based sourcing rules, and asset managers are taking a fresh look at their California tax exposure – often with unexpected results, especially for management companies.

After years of taxpayer disputes and regulatory refinement, the California Franchise Tax Board (FTB) has clarified how asset management fees are sourced for California tax purposes beginning in tax year 2026. While the mechanics are technical, the takeaway is straightforward: An asset manager’s California tax exposure might now be driven by the location of the investors, even if the manager itself operates entirely outside the state and holds no California-based assets.

For some firms, the changes bring new California filing considerations into focus and create actionable steps to take before year-end. For others, they provide the opportunity to revisit long-standing sourcing positions that might no longer align with the updated guidance – and, in some cases, to reduce California exposure. Because the new rules are now in effect, the implications are immediate and highly fact-dependent, affecting both filing obligations and the amount of asset management fees sourced to California. Firms that take a proactive approach will be better positioned to manage exposure and identify opportunities, while those that defer the analysis might find their options limited once FTB inquiries, audits, or assessments begin.

An Investor-Focused Lens on Asset Management Fees

California’s updated sourcing framework reflects a shift away from entity-level assumptions and toward the economic reality of the asset management relationship. Rather than focusing solely on where a fund is formed or managed, the analysis turns on who holds the capital being managed and where those holders are domiciled – whether direct investors or, in some structures, underlying beneficial owners.

To give effect to that investor-focused perspective, the regulations contemplate a look-through analysis that considers the geographic profile of investors and, if applicable, underlying beneficial owners. The rules introduce an average value of interest methodology that allocates receipts based on the relative value of interests in assets held by California-domiciled investors or beneficial owners during the year. If that information is unavailable, the regulations allow the use of a reasonable estimation approach, providing flexibility while underscoring the importance of thoughtful, well-supported methodologies.

Because receipts sourced to California under the new framework count toward the state’s “doing business” thresholds, the impact on an asset manager’s California filing profile can be significant – and can move in either direction. Out-of-state managers might find that fees attributable to California-based investors or beneficial owners push California-sourced receipts above the economic nexus threshold, resulting in a California filing obligation. Conversely, managers that have historically sourced a significant portion of fees to California – based on fund or management location – might determine that applying a look-through approach meaningfully shifts receipts outside the state, thereby eliminating the filing requirement.

For reference, for 2025, sales must exceed the lesser of $757,070 or 25% of total sales to meet the economic nexus threshold. The 2026 economic nexus dollar threshold has not yet been released but is expected to be indexed to a similar level. 

Practical Next Steps for Asset Managers

Evaluating the impact of California’s new sourcing rules is highly nuanced and fact-specific because the rules influence both California filing obligations and the level of asset management fees sourced to the state. Asset management firms – whether based in California or elsewhere – should act now to assess the impact of the new sourcing rules, particularly because changes in sourcing outcomes can materially affect overall California tax exposure. In light of the effect of the changes, firms should take the following steps:

• Confirm whether the rule applies. Determine whether the fees earned qualify as asset management fees under the updated definition. That analysis is highly dependent on the facts and circumstances, including the composition of the investors, internal structure of fee-paying entities (e.g., flow-through entities, corporations, separately managed accounts), and other activities that generate receipts sourced to the state, such as origination income or other ancillary revenue streams.
• Evaluate the impact on the management company. Consider how the new sourcing framework affects the management entity itself, including the residency profile of the principals and owners, whether historical state filing positions and tax payments need to be revisited, and how new or reduced filings could affect overall state tax obligations across the organization.
• Analyze the investor base. Identify investors or beneficial owners domiciled in California and evaluate California-sourced receipts using the average value of interest methodology or a defensible reasonable estimation.
• Test the economic nexus threshold. Compare California-sourced receipts to the applicable doing business threshold to determine whether a California filing obligation exists. 
• Document the analysis. Maintain contemporaneous documentation to support assumptions, data sources, and methodologies – regardless of whether a filing obligation is identified. Developing an annual process for updating sourcing as investor composition changes can be especially valuable if the FTB later examines the position.
• Think beyond California. Treat compliance with California’s rules as an opportunity to strengthen and standardize state sourcing practices more broadly. Some states, including New York, already apply a look-through sourcing approach, and other states might follow. Establishing repeatable data-collection and workpaper processes now can make future rule changes easier to manage and support consistent positions across jurisdictions.

Bottom line: Even asset managers with no physical presence in California could face California tax obligations beginning in 2026 if they earn asset management fees tied to California-based investors or beneficial owners. At the same time, the new framework might present opportunities to reassess and refine existing filing positions.