Recent Audits May Impact Fund Structures and Management Company Expenses

There may be a number of reasons for a manager to create separate legal entities to serve as the management company and a fund’s general partner. In particular, New York-based managers have typically done this due to New York City’s tax treatment of fees earned by fund managers. However, a recent move by the New York City Department of Finance (the “Department”) may hearken a change to this approach, and the manner in which fund managers analyze and document their expenses.

Background on New York UBT

New York City’s Unincorporated Business Tax (“UBT”) currently is, and has been historically, imposed only on management fees earned in the city, but not on incentive allocations. This tax treatment was formally approved by a statutory amendment to the UBT law over 15 years ago. For this reason, fund managers have formed one entity to be the management company that will receive the asset-based management fees, and another entity to serve as a fund’s general partner and receive the profits-based incentive allocations.

Management fees are generally used to cover both the management of the fund, and the administrative operations of the management company. Expenses related to these functions are deductible against gross income when calculating the management company’s UBT liability. The tax rate is 4% of the net UBT income.

The incentive allocations to the general partner are excluded from UBT on the basis of a statutory exemption for entities that are “primarily engaged” in self-trading for its owners and does not otherwise operate a business in New York city, as defined in the UBT law (this is because all of the administrative/operational functions are performed by the management company).

Developments in the New York City Department of Finance

Recent audits by the Department may portend a shift in this tax treatment and hence, implications for fund managers in how they structure and run their businesses. Specifically, the Department asserted that some portion of a management company’s operating expenses is ultimately attributable to tax exempt income. Because of this, the Department determined that at least some of these expenses should not be used to reduce the management company’s UBT liability. In effect, this approach will attribute some of the expenses to the tax-exempt incentive allocation that the general partner earns, rather than allowing 100% of such expenses to offset the management fee. Put more bluntly, the Department will disallow some of a management company’s expenses in calculating the net UBT income.

Interestingly, while the redistribution of tax among entities under common control is explicitly permitted under Federal tax law, the UBT law is silent on this question, though some commentators suggest that authority for this is implied because the UBT calculation starts with Federal taxable income.

As a result of this new approach, the management company’s net UBT income would increase to the extent that expenses are disallowed, and the management company would owe more tax. In years where performance is significantly up (meaning a higher incentive allocation), the tax increase would likely be more pronounced; in contrast, when performance is down and there is no allocation, the management company may still be permitted to deduct expenses as it has done previously.

Conclusion

It is important to note that the Department’s approach in the audits has not been formally adopted, nor implemented in the UBT law itself. However, given the unpredictability inherent in the Department’s expense-shifting approach in the audits, we recommend that New York-based fund managers evaluate their expenses and carefully document how they relate to the operations of the management company to maximize the ability to deduct them for purposes of calculating their net UBT income.

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Cole-Frieman & Mallon provides hedge fund formation and other legal services to managers in New York and throughout the country.  Bart Mallon can be contacted directly at 415-868-5345.