Over the past year, CPAs have been flooded with questions about the state tax implications of deferred management fee income that many hedge fund managers are expecting to receive in the near future. Aside from the authors’ recent article on the subject, there isn’t much literature on the topic. To remedy that, the questions below highlight some of the queries the authors have received and answers to them. Unfortunately, at this point, there are still more questions than answers, but CPAs should continue to remain as informed as they can.
1. Why are so many clients asking about 2017 hedge fund deferrals? What's the issue?
In 2008, Congress eliminated a common mechanism used by hedge fund managers that enabled them to defer the receipt of incentive or management fees earned. Under IRC section 457A, which was effective for fees earned for services rendered on or after Jan. 1, 2009, hedge fund managers would be limited in their ability to defer those fees. Before IRC section 457A, the management company was able to defer the receipt of the incentive or management fees (per the deferral agreements) that were charged to the offshore fund. Those fees were able to grow, tax deferred, for up to 10 years. Because the management company would elect to be a cash-basis taxpayer, the management company, and therefore its owners, did not have to recognize that taxable income until the cash was received by the management company. But under the new rules, the ability to defer fees earned after Jan. 1, 2009, was limited. So any fees earned and deferred before Jan. 1, 2009, would have to be recognized for tax purposes by 2017, and this is something being discussed in industry circles.
2. Is 2017 really a “drop-dead” date, then?
Yes it is. The deferred income will be taxable in that year.
3. Is this a federal and a state tax issue?
Yes, definitely. Much of this income will flow-through to the manager from a management company, which is generally a partnership (LP or LLC) or other flow-through entity, so it has the potential to be treated as sourceable business income if arguments are made that the income was “earned” in the state.
4. Is it possible to move to Florida and avoid this issue?
It might not be that simple. Whenever considering a move to Florida, taxpayers must be careful about state residency rules, especially if the state the taxpayer is trying to leave is New York. Despite what many taxpayers think, it is not as simple as simply spending a certain amount of time out of New York and getting a driver’s license somewhere else. (See more details on New York residency issues.) But suffice to say, changing residency is a complex process and taxpayers have to make sure they are closely following New York’s rules. The New York Tax Department is one of the most sophisticated and aggressive enforcement agencies in the country, especially in the area of residency.
5. Even if taxpayers move to Florida and really establish residency there, could the income that they receive in a couple of years still be taxed in New York?
Maybe. Certainly New York City resident taxes can be avoided with a move, since the city tax only applies to residents. But on the state tax side, the issue really is one of income allocation. Nonresidents of New York (or whatever other state they happen to be moving from) can still be taxed on income received from sources within the state. So, the question is going to be whether or not this deferred income, when received in 2017, could be said to have a “source” in New York.
6. How would such sourcing analysis work?
In all likelihood, the income will flow through to the investment manager through a partnership, so CPAs have to have a sense of the partnership apportionment rules. Under current New York rules, for example, a partnership would apportion income on a “by the books” method or based on a typical three-factor method of property, payroll, and sales. So if a taxpayer moves with the fund to another state like Florida and the fund continues to operate in the though 2017, the entity’s New York State allocation percentage could be quite low.
7. Would this be the case even though, technically speaking, the fees were actually deferred from prior years?
Maybe. While some portion of the fee was earned in prior years, it’s also obvious that a portion of the 2017 income—and maybe the most significant portion—will arise from additional appreciation earned through the investment of such funds over the course of the deferral period. So, given the nature of these fees and the fact that they are not at all fixed and will vary based on market conditions and other factors over the next few years, it may be appropriate to argue that the somewhat contingent nature of these payments makes it more like 2017 source-able income. This is especially the case if the fund moves to another state and continues to operate there. The authors suspect that state tax departments might take a different position, but it is not yet clear whether they would be on solid footing when doing so.
8. What about the New York Unincorporated Business Tax (UBT)?
A key aspect here initially will be making sure that not only are taxpayers moving themselves to another state, but they are also moving their business to the other state. If they move the business to another state, such as Florida, and in 2017 that business continues to operate and receive revenue, normally that revenue would get sourced according to the “business allocation percentage” of the entity in the year it is received. So under that rationale, the argument exists that fees received in 2017 would be sourced according to the entity’s UBT apportionment percentage (which, by 2017, will largely be based on receipts) in that year. There is nothing definitive in the UBT guidance, regulations, or case law that outlines how fees like this would be sourced. Thus, in the absence of specific rules, it would appear that the default classification could be the receipts percentage in 2017.
9. I have also heard people talking about Puerto Rico. What’s the deal there?
Puerto Rico enacted its Individual Investor’s Act to promote economic development. By adding tax incentives to relocate to bona fide residents before December 31, 2035, Puerto Rico seeks to attract new residents. Individuals must meet a physical presence test of 183 days in a given tax year, and the resident cannot have had a tax home outside of Puerto Rico and must not have had a closer connection to the United States or another foreign country during the tax year. The lure is an exemption from Puerto Rico income taxes on all passive investment income realized or accrued after an individual becomes a bona fide resident. The act provides a complete exemption from tax on Puerto Rican–sourced interest and dividend income and, with proper planning, interest and dividend income from sources outside Puerto Rico may be reduced to 10% or even 0%.
10. Are there structuring options that can be used to reduce or minimize state or city taxes?
There could be, but great care must be taken here. Changes in the structure of the fund or payment stream could have negative federal tax consequences that would need to be addressed. And it can be expected that states will be on the lookout for any structures that they believe were used with the intention to reduce or minimize tax without valid business purposes.
Timothy P. Noonan, JD, is the practice group leader of Hodgson Russ LLP’s New York Residency Practice, and he is one of the leading practitioners in this area of the law. He has handled some of the most high-profile residency cases in New York over the past decade, including the Gaied case discussed here, one of the first New York residency cases to ever reach New York’s highest court. He also co-authored the 2014 edition of the CCH Residency and Allocation Audit Handbook, and he is often quoted by media outlets, including the Wall Street Journal, New York Times, and Forbes, on residency and other state tax issues. As the “Noonan” in “Noonan’s Notes,” a monthly column in Tax Analysts’ State Tax Notes, Tim is also a nationally recognized author and speaker on state tax issues. He can be reached at 716-848-1265 or email@example.com.
Alan S. Kufeld, CPA, MST, is a partner and head of the Hedge Fund Solutions Group at FFO. Mr. Kufeld is a respected authority on family office sector trends and advanced planning strategies, specializing in wealth preservation and income and estate tax planning strategies for ultra-high-net worth individuals and families, including hedge fund managers, entrepreneurs, athletes, and entertainers. Mr. Kufeld’s focus on tax-efficient asset transfer enables families to achieve long-term goals from the financial to the philanthropic, including planned giving, charitable lead and remainder trusts and family foundation strategies. He is a frequent speaker and lecturer for tax professionals and organizations such as the Financial Planning Association (FPA), and has authored dozens of articles for professional publications. He is a member of the NYSSCPA and AICPA. He can be reached at (646)668-3451 or by email at firstname.lastname@example.org.