In his fiscal year 2010 budget proposal, President Obama called for the taxation of carried interests in investment funds as ordinary income starting in 2011. In addition, two pending pieces of legislation in New York could substantially increase the taxes payable on carried interests held by certain New York State managers. The first, Governor David A. Paterson's Executive Budget Bill, would impose New York's nonresident personal income tax on income from carried interest received for performing investment management services in New York State. The other, a bill introduced by Assemblyman Micah Kellner, would subject certain carried interest received in connection with investment management services to the New York City Unincorporated Business Tax (“UBT”). If enacted, both New York bills would take effect as of January 1, 2009.  

Federal Income Tax

Under current law, the receipt of a partnership carried interest in exchange for services is generally not a taxable event for U.S. federal income tax purposes. Rather, the recipient of the carried interest recognizes income and gain with respect to such interest only when he or she receives proportionate allocations of partnership income and gain. The character of any income and gain in the hands of a partnership is retained when allocated to its partners. Therefore, dividends and long-term capital gains realized by the partnership, for example, are taxed to the holder of a carried interest at the current federal rates for dividends and long-term capital gains, and not as ordinary income.  

President Obama’s budget proposal, submitted to Congress on February 26, 2009, contains a single line item that calls for the taxation of carried interest as ordinary income. While the proposal indicates that this change would take place in 2011, it provides no details as to how ordinary income treatment would be achieved. The legislation resulting from this proposal could, among other things, treat all carried interest allocations as ordinary income notwithstanding the underlying character of the income or gain (which was the approach taken in legislation considered in the House of Representatives in the past two years), or it could take a different approach, such as taxing the initial grant of a carried interest. To best determine whether adjustments to investment fund structures may be required to deal with this change in taxation, we will continue to monitor any further legislative developments with respect to the President's proposal.  

New York State Nonresident Income Tax

Under current law, a nonresident of New York State is subject to New York State income tax on the nonresident’s New York source income. Thus, under current law, a nonresident partner in an entity that manages an investment fund is subject to New York State personal income tax on his share of management fee income arising out of management services performed in New York. The nonresident partner’s share of the carried interest allocations made to the general partner, however, is not taxed as New York source income. That income, generally consisting of interest, dividends, and capital gains, is not earned in connection with a New York trade or business, and is not considered New York source income. Therefore, it is not taxable in New York to nonresidents.  

Governor Paterson’s proposal would amend the New York Tax Law to require nonresident partners to include in their New York source income any income, gain, loss, and deduction attributable to “investment management services performed in exchange for consideration to a partnership or other entity.” As a result, income attributable to carried interests, in addition to management fees, may be taxable to nonresidents providing investment management services in New York. Governor Paterson's proposal defines “investment management services” as: advising a business as to the value of any property; advising a business as to the advisability of investing in, purchasing, or selling any property; managing, acquiring, or disposing of any property; arranging financing with respect to acquiring property; and related support services. For this purpose, “property” includes stock, debt, derivatives, commodities, and real estate.  

There is some uncertainty concerning the application of this proposal to a typical investment fund structure. Many investment funds, particularly in New York City, are currently structured in such a way that one entity acts as the investment manager and receives management fees, while the carried interest is actually allocated to the fund's general partner. Since the carried interest is not received by the entity providing investment management services, it is possible that for funds with this structure, carried interest allocations to nonresident managers will remain non-New York source income and therefore exempt from New York State income tax.  

New York City Unincorporated Business Tax

The New York City UBT is a 4% tax imposed on the business income of every unincorporated business conducted, in whole or in part, in New York City. The UBT is currently imposed on management fees earned by fund managers. Income and gains generated from buying and selling property for one’s own account are exempt from the tax because such activity does not constitute an unincorporated business. The character of the income and gains arising out of an unincorporated entity’s selftrading is retained when allocated to partners of the entity. This is true regardless of how the interest in the unincorporated entity was acquired and regardless of whether the distributive share is proportionate to a partner's capital interest in the entity. Thus, carried interest in an investment fund is generally exempt from the UBT.  

Assemblyman Kellner’s bill would modify the trading exception by providing that any income or gain realized in connection with an “investment management services interest,”other than any portion of the interest received as a result of a capital contribution, will not be eligible for the trading exemption if held by an unincorporated business whose assets exceed $10 million. In general, carried interest in an investment fund constitutes an “investment management services interest,” which the Budget Bill defines as “any interest in a business which is held by any person if such person provides, directly or indirectly, in the active conduct of a trade or business, a substantial quantity of any of ” certain financial management services, which are substantially the same as those enumerated in the Budget Bill.