The deductibility of payments to partners under the New York City unincorporated business tax (“UBT”) has long been a source of controversy.  Among the areas of dispute is the deductibility of payments made to a corporate partner.  In a case involving  the deductibility of payments made to a corporate partner as compensation to the partner’s employees who also were partners of the taxpayer partnership, an Administrative Law Judge has held that those payments were subject to the UBT add-back for payments to partners for services.  Matter of Tocqueville Asset Mgmt. L.P., TAT(H)10-37(UB) (N.Y.C. Tax App. Trib., Admin. Law Judge Div., June 17, 2014).

Facts.  Tocqueville Asset Management L.P. (“Tocqueville”) is an investment advisor limited partnership that conducts business in New York City and is subject to the UBT.  Tocqueville has no employees of its own.  Its affairs are managed by, and it acts solely through, the employees of its sole general partner, Tocqueville Management Corp. (“TMC”), an S corporation that also manages a related securities broker-dealer.

Tocqueville paid TMC an annual management fee for these management services, computed based on TMC’s expenses incurred to provide the services.  The largest component of TMC’s expenses was compensation paid to its employees, many of whom were also partners in Tocqueville. Tocqueville’s partners, including TMC, then received their distributive share of Tocqueville’s net income after payment of the management fee.

In its UBT returns for 2005, Tocqueville deducted the management fee paid to TMC that represented compensation paid to TMC’s employees, including those employees who  were also partners in Tocqueville.  The Department of Finance disallowed the deduction for payments for salaries to partners, totaling nearly $11 million.  (The decision does not state explicitly whether the Department also disallowed the portion of the management fees that represented salaries paid to TMC’s employees who were not partners in Tocqueville.)

The UBT law provides that no deduction is allowed “for amounts paid or incurred to a proprietor or partner for services or for use of capital.”  Admin. Code § 11-507(3).

There are detailed UBT rules interpreting this section. For instance, the rules state explicitly that payments to a corporate partner for services provided by the corporate partner’s officers are not deductible. 19 RCNY 28-06(d)(1)(ii)(B). Most relevant, the rules do permit the deduction of payments made to a corporate partner “which reasonably represent the value of services provided by the unincorporated business by the employees of such partner.” 19 RCNY § 28-06(d)(1)(ii) (D) (emphasis added) (“D Exception”). The rule conditions deductibility on the payment being “included in that partner’s gross income for Federal income tax purposes.”

At the administrative hearing, Tocqueville argued that the UBT rules do not require the add-back of payments to a corporate partner for the services of an employee of that partner who is also a partner in the taxpayer partnership. To the extent the payment made to TMC was for services of Tocqueville’s individual partners, those partners were rendering services as employees of TMC.  Thus, Tocqueville maintained that it was not a payment to a partner for services performed for the partnership, and was properly deductible. The Department took the position that the payments were nondeductible payments for services rendered by partners.

Decision.  The ALJ held that because the management fees paid by Tocqueville to its corporate partner were compensation for services provided by partners in Tocqueville, they were not deductible.  It did not matter whether the services were performed by those partners directly for Tocqueville.  Although the ALJ found that the taxpayer’s management fee arrangement was bona fide and had  economic substance, and was not done to avoid UBT, he nonetheless concluded that those facts were not relevant, since the statute itself was clear.

Tocqueville also claimed that it qualified for the D Exception to the add-back in the UBT rules, which (as discussed above) allows a deduction to the extent the payment to the corporate partner is for services provided by employees of the corporate partner.  The ALJ held that the D Exception did not apply, interpreting that rule as applying “only where the employees are not themselves partners in the partnership.”

The ALJ noted that if Tocqueville’s position was upheld, taxpayers could avoid UBT “by simply establishing a corporate partner and making the taxpayer’s partners employees of that corporate partner.”  The ALJ cited the City Tribunal decision in Miller Tabak Hirsch & Co., TAT(E) 94-173(UB) (N.Y.C. Tax App. Trib., Mar. 30, 1991), which held that payments made to employees of a partnership in their capacity as employees, but who are also partners in that partnership, are not deductible. The ALJ concluded that Miller Tabak “made clear that once it is determined that payment is to a partner, the payment for services ‘in whatever capacity’ [quoting Miller Tabak] is not deductible.”

The ALJ also rejected the applicability of the D Exception to the add-back because it also requires that the payments be included in the partner’s gross income in order to be deductible.  Here, TMC, the corporate partner, acknowledged that it did not report the management fee as income for tax purposes.  While there were bona fide reasons for not reporting the income — including the fact that it had the same effect it would have had if TMC had deducted the employee salaries and reported the management fee income — the ALJ concluded that this was not relevant to qualifying for the add- back exception.

Additional Insights

The language of the UBT add-back for payments to partners for services is admittedly broad in scope.  Taxpayer claims  that a payment to a corporate partner qualifies as a deduction often involve analyzing whether that scope has been narrowed under the UBT rules.  The ALJ is correct in stating that the law and rules should not be interpreted in a way that facilitates tax avoidance by simply allowing a partnership to create a corporate partner and make its partners employees of the corporate partner.  On the other hand, nowhere in the D Exception to the add-back does the rule deny the exception to payments for services of the employees of the corporate partner if the employees are also partners in the taxpayer partnership.  In contrast, it is quite clear under the UBT rules that payments made to a corporate partner for services performed by an individual who is both an officer and an employee of the corporate partner are not deductible.  Given the continuing confusion regarding the scope of the D Exception, the time may be ripe for clarifying amendments.