Just to recap the issue: In 2008, Congress eliminated a common mechanism used by cash basis hedge fund managers to defer the receipt and recognition of certain incentive or management fees. Under IRC § 457A, which was effective for fees earned for services rendered on or after January 1, 2009, hedge fund managers were limited in their ability to defer those fees. Before IRC § 457A, the management company was able to defer the receipt and recognition of the incentive or management fees (per the deferral agreements) that were charged to offshore funds. Those fees were able to appreciate, tax-deferred, for up to 10 years. Because the management companies taking advantage of the benefit were cash-basis taxpayers, the management companies, and therefore their owners, did not have to recognize the deferred fees until they were received.
Under the new rules, the ability to defer fees earned after January 1, 2009 was limited, and any fees earned and deferred before January 1, 2009, would have to be recognized for tax purposes by the end of 2017. As 2017 approached, many wondered what states (and cities) would do.
I’ve addressed this issue a few times in past writings: "10 Questions on Deferred Management Fees for Hedge Fund Managers in 2017" and “Hedge Funds & Deferred Management Fees: State Taxes.” And as I noted in "Better Late than Never? Issues on Hedge Fund Deferred Compensation,” the New York State Tax Department issued a Technical Memorandum addressing the issue back in April, right before tax returns for 2017 were due. Good timing. The City did them one better, waiting until June to issue guidance! Better later than never, I guess...
The City’s guidance explains how taxpayers should report this deferred income under the city’s entity-level tax regimes (primarily under New York City’s unincorporated business tax (“UBT”), but also under the city’s business corporation tax and general corporation tax.
The main takeaways (from a very detailed memo) are:
1. Taxpayers must recognize the full amount of their deferred income as compensation for services in the same tax year that they recognize the income for federal income tax purposes;
2. Taxpayers must use the law and rules that apply in the year of recognition to compute their business allocation percentage (“BAP”); and
3. Taxpayers’ activities that generated the right to its deferred income determine their connection to the city and place of performance for purposes of the payroll and gross income factors attributable to that income in their BAP.
In plain English, this means taxpayers have been instructed to treat deferred compensation as taxable business income and to use the allocation factors and rules that apply in the year of recognition (for tax year 2017, the UBT allocation factors include 93% sales, 3.5% property, and 3.5% payroll) but use the facts and places of performance that existed in the year(s) the income was earned. So the idea is to use current apportionment rules with historic apportionment factors.
The New York City Department of Finance also notes at several points in its memo that it may need to use its “discretion” in certain cases to compute an equitable BAP and includes three helpful examples of actual UBT calculations to assist taxpayers in understanding the city’s position.
This publication, however, should be taken with a grain of salt. Because legislation and/or regulations remain absent, many taxpayers may take the position that this memorandum is non-binding and merely advisory in nature. We’ll save that argument for another day.
