There have been countless reports in recent years of hedge funds leaving New York in favor of better state tax and business climates.[1] And New York’s weather isn’t driving the exodus.  Instead with the onset of remote work during and after the COVID-19 pandemic, many service professionals have realized that they can do their work from anywhere. Couple that with New York’s high tax rates (including an increase in rates in 2021), and hedge fund managers started leaving New York in droves in 2020 and 2021, often taking their entire companies with them.  In this article, we’ll explore the attendant tax implications of these moves for the funds, as well as the funds’ managers and employees.

Setting the Stage

“Hedge fund” is a term of art, generally referring to an entity that holds a pool of securities and other assets, where the interests are not publicly traded.[2] Vast and complex tax issues arise for hedge funds and their investors. This article focuses on key New York State tax considerations, but we’ll begin with an overview of typical fund structures for federal tax purposes. 

Hedge funds are generally structured as pass-through entities such as limited partnerships (LPs) or limited liability companies (LLCs) taxed as partnerships with one general partner and several limited partners. As such, the fund’s gains and losses as well as its federal (and state) tax obligations flow through to the fund’s investors or limited partners. These investors, in turn, recognize their share of the fund’s income and losses on their personal tax returns. The fund’s manager (the general partner) also receives income from the fund, mainly as carried interest that enjoys the preferential federal tax rate for capital gains. 

The typical hedge fund structure involves an entity formed as an LP acting as an investment manager, and a separate entity functioning as the general partner. The investment manager (master fund) pays a management fee to the fund’s manager (the general partner), which is typically tied to the fund’s net asset value as of a particular date. The general partner also receives an incentive allocation (carried interest) based on the master fund’s performance. Potential state-level income tax issues arise for the master fund, its manager (the general partner), and the investors (limited partners) in this typical structure.

I. New York Residency Rules and Audit Issues

For personal income tax purposes, the New York tax implications of the income received depends primarily on the individual’s resident status.

Individuals are considered residents or part-year residents in any year (or part-year) that the individuals are domiciled in New York for all or part of the year,[3] subject to certain exceptions.[4]  Even if domiciled outside New York, individuals may nonetheless qualify as New York residents under the statutory residency test, in any calendar year where they maintain an in-state “permanent place of abode” and spend over 183 days in New York.[5]  

If individuals qualify as New York resident under either test in a given year, their income from all sources is subject to New York tax whereas nonresidents are subject to tax only to the extent that they receive income from New York sources.[6] Thus, individual investors who are New York resident partners are subject to New York tax on all of their income from the fund, whereas the nonresident partners are only subject to New York tax on the “items of income, gain, loss and deduction derived from or connected with New York sources.”[7] New York’s tax regulations prescribe rules for apportioning partnership income, such as income received by the fund’s investors.[8] These rules also apply to the income received by the fund’s manager, as we’ll discuss below, assuming there is nexus, or sufficient connections with New York, which should not be treated as a foregone conclusion if the fund has established operations outside New York.[9]

As noted above, there are exceptions to the domicile test for residency, including two exceptions that are worthy of mention here. The first exception, known as the 30-Day Rule, provides that persons are not treated as New York domiciliaries in any year where they: (1) do not maintain a “permanent place of abode” (PPA) in New York, (2) maintain a PPA elsewhere, and (3) spend no more than 30 days in New York.[10] The second exception, known as the 548-Day Rule, is more nuanced, but the gist of it is that individuals are not treated as being domiciled in New York in any 548-day period where they meet certain thresholds for spending time abroad and cap their time in New York days to certain thresholds.[11]

These two exceptions create potential planning opportunities. For example, say a hedge fund manager is a long-time resident of New York and is expecting a significant carry during the 2024 tax year. It may not be possible for the manager to cut sufficient ties with New York in order to break domicile so as to qualify as a nonresident in 2024. However, the manager can temporarily qualify as a nonresident in 2024, which should eliminate New York tax on the carry, if they can satisfy either the 30-Day Rule or the 548-Day Rule during the 2024 tax year.[12]  We recognize that even these two exceptions have very specific criteria that may not be feasible for many individuals or may be too disruptive or otherwise problematic. However, we’ve helped numerous taxpayers over the year qualify under the exceptions and in a case where the “juice is worth the squeeze,” the tax savings can be significant.

Apportionment Rules and Considerations for Nonresidents

As noted, nonresidents of New York are subject to tax only to the extent that they receive income from New York sources.[13] For hedge fund managers and their employees, sourcing issues arise both in terms of W-2-based compensation as well as partnership or flow-through income. 

A. Allocation of Employee Compensation

Nonresidents of New York are taxed on their compensation based on the percentage of days worked in New York during the tax year. All states essentially use the same approach. However, New York and a few other states[14] diverge from this typical approach by treating days worked outside New York by the employee for their convenience, as opposed to employer necessity, as days worked by the employee in New York:

“If a nonresident employee . . . performs services for his employer both within and without New York State, his income derived from New York State sources includes that proportion of his total compensation for services rendered as an employee which the total number of working days employed within New York State bears to the total number of working days employed both within and without New York State. However, any allowance claimed for days worked outside New York State must be based upon the performance of services which of necessity, as distinguished from convenience, obligate the employee to out-of-state duties in the service of his employer."[15]  

Rather than loosen the application of this rule during COVID, when many New York nonresidents were forced to work at home for a year or more, New York doubled down on the application of this rule. Specifically, in July 2020, the New York State Tax Department issued guidance—in the form of a post on its website—stating that the convenience rule still applied to those who were telecommuting as a result of the COVID-19 pandemic.[16] This meant, according to this Department policy, that all those nonresidents who historically worked in New York but were working outside the state due to the stay-at-home orders would continue paying tax to New York on their wages.

Absent the application of this convenience rule, the math for nonresident employees of hedge funds is pretty simple: compensation is allocated to New York based on the percentage of days worked in New York during the tax year. Keep in mind, however, that the percentage utilized is generally based on the year the income was earned, not necessarily based on the year the income was paid. Thus, if a bonus for 2021 work was paid in 2022, generally the workday percentage for the 2021 tax year would be used to allocate income to New York.

But the convenience rule offers up an additional twist, one that often arose during and after the pandemic. Specifically, as noted above, if the nonresident employee was working at home in Florida or from wherever they were living, New York would treat those days as New York workdays for purposes of the allocation fraction. Thus, even during periods of time during COVID when most hedge funds (as well as other businesses) simply closed their offices, New York is still insisting that days worked at home get treated as New York workdays. Currently there is litigation challenging this rule, both the convenience rule generally as well as the application of the convenience rule during COVID.[17] But until litigation on these issues gets resolved, we expect this to be a continued area of audit focus for nonresident employees.                                                                                                                                                                                                                                   B. Allocation of Flow-Through Income: Management Fee Income

An entirely different set of rules applies in the context of partnership income. Here, while income like carried-interest would escape taxation if the taxpayer is a nonresident, flow-through management-fee income is still going to attract some taxes, at least if the management company itself retains sufficient ties in New York. Specifically, New York–sourced income includes “items of income, gain, loss and deduction derived from or connected with New York sources.”[18]  The regulations contain apportionment rules for partnerships[19] that are hardly a model of clarity, and the complexity is heightened in the hedge fund context. Ultimately, New York authorizes two possible methods for apportioning partnership income, each with the propensity to produce very different New York tax consequences.

The first method, which seems to be used less frequently than the other, has the partners allocate items of income, gain, loss, and deduction to New York based on the partnership’s “books and records.”[20] The Tax Department’s Nonresident Allocation Guidelines provide an example of a law firm where the books and records separately tracked the net income earned by each of the firm’s three offices.[21] In that case, the firm and its nonresident partners are required to apportion their income using this “direct accounting” approach.

The second and more common approach apportions partnership items to New York using an equally-weighted three-factor formula of property, payroll, and gross income.[22] For property, the partnership determines the value of its real and tangible personal property (both owned and rented) in New York and divides that amount by its “everywhere” property to compute the property factor for the year.[23] Similarly, the payroll percentage is determined by dividing total wages and salaries (but not payments to partners or contractors) in New York by the “everywhere” wages and salaries to compute the payroll factor for the year.[24]

The gross income factor is more nuanced than the other two. It is computed by dividing: (1) the gross receipts “for services performed by or through an office, branch or agency of the business located within New York State,” by (2) the “everywhere” gross receipts.[25] Generally, a “receipt” is allocated to New York if the sale was consummated at the partnership’s New York office or performed by a person assigned to the partnership’s New York office. Therefore, importantly, if the partnership has no New York office, its gross income factor should be zero.  Note that the relevant taxpayer for this analysis is the master fund; therefore, the inquiry looks to whether the master fund, not the general partner, has an office in New York.

 C. Allocation of Flow-Through Income: Carried Interest

For carried-interest and other investment-type income (interest, dividends, and capital gains), in almost all cases a nonresident of New York will not have to pay tax on this income. Under New York law, nonresident partners of certain investment partnerships generally are not considered to be engaged in a trade or business in New York and consequently are not taxable on their distributive share of income from the partnership. This is the so-called “Self-Trading Exemption” and its application depends on two factors: (i) the nature of the partnership’s activities in New York, which must be limited to buying and selling securities for its partners, and (ii) whether this constitutes the sole activity of the partnership.[26] Taxpayers seeking to qualify under this exemption should be prepared for questions in the audit context regarding both factors. We’ve seen New York’s Tax Department take the position in audits that even a small amount of business income from customers taints the income and disqualifies it from the self-trading exemption, potentially subjecting the nonresident partner to New York tax.[27]

But even if the partnership’s activities exceed the “Self-Trading” Exemption, a nonresident’s income may still be nontaxable in New York if it is characterized as intangible, namely income from the purchase or sale of securities and other investment assets.[28] Note, however, than an important exception to this favorable tax treatment could apply if the intangibles assets are employed in a business, trade, profession or occupation.[29] This exception should not arise often, and should have limited applications, such as instances where the intangible property is used as collateral for a business loan or otherwise employed as an asset in the business.[30] It does not apply, for instance, to carried interest, even if the affiliated management company has offices or employees in New York.

D. Part-Year Resident Issues 

Investors or managers reporting mid-year residency changes may need to focus on part-year resident rules and the implications of New York’s accrual rule. Normally for part-year residents, income received in the resident period is taxed fully in New York, and income received in the nonresident period is only taxed in New York if it came from New York sources. But there are several important considerations and nuances.

First, we have the accrual rule, found in N.Y. Tax Law § 639,[31] which essentially transforms all cash-basis taxpayers into accrual-basis taxpayers for the year in which a residency change occurs.[32] When a taxpayer changes her filing status from resident to nonresident, Tax Law § 639(a) requires that she include any income that accrued to her before the change of residence.[33] As such, the taxpayer must attribute items of income, gain, loss, or deduction to their former state of residence if she had the right to receive those items before the move.[34]This rule basically ignores the fact that, as a cash-basis taxpayer, the former resident does not receive payment until after she changes her resident status, and essentially transforms a cash-basis taxpayer into an accrual-basis taxpayer. This also works the other way around: a taxpayer who changes her filing status from nonresident to resident to must include in her nonresident period any income that has accrued before the date of her move into New York.[35] It also applies to changes in residency from New York City as well.[36]

However, N.Y. Tax Law § 639(f) prescribes specific rules for allocating partnership income, gains, and losses in the year of a residency change, and establishes two possible approaches which can have very different tax consequences.

Under the first approach, the taxpayer is required to prorate their distributive share of income between the resident and nonresident periods.[37] Essentially, the number of days in the resident period is determined as a percentage of total days in the entity’s tax year, and that percentage is applied to the taxpayer’s distributive share of partnership items. For example: ABC LLP is a calendar year taxpayer; one of its limited partners, James, moves out of New York on 6/1/2023 which is the 152nd day of the year. His distributive share of ABC LLP’s partnership income in 2023 is $100,000. Because James was a resident for 42% of the 2023 tax year (152 ÷ 365 = 42%), 42% or $42,000 of his distributive share is pro-rated to the resident period and the other $58,000 is treated as having been received during the period when James was a nonresident. In the hedge-fund context, pro-ration is often the proper method for items of income like management-fee income, which is more often than not received throughout the year at various times.

The other approach is to accrue the taxpayer’s distributive share of partnership items to the resident and nonresident portions of the year based on the date that such item accrued within the partnership. This approach, and the framework of Tax Law § 639(f) generally, arose out of the Falberg case, where we had a specific income event (sale of assets) occurring within a flow-through entity on a date certain, after the partner had moved.[38] The judge in that case found that prorating that income—as the Tax Department wanted to do—was improper, since the gain didn’t actually occur until after the partner left New York. Therefore, Tax Law § 639(f) was added to codify the holding in Falberg, and the general idea was that if partnership income was earned throughout the year, it should be pro-rated; if it accrued on a specific date, you could use the date of accrual. This is also sometimes discussed in terms of using an “actual receipt” method or “direct accounting,” in cases where we know when the income in question was generated at the entity level. So in the case of a hedge-fund manager, a part-year resident partner can elect to include partnership income in their nonresident period if the income accrued within the partnership after the change in residency. This specifically could apply to a partner’s incentive allocation or carried interest, which in many cases will not accrue (i.e., crystalize) until year-end.

Timothy P. Noonan, JD, is the practice group leader of Hodgson Russ LLP’s New York Residency Practice, and he is one of the leading practitioners in this area of the law. He has handled some of the most high-profile residency cases in New York over the past decade, including the Gaied case discussed here, one of the first New York residency cases to ever reach New York’s highest court. He also co-authored the 2018 edition of the CCH Residency and Allocation Audit Handbook, and he is often quoted by media outlets, including the Wall Street Journal, New York Times, and Forbes, on residency and other state tax issues. As the “Noonan” in “Noonan’s Notes,” a monthly column in Tax Analysts’ State Tax Notes, Tim is also a nationally recognized author and speaker on state tax issues. He can be reached at 716-848-1265 or  tnoonan@hodgsonruss.com.

Ariele R. Doolittle, Esq., is a partner in the State & Local Tax practice group of Hodgson Russ LLP.  She focuses her practice on state and local tax matters, including civil and criminal tax controversies, with an emphasis on New York State tax litigation. A considerable portion of Ariele’s practice centers on state residency and allocation issues. This includes advising clients prospectively as they are planning a move to a new location, and also representing individuals facing state residency audits and appeals. Ariele also counsels business owners regarding complex multistate tax and allocation issues, which often accompany residency changes.  Ariele can be reached at 518-433-2407 or  adoolitt@hodgsonruss.com.