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Attention Hedge Fund Investment Advisors: Connecticut Court Permits Credit for Taxes Paid on Carried Interest

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On March 7th, a Superior Court in Connecticut issued a decision that could have a significant impact on some investment fund managers who live in Connecticut but manage funds in other states. In Jonathan A. Sobel v. Commissioner of Revenue Services, the Judge held that investment (and therefore intangible) income received by Mr. Sobel, a partner in a partnership that served as the general partner and advisor of certain investment funds, was New York source income and therefore Mr. Sobel could claim a credit on his 1997 and 1998 Connecticut resident tax return for taxes paid to New York (yes, the case has been going on that long!).

The income at issue is what is typically referred to as “carried interest.” The general partner, Livingston Asset Management LLC (“LAM LLC”), of which Mr. Sobel was a 50% partner, received incentive fees (totaling approximately 30% of the increase in the value of the underlying funds) for managing the investments. LAM LLC did not receive any management fees.

Under Connecticut law (which, by the way, is identical to New York’s provisions), a credit for taxes paid in other jurisdictions on income from intangibles is only permitted where the income is from “property employed in a business, trade or profession carried on in the other jurisdiction.” Regs. 12-704(a)-4(a). Trading for one’s “own account” does not constitute a trade or business.

The judge determined that even if the activities of the partnership could be considered “trading for its own account”—and, in fact, this is the position that LAM LLC took for purposes of New York City’s Unincorporated Business Tax—its partners could still be engaged in an active trade or business. Because Mr. Sobel actively managed the investments of others as a partner of LAM LLC, he, as an individual partner, was not trading for his own account.

The judge next determined that the property generating the income was used in a trade or business because Mr. Sobel conducted his business every day from a New York City office for LAM LLC and it was the profits from this enterprise that generated the income at issue. Rather than treat the investments in securities or the partnership interests in the underlying funds as the “property” generating the income, the court simply focused on the active business itself as the profit generator.

If this case were to stand (we assume Connecticut will appeal), it could substantially benefit hedge fund managers who are dual residents of New York and Connecticut. Currently, a hedge fund manager living primarily in Connecticut and working in New York is often subject to tax in both states (with no resident credit available) on carried interest because it is treated as intangible income that does not have a source. We’ve discussed this conundrum a number of times, including in this article addressing problems with dual-resident taxation and resident credits. And we’re currently litigating a couple cases (including the Chamberlain case, discussed here) where we’re attacking this double-tax treatment on constitutional grounds. But the Sobel case provides a different avenue for alleviating this double-tax result. Per the court’s rationale, carried interest received by a partner—even if the partnership is trading for its own account—is deemed to have a “source” in the location where the partner is actively managing the investments. So under this rationale, in the case of a dual-resident taxpayer, the state of Connecticut would be required to provide a credit for taxes paid to the State of New York on this carried interest income.

Conversely, what could this mean for other taxpayers, if the rationale is correct? It could have very costly implications for nonresident fund managers whose funds are located in Connecticut or New York (which has a similar statute and regulation). Currently, carried interest is typically treated as nontaxable to a nonresident. But if the property is now where the fund managers do their investing, nonresidents will suddenly have to pay a significant amount of tax to another state. Yikes.

So though this is presented as a taxpayer victory, let’s wait to see how it all plays out. We suspect there will be yet another chapter in Mr. Sobel’s 20-year battle with Connecticut.

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