Carried interest has been at the forefront of tax reform proposals in recent years. Carried interest refers to the share of profits that many fund managers receive from managing fund capital. Typically, funds pay investment managers (or their affiliates) a management fee and a share of fund profits (often referred to as “carried interest”). Generally, the management fee is taxed as ordinary income, while income from carried interest is often taxed as capital gains.
Since 2007, there have been various proposals in Congress aimed at reforming the tax treatment of carried interest. Proponents of reform argue that the income at issue is received in exchange for providing the services of managing capital and, as such, should be taxed in the same manner as other income earned for performing services. The latest congressional proposal, the Carried Interest Fairness Act of 2015, would tax carried interest at ordinary income rates. Changing the tax treatment of carried interest was also part of President Barack Obama’s Revenue Raising Proposals for Fiscal Year 2017. However, efforts to change the tax treatment of carried interest at the federal level have stalled. Thus, for example, no action has been taken on the congressional proposal since it was referred to the House Committee on Ways and Means the day it was introduced in June 2015.
In light of the lack of movement at the federal level, on March 4, a bill was introduced in the New York State Assembly that would increase New York state income taxes on income attributable to investment management services. Investment management services are defined as a substantial quantity of any of the following services to a partnership or other entity: (i) advising the partnership or other entity as to the advisability of investing in, purchasing or selling any specified asset (generally securities, real estate, commodities, options or derivatives of the same); (ii) managing, acquiring or disposing of any specified asset; (iii) arranging financing with respect to acquiring specified assets; or (iv) any activity in support of the services described above.
The proposal characterizes partnership distributions related to investment management services as services income. For nonresident partners, this means that the income would be sourced to and taxed by the state where the services were provided, which in many cases is New York. In addition, the bill provides for a 19% “carried interest fairness fee” on all income from investment management services for both resident and nonresident partners. The tax increase is meant to offset the federal tax savings investment managers obtain by having the share of profits they receive taxed at capital gain rates (generally 20%) rather than ordinary income rates (generally 39.6%).
The New York bill would make the tax increase and income characterization contingent upon the enactment of similar laws in Massachusetts, New Jersey and Connecticut (none of which currently have similar proposals). This would ensure that investment managers could not avoid the impact of the changes by simply moving to an adjacent state. Even if this bill never becomes law or takes effect, it might spur other states to pass similar legislation (although no similar proposals have been introduced). Although many investment managers are located in the tri-state area and Massachusetts, many of the portfolio investment companies of the funds they manage derive income from a number of states. The taxation of income in a state that enacts a “carried interest fairness fee” could result in a substantially increased rate of tax on income sourced to such a jurisdiction even if that is not where the fund manager itself is located.
© 2016 Kramer Levin Naftalis & Frankel LLP – a member of the EACCNY