PwC alternatives alert, January 21, 2009

New York State budget bill targets alternative investment fund managers

Proposal to tax the carry interest for nonresident partners and S-corp shareholders

On December 16, 2008, New York State Governor David Paterson included a provision in his executive budget bill (S. 60/A.160) to expand New York's non-resident personal income tax to include general partnership incentive allocation income, which is also referred to as "carried interest" allocations. If this budget bill provision is passed, income received by non-resident partners for performing "investment management services" for partnerships or other entities doing business in New York will be treated as New York source income taxable by New York State, effective January 1, 2009.

Furthermore, Governor Paterson's 30-day amendments to the budget bill, released on January 15, 2009, emphasize that a partner providing investment management services cannot qualify for the self-trading exemption. A new proposal was also added to the budget bill that would subject non-resident shareholders of a New York S-corporation, which provides investment management services to a partnership, to the same taxation as non-resident partners on the "carried interest" allocations. Such income will be taxed as business income rather than investment income. Generally, investment income is preferentially allocated to New York State using an investment allocation percentage.

Current New York Tax Law provides that a New York non-resident is subject to New York personal income taxation only on income derived by the non-resident from a trade or business conducted in New York. A non-resident is not treated as engaged in a trade or business in New York State solely by reason of the purchase and sale of property (e.g., securities) for his own account (i.e., incentive allocation income). As a result, a non-resident partner of an investment management partnership, or LLC treated as a partnership for tax purposes, located in New York is not subject to New York personal income tax on his share of any incentive allocation income derived from the securities trading activity of an investment fund in which the investment manager is the general partner. The incentive allocation income retains its character as capital gain and is not considered New York source income. On the other hand, a non-resident partner of an investment management partnership is subject to New York State personal income tax on his share of any management fee and incentive fee income derived by the investment manager.

The statement in support of the provision provides that a non-resident partner of an investment management partnership escapes New York State income taxation on incentive allocation income whereas resident partners in the same partnership are taxed on all of their income, including any incentive allocation income they receive from the partnership. While the original budget bill provision did not specifically refer to incentive allocation income received by general partners of investment management partnerships, the Governor's 30-Day Amendments clearly provide that the self-trading exemption would not exclude the taxation of incentive allocation income received by non-resident partners providing the investment management services.

The budget bill defines "investment management services" to mean providing a substantial quantity of the following services: (i) advising as to the value of any specified asset; (ii) advising as to the advisability of investing in, purchasing, or selling any specified assets; (iii) managing, acquiring or disposing of any specified asset; (iv) arranging financing with respect to acquiring specified assets; and (v) any activity in support of these services. The term "specified asset" means securities, real estate, commodities or options or derivative contracts with respect to securities, real estate or commodities.

Pursuant to the proposed budget bill, if the incentive allocation income arises by means of a stock sale, that piece of the incentive allocation income would now be taxable in New York for non-residents. Historically, the income would have been taxed only in the partner's resident state. This will require tracking, by investment, for any sale of stock to determine the apportionable amounts to New York. Since New York State does not have different rates for types of income (ordinary vs. capital gain), any amount of the carried investment income apportionable to New York would be taxed at the rate of 6.85%.

At the present, the proposed carried interest legislation only impacts New York State non-resident partners and S-corporation shareholders. We anticipate that New York City may adopt similar provisions related to the New York City Unincorporated Business Tax for partnerships and General Corporation Tax for S-corporations.

The provision to tax carried interest investment income is not the only provision of the budget bill that will potentially impact alternative investment funds. While the proposed taxation of carried interest income has received the most press coverage, three other sections of the budget bill should be noted.

New York to adopt a state "FIRPTA"

Part H of the budget bill would require non-residents to include gain from the sale of partnership, S corporation and LLC interests as New York source income to the extent the entity owns real property located in New York. In particular, the budget bill would amend the definition of New York source income for non-resident individuals in New York Tax Law §631 to include the sale of an interest in a partnership, limited liability corporation, S corporation, or a non-publicly traded C corporation with one hundred or fewer shareholders that owns real property located in New York. Under the Foreign Investment Real Property Transfer Act, FIRPTA, the IRS is authorized to apply a withholding income tax on nonresident aliens and foreign corporations with sales of real property as well as sales of shares in certain US corporations that primarily hold and sell real property in the United States. If this budget bill is passed, New York would become a "FIRPTA" type state; this provision would take effect immediately and apply to sales or exchanges of entity interests that occur 30 or more days after the budget bill becomes law. Currently, New York Tax Law provides that non-residents are taxed on income attributable to an ownership interest in real or tangible property located in New York. A non-resident can escape taxation by placing the New York real property in an entity and then selling his or her interest in the entity. New York has traditionally treated the sale of an interest in these entities as a sale of an intangible asset that is not taxable to a non-resident. Pursuant to the budget bill, a non-resident would be required to include a portion of the gain or loss from the sale of his or her interest in an entity if fifty percent (50%) or more of the entity?s assets consist of real property located in New York. This percentage is a figure the numerator of which is the fair market valuation of all the entity?s real property located in New York and the denominator of which is the fair market value of all the assets of the entity that the entity has held for at least two years on the date of the sale. If it is determined that the entity?s New York real property equals or exceeds the 50% threshold, the taxpayer must allocate to New York the gain or loss from the sale of the interest in the entity. This proposed tax treatment is consistent with federal law. Under Internal Revenue Code §897(c)(1)(A)(ii), a non-resident alien is taxed on the sale of his or her interest in a domestic corporation if the fair market value of the real property in the United States equals or exceeds 50% of the total assets of the corporation. Similarly, Internal Revenue Code § 897(g) taxes a non-resident alien on the sale of a partnership interest to the extent attributable to real property located in the United States.

LLC filing fee to extend to limited partnerships

Part J of the budget bill proposes to extend the annual LLC filing fee to certain partnerships based on their New York source income, effective for taxable years beginning on or after January 1, 2009. Currently, general partnerships are not subject to the filing fee imposed by New York Tax Law § 658 on limited liability companies and limited liability partnerships. This budget bill provision seeks to impose a filing fee on certain general partnerships to equalize the treatment of these different types of entities. Partnerships that are not limited liability partnerships and have New York source income of less than one million dollars would be exempt from this filing fee.

New York to further limit itemized deductions for a million dollar wage earners

Part M of the budget bill proposes to limit the use of itemized deductions, except charitable contributions, by individuals whose adjusted gross income is over $1 million and allow these individuals to claim only the standard deduction. Currently, New York State limits 50% of itemized deductions for all individuals who earn more than $525,000. For purposes of determining the required estimated tax payments for 2009, the computation of 100% of the tax for the preceding year should be made as if the proposed limit on the use of itemized deductions had been in effect in 2008. If passed, this budget bill provision would become effective immediately.

Specific advice and assistance may be sought from your PwC engagement team or from any of the partners in our Alternative Investment Fund Group.