New Jersey recently amended its Gross Income Tax to create a new tax on carried interest.1 New Jersey taxpayers that own partnerships, LLCs or S corporations that serve as general partners to investment funds may be subject to an additional 17% tax on their distributive shares of carried interest. This tax, if it becomes operative, will affect both New Jersey residents that are principals of funds’ general partners, regardless of whether the fund is managed in New Jersey or elsewhere, and non-New Jersey residents that are principals of general partners of funds that are managed within New Jersey.
This 17% carried interest tax will remain inoperative until New York, Connecticut and Massachusetts all enact legislation that would have an identical effect. As of the date of this publication, all three states have considered drafts of legislation that would have a substantially similar or identical effect, but none of New York,2 Connecticut or Massachusetts have enacted such proposals.
The 17% tax on “investment management services” represents the difference between the highest marginal Federal ordinary income tax rate and the highest marginal Federal long-term capital gains rate. The New Jersey carried interest tax will not apply to any partner or S corporation shareholder to the extent such partner or S corporation shareholder: (x) is taxed as a C corporation; (y) holds a capital interest in a partnership that provides the taxpayer with a right to share in partnership capital commensurate with the amount of capital contributed; or (z) holds a partnership interest, the value of which is subject to Federal income taxation under section 83 of the Internal Revenue Code upon receipt or vesting of such interest.The New Jersey tax law defines “investment management services” as the provision of a substantial quantity any of the following services to a partnership, S corporation or other entity as partner thereto:
(A) advising as to the advisability of investing in, purchasing, or selling a specified asset;
(B) managing, acquiring, or disposing of a specified asset;
(C) arranging financing with respect to acquiring specified assets; and
(D) any activity in support of the above services.
“Specified assets” means securities, real estate held for rental or investment, interests in partnerships, commodities, options and derivative contracts. A partnership will not be treated as holding specified assets if at least 80% of the value of the partnership consists of real estate.3 Consequently, general partners of New Jersey-based real estate funds should not be affected by this new tax should it become effective.
It is unclear whether the New Jersey carried interest tax will apply to all carried interest or if it will be confined to carried interest that is taxed at long-term capital gains rates for Federal income tax purposes.4 It is possible that without a legislative amendment or administrative guidance, the current tax on carried interest would apply to all carried interest received by a New Jersey taxpayer, regardless of its treatment for Federal income tax purposes.
New Jersey-based managers who are interested in how this new tax may affect their specific situations should call us. For additional information on recent tax law, 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).
1 In addition to imposing a new tax on carried interest, New Jersey created a new tax bracket imposing Gross Income Tax at a marginal rate of 10.75% (up from 8.97%) on income over $5 million. The other tax brackets remain unchanged.
2 New York’s proposed tax on carried interest, like New Jersey’s, is contingent upon the passage of similar legislation in New Jersey, Massachusetts, Connecticut and Pennsylvania. If Connecticut, Massachusetts and New York enact similar legislation and Pennsylvania does not (thereby causing New York’s law to remain ineffective), New Jersey’s law would become operative because the statute merely requires that New York enact the legislation, not that the New York legislation actually become effective.
3 We note that there is no explicit carve-out for interests in partnerships, 80% of the assets of which are real estate. Therefore, it is possible that a narrow interpretation of this law may capture real estate funds where the value of interests in co-investment vehicles exceeds 20% of the fund’s NAV.
4 See section 1061 of the Internal Revenue Code of 1986, as amended.