In response to U.S. federal income tax reform, New York State1 has proposed a state tax on certain unincorporated businesses and Connecticut has already adopted similar legislation. These new laws may reduce the U.S. federal income tax liability of owners of certain pass-through businesses by taxing these businesses directly rather than taxing their owners. This Client Alert describes the general features of these unincorporated business taxes and addresses how such new regimes may impact investment managers and funds. As discussed below, fund managers may want to revisit their company structures to ensure that they remain efficient from a tax perspective.
If adopted, the New York State unincorporated business tax would be imposed at a rate of 5% effective for taxable years beginning on or after January 1, 2019. Connecticut adopted its unincorporated business tax on May 31, 2018, imposed at a rate of 6.99% effective for taxable years of beginning on or after January 1, 2018.
Unincorporated Business Taxes in General
The proposed New York State tax and the adopted Connecticut tax on unincorporated businesses will generally subject entities taxed as partnerships for U.S. federal income tax purposes to entity level taxation. Neither the New York proposal nor the Connecticut tax applies to disregarded entities. The Connecticut tax applies to S corporations, but the proposed New York tax would not.
The owners of unincorporated businesses will continue to be subject to state income taxation on their distributive shares of partnership income but will also receive a corresponding state income tax credit for their share of the unincorporated business tax paid at the entity level. In New York, the proposed credit system takes into account tiered partnerships.
Economically, a partner or other owner of an unincorporated business ought to receive the same amount of income after state taxes, but a portion or all of the state taxes will be paid at the entity level. As a result of these new unincorporated business taxes, unincorporated business owners may have federal income tax savings.
Absent such a tax, the unincorporated business owner’s state income taxes paid in respect of income from the business are generally subject to a $10,000 federal income tax limitation. Since the $10,000 limitation does not apply to taxes that are paid in connection with carrying on a trade or business, unincorporated business taxes borne by the partnership or LLC should not count towards a partner’s limit on the deductibility of state and local income taxes (although there can be no assurance that the Internal Revenue Service will agree).
Hypothetically, an entity that pays $100,000 in unincorporated business tax to a state taxing authority could generate U.S. federal income tax savings of up to $37,000 in the aggregate for all of the partners. This example is meant to illustrate the potential federal income tax benefit envisaged by state legislators and assumes that all of the partners are individuals subject to U.S. federal income tax at the highest marginal tax rate and the partners’ other state and local taxes exceed $10,000.
Impact on Investment Managers and Funds
Under the New York proposal, all unincorporated businesses doing business in New York would be subject to the tax. Therefore, all investment management companies that are based in New York and are partnerships or S corporations for tax purposes will be subject to the New York unincorporated business tax.
In addition, the New York proposal does not include a “trading for one’s own account” safe harbor, such as the safe harbor from the New York City unincorporated business tax. However, under general sourcing rules, funds and their general partners should not be subject to the proposed New York State unincorporated business tax. Further, it is unclear how this proposal would affect partnerships that file composite income tax returns on behalf of out-of-state taxpayers.
The Connecticut unincorporated business tax would have a similar effect on investment managers located in Connecticut. It appears that funds and general partners should not be subject to the Connecticut unincorporated business tax under general sourcing rules and rules excluding certain items from Connecticut gross income. A partnership can elect to treat its Connecticut source income as being equal to the percentage of income attributable to Connecticut resident partners. Thus, a general partner entity with Connecticut resident partners, which would generally not be subject to this new tax, would likely want to make this election. A fund should consult its advisors to determine whether this election is advisable.
Investment managers should consider how these new laws may impact their businesses and whether there are potential advantages to restructuring existing entities, such as converting single member LLCs that are disregarded entities to partnerships or S corporations.
For additional information on state level unincorporated business taxes and other recent income tax changes, please contact Ronald P. Cima (212-574-1471), Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210) or Brett R. Cotler (212-574-1269).
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1 New York City currently imposes an unincorporated business tax on all unincorporated businesses, including sole proprietors, that do business in New York City. This Client Alert does not discuss the New York City unincorporated business tax.
