California's A.B. 2731 seeks to accomplish what the federal Tax Cuts and Jobs Act did not, namely, to close the carried interest “loophole.” Currently making its way through state assembly committees, AB 2731 would impose an additional 17 percent tax on interest income derived from investment management services on taxpayers subject to California’s personal income tax law.
The TCJA’s Compromise
Prior to the passage of the TCJA, Internal Revenue Code Section 1061 provided investment fund managers with preferential tax treatment for partnership interests received in exchange for the performance of services related to raising capital or investments involving specified assets (i.e., carried interest). If the underlying assets were held for at least one year, carried interest was taxed as long-term capital gain as opposed to ordinary income, thereby subjecting it to a lower tax rate. Critics of this preferential tax treatment typically argue carried interest was simply compensation and should be taxed as ordinary income whereas supporters argue capital gains treatment rightly encourages long-term investments. Many critics anticipated the TCJA would eliminate the preferential tax treatment. However, the TCJA merely extended the asset holding period for the preferential treatment from one year to three years. Federal lawmakers may have seen this change as a balance between critics and supporters, but some states, like California, do not agree.
California’s Solution to the Loophole
In California, AB 2731 would impose an additional 17 percent tax on the portion of a taxpayer’s taxable income derived from an “investment management services interest” for tax years beginning on or after Jan. 1, 2018.1 The bill defines “investment management services interest” as:
any interest in a business which is held by any individual if that individual provides, directly or indirectly, in the active conduct of a trade or business, a substantial quantity of any of the following services to the business:
(A) Advising the business, including a partnership, S corporation or any other business entity, as to the advisability of investing in, purchasing or selling any specified asset.
(B) Managing, acquiring or disposing of any specified asset.
(C) Arranging financing with respect to acquiring specified assets.
(D) Any activity in support of any service described in subparagraphs (A) to (C), inclusive.2
“Specified asset” includes any of the following:
If at least 80 percent of the average fair market value of the specified assets of the business during the taxable year is real estate, then the interest is specifically excluded from the definition of “investment management services interest.”4
Concerns to Be Addressed
While it is still early in the legislative process, a number of concerns have already been raised about the bill. The California Franchise Tax Board, for example, has expressed concern over the scope of the new provisions. While targeted at investment fund managers, the additional tax would apply to all taxpayers subject to California’s personal income tax, including individuals, estates, and trusts.5 In addition, there is a concern that the bill’s failure to define certain terms could lead to unnecessary disputes with taxpayers and complications regarding the administration of the bill.6
Along with concerns related to the language of the bill, there are multiple policy concerns. For instance, AB 2731 only imposes the additional tax on business entities subject to the personal income tax (i.e., sole proprietorships, noncorporate partners of partnerships, limited partnerships and limited liability corporations) and not on other business entities such as corporations. Accordingly, it creates differing, arguably discriminatory, tax treatment for entities based on business classification.7
Moreover, with the introduction of AB 2731, California joins a growing list of states, including Illinois, Maryland, Massachusetts, New Jersey, New York and Rhode Island, with pending legislation aimed at addressing what they collectively view as a loophole. However, unlike the legislation proposed in a number of these other states, California’s bill does not rely on neighboring states passing similar laws in order for it to take effect. Thus, if AB 2731 is passed, long-term investment in California may be impacted negatively due to California providers moving to neighboring states that have not enacted similar legislation.
Next Steps for AB 2731
AB 2731 is currently with the assembly rules committee, having passed through the assembly revenue and taxation committee on April 23 and assembly appropriations committee on May 25. Because AB 2731 would result in a tax increase, both the California State Senate and California State Assembly must pass the bill by a two-thirds majority vote. Given California Democrats lost their supermajority in the state senate, coupled with the fact this is an election year, the bill’s ultimate prospects are questionable. Nevertheless, if passed, AB 2731 could result in revenue gain for the state of California totaling $700 million in the 2018-19 fiscal year and approximately $450 million in future years according to the franchise tax board.8
While it is clear California-based asset and fund managers will be impacted by the passage of AB 2731, asset and fund managers outside California may also feel the impact of the additional tax due to the franchise tax board’s proposed changes to California’s market-based sourcing regulation. Under the proposed changes, asset management service providers will be required to source receipts based on the location of the shareholder.9 California shareholders, then, may give rise to taxable California source income for nonresident managers.10 Thus, all asset and fund managers, including those located outside California, could face a significant tax increase by the passage of AB 2731.