State Taxation of Carried Interests

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

Tax Policy

Investment managers for private equity funds typically receive both a management fee and a share of the profits in the funds they manage. The profits are typically received through a partnership interest, and are known as “carried interest.” Unlike management fees, which are taxed as ordinary income, carried interest may be taxed at a lower capital gains rate. At the federal level, critics argue that carried interest should be taxed as ordinary income. In this article, McDermott Will & Emery's Alysse McLoughlin discusses how carried interest is taxed at the state level, and proposals to change how it's taxed.

Alysse McLoughlin

By Alysse McLoughlin

Alysse McLoughlin is a partner in McDermott Will & Emery's state and local tax practice.

Due to the increasing attention that the taxation of carried interests have received for federal income tax purposes, an analysis of the state and local tax treatment of such interests is warranted. In addition, this article discusses some proposed state-level legislation addressing the taxation of carried interests.

Background

Typically, investment managers for hedge funds and private equity partnerships (“Investment Partnerships”) receive two types of incentive payments: a management fee—frequently equal to 2% of the assets under management (or the assets owned by the Investment Partnership)—plus a profits share—frequently equal to approximately 20% of the profits earned by the Investment Partnership. In the most common Investment Partnership structure, two different legal entities are used by the investment manager or the investment management team—one legal entity that performs the investment management services in exchange for the management fee and another legal entity that owns a partnership interest in the Investment Partnership as a partner and receives the profits share through its partnership interest. When this structure is used and the profits share is received by the investment manager through a partnership interest, such profits share is generally called an incentive allocation or a carried interest. When the profits share is paid to an entity that is not a partner in the Investment Partnership, this profits share is generally called an incentive fee. Characterization of the profits share as a carried interest or as an incentive fee can result in a large difference in the tax treatment afforded the profits share.

Federal Income Tax Treatment of Carried Interests

The taxation of carried interests has become a controversial topic for federal income tax purposes. For such purposes, a carried interest is treated as profits earned by the investment manager from its partnership interest in the Investment Partnership, with such profits being subject to tax as income from the Partnership's underlying investments when flowed through from the Partnership to the investment manager (or, if the investment manager is itself a partnership, to the partners in the investment manager); thus, to the extent the Investment Partnership realizes long-term capital gains, the investment manager's share of such gains is subject to tax at the 20% capital gain tax rate, instead of at the higher tax rate that is imposed on ordinary income. (Currently, the top tax rate for ordinary income is 39%.)

Critics of this current regime argue that the carried interest, to the extent it is not attributable to capital contributions made to the Investment Partnership by the investment manager partner, should be considered an additional payment for the investment manager's services and, as such, should be taxed as ordinary income. Supporters of the current system, however, assert that, even though the investment manager may not have capital at risk with respect to the carried interest, it is taking entrepreneurial risk with respect to the venture, may not be paid any profits at all until the other partners earn back their capital contributions, and may provide guarantees with respect to the Investment Partnership's operations; all of these activities suggest that the carried interest should be taxed as a true partnership interest. Thus, it is widely debated for federal purposes whether a carried interest should be taxed as investment income, with the investment manager's portion of the Partnership's capital gains continuing to be subject to tax at the 20% capital gain tax rate, or whether such income should be treated as ordinary income earned for the provision of investment management services, with the investment manager taxed on such income at the ordinary income tax rate.

Current State Tax Treatment of Carried Interests

Many states, if they impose a personal income tax on individuals, impose that tax on all of the income earned by residents of the state. Furthermore, in most states there is no distinction in the rate applied to capital gains vs. the rate applied to ordinary income. Thus, with respect to any carried interest received by an individual (whether directly as a partner in the Investment Partnership or as a partner in a partnership that is a partner in the Investment Partnership), in such individual's state of residence there may not be a difference in the tax treatment of the income earned from the carried interest, regardless of whether such income is characterized as income from a partnership interest or as compensation income. (Please note that this article discusses the state tax treatment of carried interests in general, and does not attempt to address the exact tax treatment of carried interests in all states.)

However, such characterization may be important in those states in which the investment management services are performed if the individual receiving the income from the carried interest is not resident in such state. States frequently tax nonresidents only on income derived from sources in the taxing state, including income from the performance of services in such state. Income derived from sources in the taxing state frequently does not include income from intangibles; instead, income from intangibles is frequently subject to tax only by an individual's state of residence. Thus, to the extent that a carried interest is considered to be the ownership of a partnership interest, a nonresident of a state may not have to pay tax on such income to the state, even if the investment manager performed all of his or hers services in such state. However, if the treatment of a carried interest is recharacterized at the federal level as compensation for the performance of services, such recharacterization, if it also applies at the state level, may also result in a dramatic change in the state tax treatment of such income; if the income from the carried interest is considered to be income from services performed in a state, a nonresident recipient of the carried interest may become subject to tax on his or her income from the carried interest in the state where the investment activities are performed.

It should be noted that if an individual does become subject to tax on the carried interest in a state where he or she is not resident but where the investment services are performed, such individual may also be eligible for a credit for such tax in the individual's state of residence, assuming the state of residence does impose a personal income tax.

New York City Unincorporated Business Tax

Since many Investment Partnerships are located in New York City, it is also worthwhile examining the treatment of carried interests for purposes of the New York City Unincorporated Business Tax (“NYC UBT”). While the NYC UBT is imposed on all partnerships engaged in a trade or business in New York City, the NYC UBT also provides an exemption specifying that partnerships that are engaged solely in trading property for their own accounts are not considered to be involved in a trade or business. Similarly, since the NYC UBT provides that ownership by an unincorporated entity of an interest in a lower-tier unincorporated entity that is not carrying on any trade or business in the City will not cause the upper-tier unincorporated entity to be deemed to be carrying on a trade or business (Tax Law Sec. 11-502(a)), a partnership that receives a carried interest from an Investment Partnership that is not considered to be carrying on a trade or business because the Investment Partnership is merely trading for its own account, will not be deemed to be carrying on a trade or business for purposes of the NYC UBT. See also, 11-502(c)(2) (“An individual or other unincorporated entity, … shall not be deemed engaged in an unincorporated business solely by reason of (A) the purchase, holding and sale for his, her or its own account of property, … , or … (B) the acquisition, holding or disposition, other than in the ordinary course of a trade or business, of interests in unincorporated entities engaged solely in activities described in subparagraph (A) … of this paragraph”). In other words, for NYC UBT purposes, an entity that is trading for its own account is exempt from tax, as is an entity whose only activity is the ownership of an interest in the lower-tier entity that is trading for its own account.

Due to these provisions of the NYC UBT, as discussed above, an Investment Partnership entity structure usually entails the use of two legal entities by the investment manager – one legal entity that receives the management fee from the Investment Partnership and a second legal entity that is a partner in the Investment Partnership and receives the carried interest; this separation of the legal entity receiving the management fee from the legal entity receiving the income earned by the carried interest ensures that the only activity of the partner receiving the carried interest will be such partner's acquisition, holding, or disposition of interests in an unincorporated entity that is trading for its own account, thus causing such partner to be deemed to not be involved in a trade or business in New York City and thus not subject to the NYC UBT. If the same entity receives both the management fee and the carried interest, the receipt of the management fee could cause such entity to be considered to be receiving fees for services and thus cause such entity to be considered to be involved in additional activities other than just trading for its own account; therefore, an entity receiving both the management fee and the carried interest would likely be considered to be conducting a trade or business in New York City such as would cause that entity to become subject to the NYC UBT.

Due to the existence of the trading for one's own account exemption, characterization of a carried interest can be very important in determining whether the owner of the interest is subject to the NYC UBT. If the income from a carried interest is recharacterized as income for the performance of investment services for federal tax purposes, and if such recharacterization carries over for purposes of the NYC UBT, such change could cause many investment manager partnerships to become subject to the NYC UBT on their carried interest income.

Potential State Legislation Concerning Carried Interests

Due to continuous inaction concerning the treatment of carried interests at the federal level, legislators in several northeastern states—Connecticut, New Jersey, New York, and Massachusetts—have explored the possibility of acting jointly to curtail the favorable tax treatment granted to carried interests.

The rationale for this proposed legislation is, if the federal government does not act to change the favorable treatment afforded to carried interests at the federal level, the states can. None of these four states, however, wants to act in isolation in passing legislation detrimental to Investment Partnerships because none of these states wants to take the chance that it may drive Investment Partnerships out of the state; thus, none of those bills will become effective until similar carried interest legislation is passed in the other three states.

Such legislation has been proposed in the 2017 legislative season in Connecticut, Massachusetts, and New York (House Bill 6973 in Connecticut, Senate Bill 2050 in Massachusetts, and Assembly Bill 3554 in New York). The Massachusetts bill provides for a 24% surcharge on the income from carried interests while the New York and the Connecticut bills provide for a 19% surcharge. Similar legislation was introduced in New Jersey in 2016 (Assembly Bill 8368), whereby income from carried interests would have be subject to an additional 19% tax imposed on such income to neutralize the federal tax benefit received by such interests.

We understand that it is very unlikely that any of these state tax, carried interest bills will pass. For example, Governor Malloy of Connecticut has indicated that he has no inclination to have Connecticut step into the fray and that he believes that the federal government should take the lead in this area.

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