As is often the case in state tax practice, changes in federal law have had a major impact on tax planning and compliance. A few years ago, Congress eliminated a common mechanism used by hedge fund managers that enabled them to defer the receipt of incentive or management fees earned. Under IRC section 409A, which was effective for fees earned for services rendered on or after January 1, 2009, hedge fund managers would be limited in their ability to defer those fees.
The deferral mechanism created a potential for multiple state taxation, particularly in circumstances in which taxpayers are living or working in different states from the time of the deferral. This article will examine the state and local tax questions associated with those deferred fees.
Background: Basic Hedge Fund Structure
Various structures are used when setting up a hedge fund. Most of those structures consist of a domestic and foreign or offshore fund. The most common structures are master feeder, mini-master feeder, and side-by-side. The deferral issue we're discussing arises with the offshore fund. This offshore fund is normally set up as a corporation in a foreign country. Generally, foreign, tax-exempt, and other types of investors invest in that offshore corporation. The offshore fund enters into an investment management contract with the management company. The management company is typically owned by the hedge fund managers. Under that investment management contract, the management company is hired to manage the assets of the fund in exchange for an incentive fee and a management fee. Generally, the incentive fee is based on 20 percent of the positive performance of the fund and the management fee is 2 percent of the assets under management.
Before IRC section 409A, the management company was able to defer the receipt of the incentive or management fees (per the deferral agreements) that were charged to the offshore fund. Those fees were able to grow with tax deferred for up to 10 years. Because the management company would elect to be a cash basis taxpayer, the management company and therefore its owners did not have to recognize that taxable income until the cash was received by the management company.
Changes reflected in IRC section 409A revised those deferral rules. Under the new rules, the ability to defer fees earned after January 1, 2009, would be limited. Any fees earned and deferred before January 1, 2009, would have to be recognized for tax purposes by 2017.
So what happens for state tax purposes in 2017 when that income is picked up? Who gets to tax it? Let's examine those questions under a couple of different scenarios:
- Scenario One: A hedge fund manager lives and works for the fund in New York City. In 2008 the manager defers $20 million of fees. In 2013 the manager sells his New York City apartment and moves himself and his family to Florida, places his kids in Florida schools, closes the New York office of the fund, and opens an office in Florida. Fees are deferred and reported in 2017.
- Scenario Two: A hedge fund manager lives and works in New York City. In 2008 he defers $20 million of fees. In 2013 he purchases a home in Greenwich, Conn., but keeps his New York apartment and effectively splits his time in both locations. An office is opened in Connecticut but the manager keeps the office in New York and splits his time between both locations. Fees are deferred and received in 2017.
- Scenario Three: A hedge fund manager lives and works for the fund in Connecticut. In 2008 he defers $20 million worth of fees. In 2013 he sells his home in Connecticut, purchases a home in New Jersey, places his kids in New Jersey schools, closes the Connecticut office, and opens an office in New York City. Fees are deferred until 2017.
So in 2017 each of those three taxpayers is going to receive his $20 million in deferred fees and, of course, pay full federal taxes as required. But what about the state taxes? Do we look to where they earned the fees? Do we look to where they lived when they earned it? Do we look to where they live now?
In trying to answer those questions, each of those three taxpayers will have to understand three (and possibly four) separate state and local tax issues.
This is one of the most basic concepts in all of state taxes, and one that's often covered in this column. Residents of a state are taxed on all of their income, regardless of its source. In general, most states use two tests to determine residency. One of the tests is based on domicile, or where the taxpayer's permanent and primary home is located. The secondary test is generally called statutory residency, because many state statutes include in the definition of resident a taxpayer who spends more than 183 days in the state and maintains living quarters or a "permanent place of abode" in the state.1 So the first step in any analysis is to figure out where the taxpayer is going to be a resident in 2017.
Nonresidents, though, aren't completely off the hook. In any state that imposes an income tax, nonresidents of that state are subject to tax on income that is earned in the state, often referred to as source income. In the case of hedge fund managers deferring management fees, generally the fees are not paid out on a Form W-2 or 1099, but are paid to a management company (usually a limited liability company) and flow through to the fund manager via Schedule K-1. So an understanding of how the sourcing rules work for LLCs or partnerships in each state has to be examined as well.
The Accrual Rule
States don't like it when people leave, so some have special rules designed to tax soon-to-be nonresidents on the way out. Those rules are often referred to as "accrual rules," since they put taxpayers leaving the state (or entering the state) on an accrual basis for the purposes of determining income in the year of move-in or move-out. Accrual basis taxpayers have to attribute items of income, gain, loss, or deduction to their former state of residence if two requirements are met: (i) they had the right to receive the income before the move; and (ii) the amount of the income could be determined with reasonable accuracy.2 Connecticut has an accrual rule that mirrors New York's,3 but New Jersey does not appear to have such a rule. In each of the scenarios outlined above, the taxpayer is moving from one state to another before the receipt of the deferred management fees. Thus, the implications of the accrual rule must be considered as well.
Here, the most likely entity-level tax that could apply is New York City's unincorporated business tax (UBT). Under New York City law, partnerships, LLCs, and other unincorporated entities doing business in the city are subject to an entity-level tax calculated similar to income-based taxes on corporations, historically based on the three-factor formula of property, payroll, and receipts. But beginning in 2009, the city began a slow move toward single-factor apportionment based on the sales factor, calling for a fully phased-in single sales factor by 2018.4 So the company will have to determine to what extent there is 2017 UBT liability when the fees are taken into income.
Analysis of Scenarios
Scenario One: 2013 Move to Florida
Note, however, that there is no "allocation" to New York City for purposes of the city's personal income tax because it does not impose a tax on nonresidents. Thus, even though these deferred management fees were earned while the taxpayer was living and working completely in New York City, no New York City tax is imposed on this income provided he is a nonresident when it is received. Well . . . probably. Keep reading.
Scenario Two: 2013 Move to Connecticut
Scenario Three: 2013 Move From Connecticut to New Jersey
We obviously have not endeavored to answer every question that will arise in 2017 when state and local tax departments will be looking for their respective chunks of tax on this deferred income. That is much too complicated, and heavily dependent on specific facts and circumstances for the individual taxpayer and fund. However, as is often the case, sometimes half the battle is simply identifying the type of questions that have to be considered, and this article should give practitioners a good feel for that. Moreover, even though this ticking time bomb isn't set to go off until 2017, practitioners have to be aware of it now, as clients are making decisions about where to live, move, or work, so that they can properly advise their clients on the potential state tax consequences that will hit them in 2017. So procrastinators beware. This is one 2017 issue that has to be addressed now.
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Noonan's Notes on Tax Practice is a column by Timothy P. Noonan, a partner in the Buffalo and New York offices of Hodgson Russ LLP. This month's column was coauthored with Alan S. Kufeld, a principal in the New York City office of Rothstein Kass.
1 See N.Y. Tax Law section 605(b)(1)(B), section 1305(a)(2); Conn. Gen. Stat. section 12-701(a)(1)(B); N.J. Stat. Ann. section 54:8A-3.
2 See N.Y. Tax Law section 639(a).
3 See Conn. Gen. Stat. section 12-717(c).
4 See N.Y.C. Administrative Code section 11-508.
5 See Tax Law section 658(c); 20 NYCRR 132.15. Note that this is different from the single-factor apportionment provisions applicable for corporate franchise tax purposes under Article 9-A of the Tax Law. Perhaps that oddity in New York law will be corrected by 2017?
8 See N.J. Stat. section 54:8A-16.
END OF FOOTNOTES
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