Tax Law

Pepper Hamilton, LLP: New York Making a Play to Tax Carried Interests

We have previously reported the considerations of Congress’s proposal to tax partnership income related to a carried interest as ordinary income from the performance of services. (See our Tax Alert for December 31, 2007, “Carried Interest Legislation: Cross Border Consequences.” At the federal level, this proposed legislation has remained in limbo over the last year, but may gain new life under the Obama administration in 2009. It also appears that some states may follow the federal government’s lead and change the tax consequences of fund managers’ carried interests.

New York’s Proposal

On December 16, 2008, New York Gov. David Paterson published a proposed budget that included a proposal to treat income received by non-New York resident partners that perform investment management services for investment partnerships (or other entities) doing business in New York as New York source income. As currently drafted, this proposal would be effective for taxable years beginning on or after January 1, 2009, and, according to the governor’s budget materials and the New York Department of Revenue’s memorandum in support of the governor’s proposal (the NYDOR Memorandum), will increase tax receipts by the state by $60 million annually.

This proposal is a fundamental shift in New York’s tax system. Currently, income recognized by fund managers with respect to their carried interests is capital gain that would not be subject to tax in New York to a partner that is not a resident of New York. However, according to the NYDOR Memorandum, income received by a partner with respect to his or her carried interest “is in reality a type of compensation,” and that by changing the source of the capital gain to New York (rather than the nonresident partner’s state of residence) the proposal will “rectify” the fact that the nonresident partners “escape taxation on this type of compensation.” In addition, the NYDOR Memorandum provides that the proposal will equalize the treatment of nonresident and resident partners, as New York resident partners are taxed in New York on all their income from investment partnerships.

Specifically, Gov. Paterson’s proposal provides that income shall be considered New York source, and therefore subject to New York tax, if it is attributable to “investment management services” for a partnership or other entity that conducts a business, trade, profession, or occupation in New York. Investment management services means providing a substantial quantity of any of the following services to the partnership: (1) advising the partnership as to the value of any specified asset; (2) advising the partnership as to the advisability of investing in, purchasing or selling any specified asset; (3) managing, acquiring or disposing of any specified asset; (4) arranging financing with respect to acquiring specified assets; or (5) any activity in support of any service described in (1) through (4). Specified assets are securities(1), real estate, commodities(2), or options or derivatives with respect to such securities, real estate, or commodities.

Pepper Perspective

Gov. Paterson’s proposal builds upon Congress’s proposed carried interest legislation. By recharacterizing income from a carried interest as compensation for services rather than a share in the partnership’s underlying investment profit, each proposal seeks to levy additional tax on fund managers. Gov. Paterson’s proposal creates many unresolved issues. It is unclear how a sale of a carried interest is to be addressed under the proposed legislation. Similarly, the proposal does not address the consequences of a disposition of a carried interest that is not a sale. Finally, perhaps the most frightening aspect of the proposal is that it appears to subject individuals who are not resident in the U.S., let alone in New York, to tax in New York. The proposal provides that income attributable to investment management services is New York source income if the partnership in question is doing business in New York. The legislation purports to justify such an approach on the grounds that it equalizes the tax burden of in-state and out-of-state partners, because resident carry partners are taxable in New York state even when carried interest is treated as capital gain. This approach, however, ignores the fact that the carried interest is likely subject to tax in the home jurisdiction of the non-resident partner. Thus, it inflicts a greater amount of tax on the non-resident partner, as the non-resident partner picks up the New York sourcing of the investment management income, as well as the taxation in his home state. Further, the credit in his or her home state may not entirely offset such a tax. This methodology may not withstand constitutional scrutiny as New York State is essentially appropriating out-of-state tax. Additionally, some consistency issues may give rise to constitutional issues under such an approach, especially if the partnership in question is doing business in more than one jurisdiction (i.e., inside and outside New York). It is intriguing that New York is moving forward on this proposal when passage of the federal carried interest legislation would essentially accomplish New York’s goals without raising the constitutional issue.

We also note that New York City also has considered subjecting fund managers to additional tax with respect to their carried interests. On June 4, 2008, legislation was introduced in the New York City Council that would provide that income and gain realized in connection with an “investment management services interest” would generally be subject to New York City’s Unincorporated Business Tax. This proposal has been under review by the Ways and Means Committee in Albany, but the introduction of Gov. Paterson’s proposal may revive New York City’s proposed modification to its Unincorporated Business Tax.

Whether Gov. Paterson’s proposal ultimately will become law is difficult to predict. Congress’s proposed legislation met stiff resistance, but turnover in Congress and the White House following this year’s elections lead many to believe that the legislation will be enacted. Although New York appears to be moving forward independent of federal action, its politicians may be reluctant to impose additional tax on carried interests without the political cover that federal action could provide. In addition, New York also may face the possibility of alienating members of Wall Street, who have historically accounted for 20 percent of the state’s annual tax revenue.(3) Ultimately, the ability to avoid billion-dollar deficits in a depressed economic environment may prove too appealing.


(1) For this purpose, “securities” generally means any (a) share of stock in a corporation; (b) partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (c) note, bond, debenture, or other evidence of indebtedness; (d) interest rate, currency, or equity notional principal contract or (e) evidence of an interest in or a derivative financial instrument in any of the foregoing, or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency.

(2) For this purpose, “commodities” generally means any commodity which is actively traded; any notional principal contract with respect to a commodity that is actively traded; or any evidence of an interest in, or a derivative instrument in, any foregoing commodity, including any option, forward contract, futures contract, short position and any similar instrument in such a commodity.

(3) Source:

The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

This article is republished with permission of Pepper Hamilton, LLP. Further duplication without the permission of Pepper Hamilton, LLP is prohibited. All rights reserved.