Carried interests survived the 2017 Tax Cuts and Jobs Act (Tax Act) and the longer three-year hold time seems a small price to pay for continuing the benefits of this important incentive tool. But the Tax Act also hit residents in high-tax states hard, the same states where many residents derive substantial carried interest income. Those states are fighting back—proposing “charitable” contribution and employment tax alternatives to avoid low federal limits on individuals’ state tax deductions and considering unincorporated business taxes (New York’s report examining non-income tax approaches to the Tax Act is here).
These states are also proposing to take carried interests into their own hands and many are touting coordinated punitive taxes on such amounts. Governor Cuomo of New York recently re-proposed a so called, “Fairness Fix” that would heavily penalize carried interest income under a provision he hopes could raise $1 billion annually. In an effort to ensure residents don’t simply move across the border, the way many funds decamped to Connecticut decades ago to avoid New York taxes, the NY Fairness Fix proposal is contingent on neighboring Connecticut, New Jersey, Massachusetts and Pennsylvania also enacting similar programs. These are not new proposals, but the proposals lead by New York and the rhetoric around such proposals have taken on new urgency as high-tax states reel from the impact of the Tax Act and Congress’s continued acquiescence to advantageous carried interest taxation.
Governor Cuomo’s current proposal ensures that the carried interest amount is subject to tax as if the income were treated as ordinary income at the federal level, with the added benefit that the revenue will all be paid to New York. His proposal would impose a surtax of 17% on carried interest income—a rate reflecting the difference between the federal capital gain rate (20%) and the highest individual ordinary income rate 37% thereby allowing New York to capture all of the “forgone” federal tax. The proposed New York rate ignores the additional 3.8% tax on investment income imposed under the Affordable Care Act. Massachusetts offered a similar legislative proposal in 2017, imposing tax at 24%; proposals were also floated in 2016 and 2017 in Connecticut, New Jersey, Rhode Island, and Maryland, all applying a 19% surtax on carried interest income, reflecting the then-existing difference between the top federal individual rate at the time (39.6%) and the capital gain rate (20%). The proposals of states in the New York area stipulate that their new tax could only be effective if all of the surrounding states (i.e. Connecticut, New Jersey Pennsylvania, Massachusetts and New York) also enact laws having an identical effect.
Away from the Eastern Seaboard, Illinois also introduced legislation in 2017 imposing a 20% privilege tax on partnerships and S corporations “engaged in the business of conducting investment management services, until such time as a federal law with an identical effect has been enacted.”
The Illinois Department of Revenue’s Fiscal Note recognized that “constitutional issues may prevent the state from collecting any new revenue from the surcharge.” Such reference is likely to a limitation in the Illinois constitution that requires an income tax to be at a “non-graduated rate” and that at any one time there can be no more than one “non-graduated rate” imposed by the State. A penalty rate could be a second rate of tax not permitted under the State constitution. In addition, creating a penalty rate arguably creates an impermissible graduated rate of tax for the small group of taxpayers that would be subject to the tax—a graduation that acts as a penalty, but is nevertheless a graduated rate. A handful of other states have similar flat rate requirements set by state constitution, including Massachusetts. Finally, application of the tax to a small subset of taxpayers might also be subject to equal protection or uniformity challenges as high earners in careers other than investment management would escape a penalty tax on similarly large incomes.
Notwithstanding any constitutional challenges, these proposals seem to only increase the incentive created under the Tax Act for high compensation managers to move to states with significant metropolitan business centers but no personal income tax, like Florida, Nevada, Texas, and Washington. With Nashville continuing its growth tear, Tennessee might add to the US destinations attractive to managers, as it too moves toward a zero tax rate. Add to this list Puerto Rico. Even though this US possession of islands is rebuilding after Hurricanes Irma and Maria and is dealing with a pending bankruptcy and financial restructuring, it too continues to incent fund managers to relocate to the island for exceptionally low rates of tax and, in the case of certain non-Puerto Rican investment income, no tax until 2035 (Acts 20 and 22). London also continues to attract fund managers with carried interests although the UK has similarly instituted a longer hold period to achieve its reduced capital gains tax rate. In its 2016 Finance Act, the UK introduced rules that would require a 40 month holding period to completely retain capital gain treatment on carried interest returns that continue to enjoy a 28% rate (as compared rates up to 45% on high levels of regular taxable income). It remains to be seen whether the carried interest recipients can move themselves and their activities or must move the entire organization (note that Illinois’ proposal is imposed at the entity level) and whether in a game of chicken, states are willing to lose their high earners, who also are significant philanthropic engines for cities like New York and Chicago. Whether these state proposals have the potential to become reality or are really political theatre is an open question but shouldn’t be ignored.
Finally, the economic return flowing to investment managers is just that: economic. We see managers and funds evaluating new, efficient, tax structures to continue to incent managers and are routinely asked to consider those structures. We don’t see the Tax Act’s provisions on carried interest dampening our clients’ interests in working on alternative structures and methods.