New York City Audit Position Could Increase Unincorporated Business Tax

December 5, 2011

We have become aware that the New York City Department of Finance is considering a new audit position that, if raised and sustained in connection with an audit, would have the effect of increasing the annual New York City unincorporated business tax (“UBT”) liability of investment managers operating in New York City (through a partnership or an LLC) where an affiliate of the manager acts as the general partner of a private investment fund (a “Fund”) and receives the incentive allocation from the Fund (which is not subject to the UBT).

The management fees received by an investment manager operating in New York City (through an unincorporated entity) are included in the gross income of the investment manager for purposes of the UBT. The investment manager generally incurs most of the expenses associated with the investment management business, including salaries for employees, office rental, etc. These expenses are generally deductible for purposes of calculating its annual UBT liability, which is imposed at the rate of four percent (4%) on the investment manager’s net income. On the other hand, pursuant to a special statutory exemption, the incentive allocation received by a general partner of a Fund is generally not subject to the UBT and there typically are very limited expenses incurred by the general partner.

We understand that the Department of Finance is considering a new audit position that would treat a portion of the expenses incurred by the investment manager of a Fund as being attributable to the incentive allocation earned by the general partner of the Fund. If this position were successfully asserted, the investment manager would have a greater amount of net income (or a lesser amount of net loss), subject to the UBT, and therefore would be subject to higher effective taxes on its management fee income.

At this point, we note that this is only a position that the Department of Finance could assert on audit and there has been no change in the law or regulations thereunder. We have not yet seen this position asserted in an actual audit but we understand from a number of our colleagues at accounting firms that the Department of Finance is likely to take this position in connection with audits of unincorporated investment management firms that advise Funds. It is unclear whether this position will survive judicial scrutiny if it were to be challenged by a taxpayer.

We will continue to monitor and keep you apprised of any developments in this area.

If you have need assistance with these issues or have any questions, please call Ronald P. Cima at (212) 574-1471, James C. Cofer at (212) 574-1688, Peter E. Pront at (212) 574-1221, or Daniel C. Murphy at (212) 574-1210.