The New York City Department of Finance has adopted a new a position on audits that could result in additional New York City unincorporated business tax (“UBT”) or general corporation tax (“GCT”) liabilities for hedge funds managers in New York City.
Most hedge funds are investment partnerships. General partners that manage hedge funds generally receive a management fee, as well as a “carried interest” equal to a specified percentage (e.g., 20%) of realized capital gains. Many hedge fund managers in New York City, in order to avoid subjecting carried interests to the 4% UBT, form two separate legal entities: (i) a management company (a partnership or a corporation) to perform services for the hedge fund in exchange for a management fee; and (ii) a separate partnership entity solely to receive the carried interest. The carried interest received by the separate partnership is generally not subject to UBT because the income is considered to be from exempt investment activity. However, the management fee is subject to either UBT (if the management company is a partnership), or GCT (if the management company is a corporation).
Recently, the Department has informally announced that it will take the position on audit that some of the management company’s expenses in these situations are not deductible by the management company, but must be reallocated in part (on an IRC § 482-type theory) to the partnership entity that receives the carried interest. As a result, a portion of the management company’s expenses will be disallowed, resulting in an increase in its UBT (or GCT) liability. This represents a significant departure from the Department’s long-standing audit policy, and would apply even though the IRS has not made a similar IRC § 482-type adjustment. The new audit policy has not been formally announced in a Statement of Audit Procedure, and we understand that the Department has not yet issued any tax assessments under this new policy.