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 Jan. 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. But under the new rules, the ability to defer fees earned after Jan. 1, 2009 was limited, and any fees earned and deferred before Jan. 1, 2009, would have to be recognized for tax purposes by the end of 2017.
As 2017 approached, many wondered what states would do. Residents were going to be taxed on all of the deferred fees they received in 2017. But what about nonresidents? Connecticut actually passed a law back in 2014 addressing the allocation of deferred income received by nonresidents from offshore hedge funds (See Act 14-155). And last fall, the New Jersey Division of Taxation issued guidance on the issue.
But nothing from New York. However, we noticed that the issue did pop up on 2017 tax forms, issued in January 2018. See question “D3” on the 2017 resident and nonresident/part-year resident income tax returns:
The same question popped up on partnership forms:
So clearly the Department was aware of the issue and presumably looking to identify audit targets with the tax return questions. Still, though, no guidance from New York as to how it was going to treat such income. The issue was especially disconcerting for nonresidents, as deferred income-allocation issues for nonresidents have historically been pretty complicated.
But just last week, on April 6, 2018—a week or so before “tax day”—we got our guidance! However, the guidance didn’t come by way of a legislative change, or even a regulatory change. Instead, the Tax Department justice issued a "Technical Memorandum" entitled “New York State Tax Treatment of Nonqualified Deferred Compensation.” Here are some highlights of what the Tax Department memorandum asks of taxpayers:
- Nonresident employees are to allocate the deferrals (including appreciation on the deferrals) based on New York work days/total work days for each year services were performed. 20 NYCRR § 132.18 is cited. These allocations have to be done year-by-year for each year in which deferred fees were earned and then separately flowed up to the 2017 return. And here’s a funny quote from the memo: “Taxpayers must maintain documentation to substantiate the allocation.” This would have been really helpful information to have FIFTEEN YEARS AGO! Or at least maybe sometime last year when taxpayers were preparing estimated taxes?
- Proprietorships and partnerships with nonresident owners also use a year of performance approach but use a books and records method or the 3-factor business allocation percentage from the year of performance to determine the source and then flow it up to the 2017 return.
- Part-year residents use a “time of receipt” approach to determine whether they are paying tax on everything as a resident or on New York source income as a nonresident.
- C Corps and non-resident shareholders of S Corps do NOT use the year of performance, but instead, use a year of receipt (i.e., 2017) apportionment percentage to source income to New York. All of the deferred income (including the appreciation) is included in the tax base as business income. We interpret a particularly confusing passage to require nonresident S corp. owners who are also employees use the employee approach for employee compensation and the apportionment percentage for flow-through deferred comp.
Does the Tax Department have appropriate legal basis for such guidance? Is it a problem that this guidance comes by way of a nonbinding technical memo, and not in duly promulgated regulations (which prior cases say must be used to dole out multi-year income allocation rules)? We’ll leave that discussion for another blog, or article, or legal brief.
But at least we now know what the Tax Department thinks, and just in time to file your 2017 taxes, assuming you wait until the last minute like us!
