During the last two years, Connecticut, New Jersey and New York City have put hedge fund managers on notice that nonresident individuals receiving compensation for past services performed in the state generally would be subject to tax. As a result, certain hedge fund managers located in these jurisdictions that have deferred fees for services subject to IRC Section 457A must recognize income in 2017 under the IRC Section 457A transition rule. In particular, both the New Jersey Division of Taxation (NJ DOT) and the Connecticut Department of Revenue Services (CT DRS) have focused on deferred compensation received by nonresident hedge fund managers. In addition, the New York City Department of Finance (NYC DOF) has indicated that it is focused on deferred compensation and has been highlighting situations in which taxpayers have attempted to break nexus with New York City.

New Jersey

On October 12, 2017, the NJ DOT published guidance specifically addressing hedge fund managers "who deferred compensation into accounts in offshore banks."¹ The guidance addresses how a nonresident individual would determine whether deferred compensation is New Jersey source income and, therefore, subject to New Jersey income tax. An individual reports income for New Jersey tax purposes when the income is reported for federal income purposes. Thus, when the hedge fund manager's deferred income for services is reported for federal income tax purposes, consideration must be given to where the services had been performed and not the state of residence of the individual at the time the income is received. The guidance states: "[H]edge fund managers must source compensation deferred under IRC [Section] 457A to [New Jersey] if it was attributable to New Jersey at the time it was earned and deferred."² The requirement to source this income to New Jersey at the time it was earned and deferred is particular to individuals.

Connecticut

Connecticut law, like New Jersey's, states that the accounting method used for federal income tax purposes will be the same for Connecticut income tax purposes.³ The CT DRS has indicated that Connecticut also will follow the IRC's treatment of deferred compensation. In 2014, Connecticut enacted legislation requiring "compensation from nonqualified deferred compensation plans attributable to services performed within Connecticut" to be reported consistent with IRC Section 457A, stating that such income is subject to Connecticut tax.⁴ Further, the legislation required that any deferred compensation earned in Connecticut before January 1, 2009 be reported in tax year 2017 if it had not been previously reported.⁵ Additionally, in November of 2016, the CT DRS requested hedge fund managers to provide it with information on the amount of deferred income the hedge fund manager received and when it would be reported for tax purposes. The notices make clear that the CT DRS expects a nonresident individual to assign deferred compensation to Connecticut if the underlying services had been performed in the state.

New York City

The NYC DOF recently indicated that it may propose new rules related to deferred compensation expenses. The NYC DOF expressed concern that certain taxpayers may be structuring operations in such a way as to avoid the imposition of the Unincorporated Business Tax⁶ — specifically that entities are attempting to bifurcate functions and use multiple legal entities to limit nexus. The NYC DOF's proposed new rules would address this break of nexus by the otherwise taxable entity.⁷ Thus, the NYC DOF is expected to focus its attention on companies that are reporting deferred income for past activities and are now conducting business outside of New York City.

Implications

Taxpayers should consider many factors, including where services were performed, when reporting deferred compensation. Taxpayers also should document their positions and thought process in case the return is subject to examination. In addition, taxpayers should address estimated tax payment requirements to avoid any underpayment of estimated tax penalty and extension requirements to ensure the filed return will be timely.

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ENDNOTES

¹ State of New Jersey, Division of Taxation, Deferred Compensation Received by Nonresident Hedge Fund Managers Under IRC Section 457A (October 12, 2017).

² Id.

³ Conn. Gen. Stat. Section 12-708(a).

⁴ Conn. Gen. Stat. Section 12-711(a)(4); Connecticut Department of Revenue Services, 2016 Form CT-1040, Connecticut Resident Income Tax Return and Instructions, pg. 3; Connecticut Department of Revenue Services, 2016 Form CT-1040NR/PY, Connecticut Nonresident and Part-Year Resident Income Tax Return and Instructions.

⁵ Id.

⁶ New York City Finance Department Seeks UBT Reform; Prepares Guidance on Carried Interest, Lexis Nexus 20017 STT 92-1 (May 15, 2017).

⁷ Id.