Limited Partners and the MCTMT
The State’s Tax Department has been aggressively enforcing the tax on self-employed individuals, including limited partners, and one aspect of the recent law change is intended to help those efforts.
The tax on partners and other self-employed individuals is tied, per the statute, to “net-earnings from self-employment,” as the term is defined in § 1402 of the Internal Revenue Code, and which specifically exempts amounts earned by limited partners from “net earnings from self-employment,” except for guaranteed payments for services provided to a partnership. For years the IRS has tried to eliminate or change this “limited partner exception,” in some cases with success, at least as applied to partners in state-law LLPs and members of LLCs (see Renkemeyer, Campbell & Weaver LLP v. Comm’r, 136 T.C. 137 (2011); Castigliola v. Comm’r, T.C. Memo 2017-62 (Apr. 12, 2017); see also Riether v. U.S., 919 F. Supp. 2d 1140 (D.N.M. 2012); Hardy v. Comm'r, T.C. Memo 2017-16 (Jan. 17, 2017)). But up to this point, the IRS has not been able to extend that rationale to state-law limited partnerships, and efforts to change the federal law have also failed.
It turns out that New York’s Tax Department doesn’t like the limited partner exclusion either, and for the past few years it has, on its own, tried to enforce the MCTMT on state-law limited partners, with a focus on managers of hedge funds and private equity companies who earn a share of their management company income through a limited-partnership structure. But rather than wait out the IRS on the issue—the IRS is currently fighting the issue again in a couple Tax Court cases—the Legislature, presumably at the Tax Department’s suggestion, took matters into its own hands. Specifically, the Budget amends the definition of “net earnings from self-employment” to clarify the treatment of limited partners who are actively engaged in the operations of a partnership within the Metropolitan Commuter Transportation District (the “MCTD”) and establish that only “true” investor limited partners are exempt from MCTMT liability. The language of the amendment specifically states that, for purposes of the limited partner exclusion from net earnings from self-employment:
“an individual shall not be considered a limited partner if the individual, directly or indirectly, takes part in the control, or participates in the management or operations of the partnership such that the individual is not a passive investor, regardless of the individual’s title or characterization in a partnership or operating agreement.” (Tax Law § 800(e))"
On a going-forward basis, such a change is within the purview of the Legislature; it is allowed to change the MCTMT definitions or add new taxes (which we like to do in New York!). But to style this as a “clarification” is odd. Before this change, the limited partner exception was baked into the existing statute; the fact that the IRS and the State Tax Department didn’t like it shouldn’t allow them to identify the statutory change as a “clarification.” And labeling the provision as a “clarification” is often a tell-tale sign that the Tax Department might attempt to apply these rule changes retroactively, which is an unsettling reality for taxpayers who thought they were correctly navigating New York’s tax system over recent years. Whether it is constitutional to apply a law retroactively is a topic for a different day, but inasmuch as the provision is a change in preexisting law, the retroactive application of it is likely to be challenged as a violation of due process in future cases, if the Tax Department chooses to apply the change in such a fashion.
A June 23rd bulletin from the Tax Department states “Guidance regarding the legislative changes to the MCTMT imposed on certain self-employed individuals engaging in business within the MCTD will be announced at a later date.” So the Department may be waiting to see how the federal tax cases are going to be resolved before deciding whether to attempt retroactive application.
Rate Changes
Another change, albeit less intriguing, concerns rates.
Effective July 1, the Budget almost doubles the top MCTMT rate from 0.34% to 0.60% for employers in the counties of Bronx, Kings, New York, Queens, and Richmond (the “city zone”) with a quarterly payrolls over $437,500. For self-employed taxpayers with earnings sourced to the city zone, the MCTMT rate increases from 0.34% to 0.47% in the 2023 tax year and to 0.60% for the 2024 tax year. We assume that the 0.47% rate for 2023 is to phase in the 0.6% rate.
Just this week the Tax Department updated its MCTMT page to reflect the rate changes taking effect July 1.
The updated information purports to clarify how the MCTMT applies to employers with business locations in the MCTD in both the city and suburban zones. According to the updated page NYS is going to look at compensation paid to covered employees in each zone and apply the different zone rates to the covered employees in the particular zone. What constitutes a “covered employee in a particular zone” is not defined. We assume NYS will use a method that is similar to the one used to determine if a covered employee has services allocated to the entire MCTD, which you can find here. A four-prong test is used to determine whether a covered employee has services allocated to the MCTD: (1) The services are performed entirely within the MCTD, or partly in the MCTD but the services performed outside of the MCTD are incidental; (2) location of the employee’s base of operation; (3) the location from which the employee’s direction and control emanates; and (4) the location of the employees residence. If any of the four prongs results in an allocation of services to the MCTD, then the employee is a covered employee with services allocated to the MCTD. Applying this method to determine the appropriate zone for a particular employee could lead to difficulties where, for instance, an employee lives in Westchester County, but works in an employer-office in the City. Under the four-prong approach the employee has services allocated to both the metropolitan and suburban zones. But we expect that the determination of zones will be accomplished by converting the four-prong approach to a cascade approach, so that the zone will be determined by the first of the four tests to result in the assignment of a zone to the particular employee.
