March 9, 2018
State legislators continue to challenge "carried interest loophole" in 2018
In 2017, legislators in several states introduced legislation intended to close the "carried interest loophole" by enacting an additional state tax on an investment manager's performance allocation. In general, these bills would have imposed a new state tax on the performance allocation at a rate equivalent to the difference between the highest federal ordinary income tax rate and the highest federal rate on capital gains. Bills to address just that were introduced in New York, Illinois, Massachusetts, New Jersey, Rhode Island and California.
While none of the bills were enacted, the issue is surfacing again because, in the view of some states, the enactment of the Tax Cuts and Jobs Act (P.L. 115-97) did not sufficiently address the perceived "carried interest loophole."
The FY 2019 New York State Executive Budget (2019 Budget Bill) contains a proposal to impose additional New York State income tax on carried interest income earned by certain investment managers. Investment managers would owe both an income tax and a carried interest fee. Different from the 2017 proposal, this legislation has been introduced as part of the governor's budget. So, while it is expected that the proposal will be subject to push-back, it may involve more discussion and may have a greater chance of being enacted. Still, with the New York State Senate controlled by the Republicans, enactment seems unlikely.
The framework of the current proposal, however, is similar to the proposal introduced in New York in 2017. The current proposal would apply to partners, S corporation shareholders and C corporations (pass-through entity owners) that perform "investment management services" for partnerships or S corporations (investment vehicles). In general, "investment management services" would include:
— Providing investment advice on the buying or selling of securities, real estate, interests in partnerships, commodities, and options or derivatives;
There is a carve-out for real estate when investment management services would not include services for an investment vehicle for which substantially all (80%) of its assets consist of real estate held for investment or rental. In addition, the proposal would limit investment income for corporate managers and the type of activities that generate exempt self-trading income for nonresident individual partners. The carry income would not fit within the narrowed definition of buying and selling securities for one's own account.
The carried interest fee would apply when a pass-through entity owner receives a distributive share of income, gain, loss or deduction in excess of the amount the pass-through entity owner would have received if no services were performed ('carry income'). For example, if a 1% partner received 5% of the pass-through entity's income, 80% of the distributive share would be classified as carry income, as 4/5's of the partners' distributive share is above the actual interest in the partnership. It's noteworthy that the fee is not based on the character of the income for federal income tax purposes. Hence, ordinary income and capital gains from securities held less than three years can be subject to the fee.
The fee is imposed at a rate of 17%. A nonresident of New York would pay the fee to the extent the carried interest was from New York sources. Similarly, S corporation shareholders and C corporations would treat the carry income as business income and pay the fee on the amount apportioned to New York.
The 2019 Budget Bill includes a contingency provision similar to the proposal made in 2017, whereby it would not be effective until Connecticut, Massachusetts, New Jersey, and Pennsylvania pass similar legislation. Presumably the goal of this joint action by New York and these other named states would be to prevent fund managers from moving a short distance to the next state over to avoid the provisions.
In the spirit of proposals like those introduced in New York and other states, legislation has been introduced again in Illinois that would impose a 20% privilege tax on partnerships, including investment partnerships, and S corporations engaged in conducting "investment management services" (as defined similarly to the proposed language in New York). In January and February, 2018, members of the Illinois House and Senate again proposed their versions of "carried interest" bills (HB 4293 and SB 3189). They are largely similar to last year's SB 1719, which came close to making it through the legislature and landing on Governor Rauner's desk. The tax would be effective July 1, 2018, and "calculated by reference to the performance of the investment portfolio funds, rather than from the investment itself … and not imposed on fees calculated by reference to the total assets under management."
Further, following the New York proposal, the proposed bills each include an exclusion for certain real estate partnerships. Unlike the New York proposal, passage of similar bills by other states would not be a pre-condition to enactment of the Illinois tax under either HB 4293 or SB 3189.
The House bill was referred to the Illinois House Growth, Reform & Fairness Subcommittee on February 14, 2018, after a hearing on that same day in the House's Revenue & Finance Committee. The Senate bill was referred to Assignments after being proposed on February 16, 2018. While it is possible the bills will pass, they are not without serious constitutional and discriminatory challenges and at this time appear more like political overtures with little chance for success.
Although no new legislation was introduced in Massachusetts to close the perceived carried interest loophole, some Massachusetts legislators proposed a bill last year calling for a 19% surtax on carried interest income, reflecting the then-existing difference between the top federal individual rate at the time and the federal capital gains rate. Considering the change in the carried interest conversion period between the new three-year holding period and Massachusetts' one-year period for capital gains treatment, however, the inherent difference itself could be deemed to be an indirect approach to tax carried interest at higher rates.
New Jersey SB 64, like New York's carried interest legislation, is designed to impose an additional tax on recipients of carried interest income. It establishes a 19% "surtax" (which is as yet not exactly defined) on "income from investment management services." The bill would direct the New Jersey Department of Treasury to write regulations to implement these provisions, and would likely define key terms. If the bill is enacted, similar to those in other states, it would only become effective if neighboring states, including New York, Connecticut and Massachusetts, enact similar legislation.
In addition, SB 64 contains a provision that would terminate the tax if the US Congress amends the Internal Revenue Code to repeal the carried interest preference.
On January 18, 2018, SB 20179 was introduced to impose a 19% carried interest fee that is similar in scope and language to the bills introduced this year in New Jersey and New York. Like those proposals, the bill would be effective only if similar legislation were enacted in Connecticut, New Jersey and Massachusetts (but not New York). Conversely, none of the bills introduced in those states (including New York) mention Rhode Island as one of the states upon which effectiveness would be based.
On February 15, 2018, Assembly Bill No. 2731 was introduced to impose a 17% tax on income derived from an "investment management services interest" for tax years beginning or after January 1, 2018. The California bill is a cross between the New York and Illinois proposals. The technical aspect of the California bill is similar to New York's proposal, but has no contingency language, which is similar to Illinois' proposal. The effectiveness of California's proposal is not contingent upon the enactment by any other state or states of a similar tax or fee. Further, the California bill would allow for the repeal of the provisions if the federal government enacts law that has an identical effect.
Certain states continue to consider the imposition of additional taxes on investment managers to address perceived inequities in the federal tax structure relating to carried interests. On the other hand, no clear momentum appears to exist suggesting than any legislation proposing these new taxes and fees will actually be adopted, despite the broad reach of these bills to impose taxes or governmental fees on carried interests.