Taxation of carried interest payments has been under considerable scrutiny in recent years both federally and locally. In late 2011, the New York City Department of Finance (the "Department") began asserting a new audit position that would increase the amount of New York City's unincorporated business tax ("UBT") paid by partnerships and limited liability companies engaged in the management of investment funds in an effort to indirectly tax the income from carried interests.

Under a typical fund structure, the investment fund itself is not subject to the UBT because it is considered to be "trading for its own account" rather than conducting a trade or business within New York City. The management company managing the fund receives management fees in exchange for managing the assets of the fund. The management fee income is subject to the UBT but the management company can offset such income by its deductible expenses, such as rent and salaries. In addition, a separate entity, usually the general partner or managing member of the fund, receives an incentive allocation of a portion of the fund's profits (a carried interest). Income from the carried interest typically is not subject to the UBT because it is received from the fund as an allocation of investment income by a passive entity, rather than as a fee to the fund's manager.  

The Department's audit position did not seek to tax carried interest payments directly but rather sought to reallocate certain administrative expenses from the management company to the investment fund or to the general partner or managing member that holds the carried interests. Such a reallocation would result in the management company having more income subject to the UBT because it would have less expenses to deduct. The fund, general partner or managing member of the fund would receive no benefit from the reallocation because its carried interest income is otherwise UBT-exempt and the additional deductions would not affect its tax result.  

The Department's audit position had caused much concern within the fund industry. However, the Department has recently announced that it intends to discontinue asserting this audit position. Although the Department has granted the fund industry a temporary reprieve, the carried interest controversy is an issue that is likely to resurface