New York Proposal to Tax Nonresidents on Certain Carried Interest Allocations
January 23, 2009
On December 16, 2008, New York Governor David Paterson unveiled his budget plan, which contains a proposal to tax individuals not resident in New York on certain investment income attributable to investment management services provided to a partnership (or other entity) doing business in New York. In particular, this proposal, if enacted, would effectively subject to New York taxation “carried interest” allocations received by a nonresident individual for providing investment management services to an investment fund doing business in New York.
Under current New York law, nonresidents of New York are generally not subject to New York personal income tax if their only connection with the state is investment income earned within the state, even if that income is earned through an entity classified as a partnership for income tax purposes. However, nonresidents are subject to New York personal income tax on income derived from a trade or business carried on in New York, whether that income is derived directly or indirectly (e.g., through an entity classified as a partnership for income tax purposes).
Most investment funds in New York are structured such that the general partner of the fund (itself also classified as a partnership) is entitled to a share of the fund’s profits (generally at a 20% rate) pursuant to a tax allocation (often referred to as a “carried interest” allocation). A separate entity, also classified as a partnership, serves as the investment manager and is entitled to a fixed management fee (generally at a 2% rate). Properly structured, nonresidents of New York receiving carried interest allocations from the general partner are generally not considered to be receiving such income as income attributable to a trade or business carried on in New York and therefore are not subject to New York personal income tax on that income. Management fees from the investment fund, on the other hand, are generally treated as New York source income and are subject to New York personal income tax.
Thus, for purposes of the “2/20 split”, generally the 2% management fee received by a nonresident is subject to New York personal income tax, but the 20% carried interest is not.
Governor Paterson’s proposal, if adopted, would provide that New York source income (i.e., income subject to personal income tax in New York) includes items of income or gain attributable to a business, profession, trade or occupation conducted in New York, including the provision of investment management services to a partnership
or certain other entities. For this purpose, providing “investment management services to a partnership” includes (a) advising the partnership about the value of a specified asset, (b) advising the partnership on the advisability of buying, investing in or selling a specified asset and (c) managing, disposing or acquiring a specified asset.
A “specified asset” is defined broadly under the proposal to include securities, real estate, commodities, and options or derivative contracts with respect to securities, real estate or commodities.
If adopted, the proposal would effectively treat tax allocations with respect to a carried interest in a securities or real estate partnership as attributable to a trade or business in New York (and not as an interest in the partnership’s underlying passive investment income). Thus, fund managers who are not residents of New York could be subject to New York personal income tax on income allocations with respect to their carried interests.
What remains unclear, however, is the scope of this proposal. While under the proposal it seems clear that a resident of another state (for example, a Connecticut resident) who commutes into New York to perform investment management services in New York for an investment fund would be subject to tax on his or her share of the fund’s income allocated with respect to the carried interest, it is possible that New York State taxing authorities could attempt to tax a nonresident (for example, a California resident) who works in California for a partnership doing business in New York, despite the fact that the individual never actually performs services in New York. While a nonresident of New York may be entitled to tax credits in his or her state of residency, it is unclear whether this credit would completely offset the tax paid in New York.
If adopted in its current form, the rule would apply to all taxable years beginning after December 31, 2008.
Should you have any questions about this alert, please contact its authors:
Annie H. Jeong
O'Melveny & Myers LLP
Two Embarcadero Center, 28th Floor
San Francisco, California 94111