In an effort to balance the New York State budget, Governor Paterson is supporting a proposal to amend the state’s tax law with respect to the treatment of carried interest income of nonresident fund managers from an investment fund located in New York as income for the performance of services, rather than investment income. Accordingly, such income would be subject to New York income taxes as earned or “sourced” from within the state, as opposed to investment income taxable only in the state of an individual fund manager’s residence.

As currently drafted, Senate Bill 6610-C changes the characterization of income applicable to partners (including corporate partners) performing “investment management services.” The proposal treats as compensation earned for services taxable as ordinary income, a partner’s distributive share of income, gain, loss and deduction (including guaranteed payments) in excess of the amount that such distributive share would have been if the partner had not performed such investment management services. The US Congress has tried three times this year alone to reclassify the carried interest received by general partners of private investment funds as ordinary income for US federal tax purposes. To date, all attempts at the federal level have failed.

The latest version of the New York bill defines “investment management services” very broadly. The phrase is defined as the provision of a “substantial quantity” of services to a partnership, S corporation or other entity that advises, manages, acquires, disposes of, or finances securities, real estate, interests in partnerships, commodities, options or derivatives of the foregoing, or that performs any activity in support of such enumerated services. Excluded from the definition of investment management services are partners or shareholders if at least 80 percent of the average fair market value of the assets of the partnership, S corporation or other entity consist of real estate.

The proposal to change the character of such income will not impact a New York resident partner’s New York tax liability, as residents are currently subject to the same tax rate in New York for capital gain income and ordinary income. However, the change can result in double taxation for nonresident partners depending upon the sourcing rules in their state of residency or an increase in their overall state tax liability as a result of New York’s high tax rate. For example, if Connecticut and New Jersey do not conform to the New York law change in reclassifying a partner's carried interest as ordinary income, those partners who continue to commute to work in New York would potentially be taxed by two states on the same profits. For individual taxpayers earning more than $500,000, the income-tax rate in New York and New Jersey is 8.97 percent as compared to Connecticut where the rate for individual taxpayers earning more than $500,000 is 6.5 percent.

For more information about the proposed New York legislation regarding the taxation of a partner’s distributive share of income, or any other matter raised in this Legal Update, please contact C. Wells Hall or Jason S. Bazar.

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