With COVID-19 continuing to spread through much of the U.S., working from home has become the preferred, if not required, form of work for many employers and their employees. Entering the pandemic's sixth month, this new work-life arrangement shows no signs of stopping anytime soon.
Working from home may trigger a host of unforeseen state tax consequences for employers and employees alike, particularly in the Northeastern U.S. where people frequently cross state lines to travel between their office and home.
One industry in particular has seen, and may continue to see, a substantial state tax benefit from remote working arrangements: hedge fund and private equity fund managers with offices located in New York City.
Known as the unincorporated business tax, New York City's 4% tax applies to unincorporated businesses that are wholly or partly carried on in the city. An unincorporated business is generally defined as trades, professions and certain occupations of an individual, partnership, limited liability company, fiduciary, association, estate or trust.
The unincorporated business tax is effectively a pass-through tax, levying a 4% tax on entities and businesses that would typically only be subject to one layer of tax at the owner level.
For unincorporated businesses that are carried on both in and out of New York City, the unincorporated business tax will only be imposed on income that is allocated to New York City. Subject to certain exceptions, "charges for services performed shall be allocated to the city to the extent that the services are performed within the city."
The service fees generated by hedge fund and private equity fund managers based in New York City are among those most frequently subject to the unincorporated business tax. A fund manager is typically the recipient of compensation based on the services provided to the funds that they advise.
The compensation is generally split into two components: (1) a management fee for managing the fund's investment program, and (2) a carried interest in the underlying fund paid to the manager or an affiliate of the manager as the fund's general partner.
While most investment funds are unincorporated businesses — organized either as limited partnerships or limited liability companies that are classified as partnerships for income tax purposes — they are generally not subject to the unincorporated business tax because they purchase, hold and sell property, including stocks and bonds, for their own account.
As a result, the fund manager's carried interest is generally exempted from the 4% levy. The management fee, however, which is a fee for services, is typically not. That notwithstanding, the application of the unincorporated business tax can be rather draconian to unincorporated businesses that earn income that is in part subject to the unincorporated business tax on one hand, and exempt from the unincorporated business tax on the other — i.e., a general partner entity that earns both a carried interest and a management fee.
In such an instance, should the management fee exceed $25,000, the carried interest will be subject to the unincorporated business tax. To protect the carried interest from being tainted by the management fee, the manager entity earning the management fee will usually be separate and distinct from the general partner entity holding the carried interest.
While management fees vary on a fund-to-fund basis, the industry standard historically places the annual management fee at up to 2% of the fund's assets under management.
For fund managers located in New York City, the unincorporated business tax could be significant. For example, for a fund with $500 million under management, a 4% tax on a 2% annual management fee would equate to nearly $400,000 of taxes on the management fee alone. This, of course, does not include any federal or state income taxes imposed on the fund's earnings.
The unincorporated business tax produces so much revenue, in fact, that at the beginning of the year it was expected to generate a little more than $2 billion in the current year with substantial increases in the upcoming years. However, as a result of the pandemic, the New York City comptroller has recently estimated that the city may lose up to $300 million in unincorporated business tax revenue from what was originally anticipated.
Aside from the general contraction of both the national and local economies, New York City's unincorporated business tax revenue is particularly at risk because many of the people behind businesses subject to the tax are working remotely from places other than New York City.
For example, high-net-worth fund managers have historically been drawn to neighboring locals such Short Hills, New Jersey, and Greenwich, Connecticut, due to higher quality-of-life benefits. Such managers, along with thousands of others, now find themselves forgoing their daily commute to the city and instead working from home.
Further, some New York City residents have even left the region to escape the pandemic. As a result, many fund managers now find themselves with no actual services being provided in the city. Such a change in working habits could be a coup for fund managers whose management fees were typically subject to this significant tax.
Under this new remote working arrangement, aggressive fund managers have a colorable position to argue that their management fees are not subject to the unincorporated business tax because none of their employees are actually working within the city limits.
Amplified over a period of time, the tax savings could be enormous: Funds typically have a life span of 10 years, and the avoidance of the unincorporated business tax could result in savings of up to $4 million over the lifetime of a $500 million fund.
With the potential for such savings, fund managers should carefully monitor and document the location and type of work of each of its employees to appropriately determine whether it has any work being conducted in New York City. In fact, some companies have already created useful technology to assist with the documentation of each employee's whereabouts and activities. Such information would be useful in the event of an audit by the New York City Department of Finance.
This is not to say that the city will simply accept the position that the foregoing remote working arrangements will completely exempt the management fees from the unincorporated business tax, particularly as the city and state teeter on the border of economic collapse.
New York has already displayed a willingness to tax nonresident doctors and nurses who came to assist the city during the height of the pandemic. It is thus doubtful that the city will simply forgo tax revenue that it believes it is entitled to.
Some practitioners have even opined that the city may attempt to argue that because the servers and computer systems facilitating the work-from-home arrangements are located in New York City, the services provided therein are actually performed in the city notwithstanding the location of the individual performing such services.
This argument feels tenuous, as the taxing authority has explicitly stated that the allocation of income for purposes of the unincorporated business tax shall be done based on "time spent in the City earning those receipts." In particular, if work for a client is conducted both in and outside of New York City, the taxpayer "should allocate the receipts for that client based on the proportion of time spent in the City."
In addition to support via local and state law, a corollary to the allocation rules could also be drawn from the Internal Revenue Code's sourcing of services in the international tax context. In such circumstances, the location of services is generally based on the location of the services provided rather than (1) the location of the computer systems facilitating the services, or (2) the location of the client.
New York City could also seek to rewrite its administrative code to change the current location-of-services-based allocation method, specifically as it relates to fund managers and their management fees. In fact, the New York City administrative code already provides certain hardwired exceptions to the location of services rule.
For example, the administrative code states, inter alia, that gross income from services provided by "taxpayers engaged in the business of publishing newspapers or periodicals" will be allocated to New York City "to the extent that such newspapers or periodicals are delivered to points within the city."
Further, taxpayers engaged in the business of broadcasting radio or television programs will be subject to the unincorporated business tax if their programs are broadcast to listeners or viewers inside of the city.
As such, it is not inconceivable to imagine a scenario in which New York City attempts to recapture some of its lost unincorporated business tax revenue by narrowing the allocation rules for remote working fund managers and their management fees. Such a revision to the administrative code, however, is not likely to be retroactive.
As it currently stands, it appears that fund managers working remotely from a place other than New York City may be meritorious in taking the position that the management fees earned during their current work-from-home arrangements will escape the application of the unincorporated business tax.
As the pandemic shows no signs of slowing, and with remote working seemingly becoming the new normal, fund managers would be well served to document the location of all of their employees and the tasks conducted therein.
In fact, fund managers who have not seen a drop-off in their productivity since the pandemic began, may want to consider reducing their New York City footprint to only a limited set of circumstances to reduce their exposure to the unincorporated business tax. The tax savings could be well worth it.
 Working From Home' During COVID-19 Requires Individuals and Businesses to be Alert to Inadvertent State Tax Foot Faults," Duane Morris T4: Tax Trips for Troubled Times, https://www.duanemorris.com/practices/tax.html#tab_TaxTipsforTroubledTimes.
 N.Y.C. Admin. Code § 11-503(a).
 N.Y.C. Admin. Code § 11-502.
 N.Y.C. Admin. Code § 11-508(a).
 N.Y.C. Admin. Code § 11-508(c)(3).
 A "carried interest" (or commonly known as a "profits interest" in tax circles) is a partnership interest received in exchange for services to the underlying partnership. A partner receiving a valid carried interest will, inter alia, receive pass-through treatment on his/her share of the partnership's income, gains, losses, deductions and credits.
 N.Y.C. Admin. Code § 11-502(c).
 N.Y.C. Admin. Code § 11-502(c)(3).
 See Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N.Y.U. L. Rev. 1 (2008).
 See Annual State of the City's Economy and Financial at https://comptroller.nyc.gov/reports/annual-state-of-the-citys-economy-and-finances/.
 See De Lea, NYC could face significant tax revenue losses over remote work, Fox Business, July 16, 2020, at https://www.foxbusiness.com/personal-finance/nyc-remote-work-tax-revenue-losses.
 Assuming a management fee of 2% of the total assets under management.
 New York City Finance Letter Ruling No. 18-4986, 08/22/2018. Funds with employees living in the city and/or a skeleton crew going into the office may not be able to completely remove themselves from the application unincorporated business tax. However, funds that are able to demonstrate that the primary work in question is being completed outside of the city will likely be able to substantially reduce the impact of the unincorporated business tax.
 See Section 861(a)(3) of the Internal Revenue Code of 1986, as amended.
 N.Y.C. Admin. Code. § 11-508(e)(1).
 N.Y.C. Admin. Code. § 11-508(e)(2).
Reprinted with permission of Law360.