The New York State Department of Taxation and Finance has issued a Tax Guidance that limits the availability of broker-dealer sourcing under Article 9-A for tax years beginning before 2015 in situations involving partnerships and other flow-through entities. Receipts Factor Methodology for the Owners of Single Member Limited Liability Companies That Are Registered Broker-Dealers, NYT-G-17(2)C (N.Y.S. Dep't of Taxation & Fin., Aug. 2, 2017). The pronouncement concludes that a limited liability company's status as a registered broker-dealer does not entitle its indirect owner to qualify for broker-dealer sourcing, even though the LLC is a disregarded entity for income tax purposes.

Background. The ownership structure covered in the Guidance is as follows: "Brokerage," a single-member LLC, is registered with the Securities and Exchange Commission ("SEC") as a securities broker-dealer. For income tax purposes, it is a disregarded entity and its income and activities are considered the income and activities of its 100% owner, "Partnership D," which is not a registered broker-dealer.

Partnership D is 95% owned by "Investment Advisor," a limited partnership that is a registered investment advisor but not a registered broker-dealer. For SEC purposes, however, Investment Advisor is entitled to conduct broker-dealer activities under Brokerage's license. Under that license, Investment Advisor and its employees qualify as "associated persons" of Brokerage. This allows Investment Advisor to engage in SEC-regulated broker-dealer activities, despite not being itself a registered broker-dealer.

Investment Advisor is 60% owned by "Taxpayer," a corporation that is also not a registered broker-dealer. Taxpayer is subject to Article 9-A, and computes its tax using the "aggregate method" -- that is, it reports its distributive share of the income and apportionment factors of Investment Advisor, including the income and factors through its indirect interest in Partnership D (which includes Brokerage's income and factors). Investment Advisor, a partnership, receives transaction fees, monitoring fees, and management fees from the funds and accounts that it manages. Under the aggregate method, Taxpayer includes its proportionate share of those fees in its own receipts factor.

Issue. The question presented was whether Taxpayer should be considered a registered broker-dealer and therefore qualify for broker-dealer receipts factor treatment for all purposes -- including for its distributive share of fees earned by Investment Advisor -- for tax years prior to 2015, even though it is not itself registered as a broker-dealer. Under the Tax Law in effect prior to 2015, a "registered securities or commodities broker or dealer" was entitled to source specified types of income based generally on customer location. Taxpayer contended that because Investment Advisor, for SEC purposes, is an "associated person" of Brokerage (a registered broker-dealer), Investment Advisor should qualify as a registered broker-dealer and that Taxpayer, as a partner in Investment Advisor, should also qualify for broker-dealer sourcing.

Guidance. The Department concluded that since Investment Advisor was not a registered securities broker-dealer its receipts do not qualify for broker-dealer sourcing. Therefore, Taxpayer, as a partner in Investment Advisor, is only entitled to broker-dealer sourcing for its proportionate share of Partnership D's receipts that represent Brokerage's receipts from its broker-dealer activities. In other words, it is only because of the application of the aggregate method that Taxpayer may utilize broker-dealer sourcing, but limited to its proportionate share of Partnership D's receipts from Brokerage's broker-dealer activities.

Under the Guidance, Taxpayer does not qualify for broker-dealer sourcing with respect to any other receipts -- that is, neither for its share of receipts from Investment Advisor and Partnership D (other than receipts from Brokerage), nor for Taxpayer's own receipts. By not treating Taxpayer and Investment Advisor (a limited partnership) as a registered broker-dealer, Taxpayer's proportionate share of transaction, monitoring, and management fees directly earned by Investment Advisor will not qualify for broker-dealer sourcing under the new Guidance.

The Guidance notes that the Department has previously concluded that a taxpayer that was not a registered broker-dealer, but was either a single member of several LLCs that were registered broker-dealers but were disregarded entities for tax purposes, or a partner that was a single member of such LLCs, was "deemed" to be a registered broker-dealer, and thus allowed to use the production credit method to source gross income from principal transactions available only to registered broker-dealers. Advisory Opinion, TSB-A-13(11)C (N.Y.S. Dep't of Taxation & Fin., Dec. 20, 2013). The Guidance states that the Advisory Opinion did not address whether the taxpayer was a registered

broker-dealer with respect to its own receipts. As for the Advisory Opinion having stated that the taxpayer was "deemed" to be a registered broker-dealer through its partnership interest, the Guidance now concludes that "the better view . . . is that the partner may compute its distributive share of the partnership's receipts as if the partner was a registered securities broker-dealer." (Emphasis in original.)

Additional Insights

The type of advice issued, a Guidance (sometimes referred to as an NYT-G), is an informational statement of the Department's interpretation of the law, regulations, and policies, and is often issued when a taxpayer withdraws a request for an Advisory Opinion, but where the Department believes that its interpretation should nonetheless be made available to the public. This appears to have been the case here.

The Guidance follows on the heels of a recent New York City Department of Finance audit pronouncement concluding, contrary to prior letter rulings, that an owner of a registered single-member LLC entity that is disregarded for income tax purposes may not apply the broker-dealer sourcing rules, except with respect to its receipts earned by the disregarded LLC in its capacity as a broker or dealer. Update on Audit Issues, "Business Income Taxes, Income Allocation" (N.Y.C. Dep't of Fin., Nov. 25, 2016), discussed in the January 2017 issue of New York Tax Insights.

To many taxpayers and practitioners, the Guidance (like the New York City Update) reflects a retroactive and somewhat questionable hardening of the State and City positions on broker-dealer sourcing for tax years prior to corporate tax reform (customer-based sourcing is the general rule starting in 2015) that disregards the effect of business carried out through flow-through and disregarded entities. The Guidance states that the Department's interpretation regarding qualifying as a registered broker-dealer "has always been its position." While this may be technically correct, in at least one prior instance the Department invoked its discretionary authority to adjust a taxpayer's business allocation percentage by permitting a taxpayer to utilize broker-dealer sourcing for its proportionate share of receipts from an entity that was not itself a registered broker-dealer, but that was an "associated person" of a registered broker-dealer, to avoid an improper reflection of the taxpayer's income. Even if the Guidance is correct in concluding that only registered broker-dealers qualify for broker-dealer sourcing, there may still be grounds for obtaining comparable results under the Department's discretionary authority.