Hell of a Town
Ask most New Yorkers what New York City has in abundance and you’ll get responses that are as varied as the personalities to whom the question is put. Museums, restaurants, performing arts, college students,[i] office buildings, street food, subway lines, cabs, dog walkers, rats, and politicians are sure to make the list.[ii]
Ask the same question of a tax professional, and I guarantee you that the immediate response will be “taxes” – personal income tax, property tax, sales tax, real property transfer tax, mortgage recording tax, commercial rent tax, business corporation tax, general corporation tax, and unincorporated business tax, to name a few. Throw in those New York State taxes that are the counterparts of these City taxes, plus those taxes that are unique to the State, such as the estate tax, and you have an idea of what it means to own, operate, and dispose of a business in the City.[iii]
One of the above-referenced taxes that has been a unique feature of the City’s business tax landscape, and that often surprises business owners who are new to the City’s tax jurisdiction, is the unincorporated business tax (“UBT”).[iv]
Unincorporated Business Tax
The UBT is imposed on the unincorporated business taxable income (“UBTI”) of every unincorporated business that is wholly or partly carried on within the City.
The tax is imposed at a rate of 4 percent of a taxpayer’s UBTI.[v]
Any individual or unincorporated entity that carries on or liquidates a trade, business, profession or occupation wholly or partly within the City, and has a total gross income from all business, regardless of where carried on, of more than $95,000 (prior to any deduction for cost of goods sold or services performed), must file an Unincorporated Business Tax Return with the City.[vi]
An “unincorporated business” means any trade or business conducted or engaged in by an individual (a sole proprietorship) or unincorporated entity, including a partnership.[vii] A limited liability company (“LLC”) which is wholly-owned by an individual, and which has not elected to be taxed as a corporation for federal income tax purposes,[viii] is a disregarded entity, and the business operated through it is considered a sole proprietorship for UBT purposes. Also treated as an unincorporated business is any entity classified as a partnership for federal income tax purposes regardless of whether the entity is formed as a corporation.[ix]
Each of these entities is treated as a pass-through entity for purposes of the Federal and State income taxes; they do not pay an entity-level income tax – rather, their income “passes through” to their owners, who include it in their gross income in determining their own taxable income.
Unincorporated “Trade or Business”
Where there is doubt as to the status of an activity as a trade or business, all the relevant facts and circumstances must be considered in determining whether the activity, or the transactions involved, constitute a trade or business for purposes of the UBT. Generally, the continuity, frequency and regularity of activities (as distinguished from casual or isolated transactions), and the amount of time and resources devoted to the activity or transactions are the factors which are to be taken into consideration.[x]
If an individual or an unincorporated entity carries on two or more unincorporated trades or businesses in the City, all such businesses will be treated as one unincorporated business for purposes of the UBT.[xi]
An unincorporated entity will be treated as carrying on any trade or business carried on in whole or in part in the City by any other unincorporated entity in which the first unincorporated entity owns an interest (a tiered structure); for example, where a single member LLC that is disregarded for income tax purposes owns an interest in a partnership that is engaged in a trade or business in the City.
Personal Income Tax
The UBT is an “entity-level” tax. However, because of the entity’s pass-through nature for income tax purposes, its UBTI is subject not only to the UBT but also, in the case of an individual City resident, the City’s personal income tax.[xii]
Thus, in the case of a City resident who is a sole proprietor, or a partner in a partnership, or a member of an LLC, the entity’s UBTI (or the resident’s share thereof) will also be included in the resident-owner’s personal taxable income for purposes of determining their income tax liability to the City.
Thankfully, the City allows a credit to a resident-owner or partner against their personal income tax for at least some of the UBT paid by the sole proprietorship or partnership, though the amount of the credit allowed is reduced as the resident’s taxable income increases.[xiii]
Right about now, some of you may be having palpitations. You may be thinking, “UBT and personal income tax, with less than a 100 percent credit? Outrageous!”
It should be noted, however, that not every unincorporated business conducted within the City is subject to the UBT.
For example, an individual or other unincorporated entity is generally not treated as engaged in an unincorporated business solely by reason of (A) the purchase, holding and sale of property[xiv] for their or its own account, (B) the acquisition, holding or disposition, other than in the ordinary course of a trade or business, of interests in unincorporated entities that are themselves acting for their own account, or (C) any combination of such activities.[xv]
In addition, an owner of real property, or a lessee of such property, will not be deemed engaged in an unincorporated business solely by reason of holding, leasing or managing real property.
Moreover, if an owner or lessee who is holding, leasing or managing real property, is also carrying on an unincorporated business in the City, whether or not such business is carried on at, or is connected with, such real property, such holding, leasing or managing of real property will generally not be treated as an unincorporated business if, and to the extent that, such real property is held, leased or managed for the purpose of producing rental income from such real property or gain upon the sale or other disposition of such real property.[xvi]
Assuming a taxpayer is engaged in a taxable unincorporated trade or business within the City, the UBTI of such unincorporated business for a taxable year is equal to its unincorporated business gross income for such year that is allocated to the City, less its unincorporated business deductions for the year.[xvii]
In general, the term “unincorporated business gross income” is the sum of the items of income and gain of the business includible in the entity’s gross income for federal income tax purposes (with certain modifications), including income and gain from any property employed in the business, or from the sale or other disposition by an unincorporated entity of an interest in another unincorporated entity if, and to the extent, such income or gain is attributable to a trade or business carried on in the City by such other unincorporated entity.[xviii]
The unincorporated business deductions of an unincorporated business generally include the items of loss and deduction directly connected with, or incurred in the conduct of, the business, which are allowable for federal income tax purposes for the taxable year, including losses and deductions connected with any property employed in the business (with certain modifications).[xix]
Allocating Income to the City
If an unincorporated business is carried on both within and without the City – not an unusual situation – a portion of its business income must be allocated to the City; the portion so allocated is subject to the UBT, while the portion allocated outside the City escapes the UBT.
For taxable years beginning after 2017, the City completed the phase-out of the three-factor allocation formula that it employed in determining that portion of an unincorporated entity’s business income that was allocable to the City – based on gross income, payroll and property – and replaced it with a single factor based on gross income.[xx]
“Local Cross-Border Transactions”
The City’s Department of Finance recently considered a request from a non-resident individual (“Taxpayer”[xxi]) from Nassau County – though they could just as easily have been from Suffolk, Westchester, Rockland, Connecticut, or New Jersey, for example – regarding the proper method of allocating their unincorporated business income to New York City for purposes of calculating their UBT liability.[xxii]
Taxpayer had three single member limited liability companies (i.e., wholly-owned by Taxpayer)[xxiii] through which Taxpayer provided various services.
One of the LLCs provided services within the City only for its direct clients that were located in the City. The second LLC was retained by unrelated companies to provide services for their clients, some of which were located in the City. The third LLC worked for a non-New York based company.
The Department explained that where an individual or an unincorporated entity carries on two or more distinct unincorporated business, in whole or in part in the City, all such businesses are treated as one unincorporated business for purposes of the UBT.
An unincorporated business carried on both within and outside the City, the Department continued, must allocate to the City a “fair and equitable portion” of its business income.[xxiv]
In order to do that, a taxpayer must multiply its “adjusted business income” against a “business allocation percentage”[xxv] which, as alluded to above, is now equal to the quotient obtained by dividing (A) the sum of the taxpayer’s gross sales and service charges within the City, by (B) the sum of all such receipts within and without the City.
Of course, to determine the fraction of a taxpayer’s receipts from within and from outside the City, the sources for a taxpayer’s receipts need to be determined.
Generally, the UBT treats the source of receipts derived from the provision of services (as distinguished from sales of product) to be the location where the services are performed.[xxvi]
Turning to the specifics of Taxpayer’s situation, the Department began by noting that because none of the three LLCs had elected to be treated as a corporation for tax purposes, each would be treated as a disregarded entity and considered a sole proprietorship.
Moreover, because all unincorporated businesses operated by an individual in whole or in part in the City are treated as one business for purposes of the UBT, the Department stated that the LLCs would be treated as a single business conducted by Taxpayer. Therefore, only one UBT return was required to be filed by Taxpayer.
According to the Department, for purposes of allocating receipts to the City, a reasonable was required to match the receipts to the time spent in the City earning those receipts. In order to determine the amount of the receipts from services to be allocated to the City, the Department stated that Taxpayer had to determine where the work was done that generated those receipts.
If work for a particular client was split between the City and outside the City, the Department concluded that Taxpayer had to allocate the receipts for that client based on the proportion of time spent in the City.
Furthermore, if different tasks performed by the same LLC were billed at different rates, the amount to be allocated to the City could be calculated separately, based on the time spent in the City to accomplish the various tasks.
What’s The Point, Lou?
Granted, there may not – hopefully not – have been any great revelations in the foregoing discussion. Nevertheless, it will behoove business owners and their advisers to familiarize themselves with the basic concepts that underlie the operation of an unincorporated business tax similar to the City’s UBT, especially in light of the fact that so many unincorporated, closely held businesses are no longer limited to a single taxing jurisdiction but, rather, sell their products and services throughout the country.
By far, most businesses in the United States – including, of course, New York – are formed as pass-through entities, such as sole proprietorships, partnerships, LLCs and S corporations.
Under current Federal and New York State tax laws, these pass-through entities are generally not subject to an entity-level income tax.[xxvii]
However, New York City will certainly continue to impose its UBT on the taxable income of such pass-through entities,[xxviii] and will continue to surprise the unsuspecting (and ill-informed) newcomer.[xxix]
What’s more, it is possible that other state and local jurisdictions will jump on the proverbial band wagon; for example, Connecticut recently enacted an entity-level business tax on partnerships and S corporations (i.e., pass-through entities).[xxx]
Moreover, as state and local tax jurisdictions try to cope with the evisceration[xxxi] of the itemized deduction for state and local taxes – courtesy of the Tax Cuts and Jobs Act[xxxii] – some jurisdictions are looking to an unincorporated business tax as a way to possibly circumvent the $10,000 itemized deduction cap on such taxes by shifting the incidence of tax away from the individual owners of pass-through business entities and onto the entities themselves; after all, the Act did not eliminate the deduction for taxes imposed directly on the business.[xxxiii]
As this situation evolves, how will it affect “choice of entity” decisions? The Act was decidedly biased in favor of C corporations.[xxxiv] It is true that, in response to critics, Congress also added the Sec. 199A deduction[xxxv] to the Code for qualifying non-corporate owners of pass-through entities. However, will the imposition of a state or local entity-level tax on these very same pass-through entities tip the balance toward C corporations?
Or will the itemized deduction cap on state and local taxes be eliminated, thereby reducing the “need” for entity-level taxes on pass-through entities?
Or will state and local taxing jurisdictions find, as New York City seems to have found, that such taxes are intrinsically a “good” thing?[xxxvi]
[i] Many more than Boston, by the way.
[ii] Please do not read any significance into the ordering of these items.
[iv] The State repealed its unincorporated business tax at the end of 1982. However, there has been some talk in Albany of late regarding the possible reintroduction of such a tax, though it did not make it into the 2020 Executive Budget. https://tax.ny.gov/pdf/stats/stat_pit/pit/unincorporated-business-tax-discussion-draft-summary.pdf
[v] N.Y.C. Adm. Code Sec. 11-503. https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-503_11-503.html
[vi] N.Y.C. Adm. Code Sections 11-514(a)(4) and 11-506(a)(1). https://law.justia.com/codes/new-york/2006/new-york-city-administrative-code-new/adc011-514_11-514.html. Form NYC-202.
[viii] Treas. Reg. Sec. 301.7701-3.
[ix] N.Y.C. Adm. Code Sec. 502.
[xii] Unlike for federal and New York State purposes, which generally do not impose an entity level tax on unincorporated business income.
[xiii] Insofar as the State income tax is concerned, UBT that was deducted in arriving at an individual’s federal adjusted gross income must be added back by individual taxpayers to determine their New York State adjusted gross income.
[xiv] The term “property” generally means real and personal property, including, for example, stocks or bonds.
[xv] N.Y.C. Adm. Code Sec. 11-502.
[xvi] N.Y.C. Adm. Code Sec. 11-502.
[xvii] N.Y.C. Adm. Code Sec. 11-505.
[xix] For example, guaranteed payments described in Sec. 707(c) of the Code that are made by a partnership to a partner for services or for the use of capital are not deductible for purposes of the UBT. By the way, all references to the “Code” mean the Internal Revenue Code.
[xxi] Interestingly, Taxpayer was once a resident of the City. Having abandoned their City residence, they continued to own their former residence in the City, which they were careful “to occupy” for fewer than 184 days a year. Presumably, this means that they avoided statutory residence. Query, however, why the ruling used the words “to occupy”? Whether or not Taxpayer occupied the residence is irrelevant for purposes of the “more than 183 days” rule. All that matters, according to the City, is that the taxpayer was present in the City in excess of 183 days during the tax year, and that the taxpayer maintained a permanent place of abode in the City for substantially all of the tax year. The Court of Appeals has held that the Taxpayer must have a residential interest in the abode. See its decision in Gaied, 22 N.Y.3d 592, 594 (2014). https://www.taxlawforchb.com/2018/11/doing-business-in-new-york-domiciled-elsewhere-paranoid-over-new-york-residency-status/
[xxii] Some might say that the UBT is an indirect City income tax on nonresident commuters – whom the City is not allowed to tax directly.
[xxiii] Disregarded entities for Federal income tax purposes. Taxpayer did not elect to treat the LLCs as “associations” that are taxable as corporations.
[xxv] N.Y.C. Adm. Code Sec. 11-508(c) and 11-508(i).
[xxvi] There are special rules dealing with the sourcing for specific industries and businesses.
[xxvii] But see https://www.taxlawforchb.com/2015/12/did-you-say-a-taxable-partnership/. Of course, the Code imposes a built-in gains tax on certain dispositions by S corporations, under Sec. 1374.
[xxviii] It should be noted that the City also imposes a corporate income tax on S corporations that do business in the City – the City does not recognize the “S” election, and taxes such corporations at an 8.85 percent rate.
[xxix] My recollection is that, until recently, the District of Columbia was the only other jurisdiction that imposed such a tax.
[xxxi] Certainly from the perspective of a New Yorker.
[xxxii] P.L. 115-97 (the “Act”).
[xxxiii] See Sec. 164 of the Code.
[xxxiv] For example, the 21 percent flat income tax rate (a 40% reduction in the maximum corporate rate), and the 50 percent GILTI deduction (which, when combined with the 80% foreign tax credit, may even eliminate the tax on GILTI).
[xxxv] The so-called “20 percent of qualified business income” deduction.
[xxxvi] The UBT has been in place since the 1960’s.