Carried interest has been at the forefront of tax reform
proposals in recent years. Carried interest refers to the share of
profits that many fund managers receive from managing fund capital.
Typically, funds pay investment managers (or their affiliates) a
management fee and a share of fund profits (often referred to as
"carried interest"). Generally, the management fee is
taxed as ordinary income, while income from carried interest is
often taxed as capital gains.
Since 2007, there have been various proposals in Congress aimed at
reforming the tax treatment of carried interest. Proponents of
reform argue that the income at issue is received in exchange for
providing the services of managing capital and, as such, should be
taxed in the same manner as other income earned for performing
services. The latest congressional proposal, the Carried Interest
Fairness Act of 2015, would tax carried interest at ordinary income
rates. Changing the tax treatment of carried interest was also part
of President Barack Obama's Revenue Raising Proposals for
Fiscal Year 2017. However, efforts to change the tax treatment of
carried interest at the federal level have stalled. Thus, for
example, no action has been taken on the congressional proposal
since it was referred to the House Committee on Ways and Means the
day it was introduced in June 2015.
In light of the lack of movement at the federal level, on March 4,
a bill was introduced in the New York State Assembly that would
increase New York state income taxes on income attributable to
investment management services. Investment management services are
defined as a substantial quantity of any of the following services
to a partnership or other entity: (i) advising the partnership or
other entity as to the advisability of investing in, purchasing or
selling any specified asset (generally securities, real estate,
commodities, options or derivatives of the same); (ii) managing,
acquiring or disposing of any specified asset; (iii) arranging
financing with respect to acquiring specified assets; or (iv)
any activity in support of the services described
above.
The proposal characterizes partnership distributions related to
investment management services as services income. For nonresident
partners, this means that the income would be sourced to and taxed
by the state where the services were provided, which in many cases
is New York. In addition, the bill provides for a 19% "carried
interest fairness fee" on all income from investment
management services for both resident and nonresident partners. The
tax increase is meant to offset the federal tax savings investment
managers obtain by having the share of profits they receive taxed
at capital gain rates (generally 20%) rather than ordinary income
rates (generally 39.6%).
The New York bill would make the tax increase and income
characterization contingent upon the enactment of similar laws in
Massachusetts, New Jersey and Connecticut (none of which currently
have similar proposals). This would ensure that investment managers
could not avoid the impact of the changes by simply moving to an
adjacent state. Even if this bill never becomes law or takes
effect, it might spur other states to pass similar legislation
(although no similar proposals have been introduced). Although many
investment managers are located in the tri-state area and
Massachusetts, many of the portfolio investment companies of the
funds they manage derive income from a number of states. The
taxation of income in a state that enacts a "carried interest
fairness fee" could result in a substantially increased rate
of tax on income sourced to such a jurisdiction even if that is not
where the fund manager itself is located.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.