A recent decision involving the New York City unincorporated business tax addback for payments to partners is an important reminder that the addback may sometimes be applied even for payments that are not made to a partner of the unincorporated business. Matter of Skidmore, Ownings & Merrill, LLP, NY City Tax Appeals Tribunal, Admin. Law Judge Div. TAT (H) 17-21 (UB), (July 30, 2021).
Background: The New York City unincorporated business tax (“UBT”) is a four percent tax imposed on unincorporated businesses, including partnerships, that conduct business in New York City. In calculating UBT taxable income, the law disallows deductions for “amounts paid or incurred to a proprietor or partner for services.” This provision is perhaps the most hotly contested UBT audit issue, with the City of New York often applying the disallowance by elevating form over substance, such as by seeking to disallow payments to bona fide employees who also hold non-executive officer titles with corporate partners of the unincorporated business.
Facts. Skidmore, Owings & Merrill LLP (“Skidmore”) is an architectural, urban planning, and engineering firm that conducts business in both New York City and throughout the world. Skidmore is subject to the UBT and, during the years in issue (2011 and 2012), it had 14 active equity partners. Skidmore formed a Domestic International Sales Corporation (“DISC”) to function as a commissioned sales agent, whose shareholders were all partners in Skidmore. Skidmore’s commissions paid to the DISC were fully deductible for federal income tax purposes.
On its UBT returns, Skidmore deducted the commissions paid to the DISC consistent with the federal treatment. The Department of Finance disallowed the deductions, treating them as payments to Skidmore’s partners for services. Skidmore maintained that the commissions were properly deductible because they were not paid to its partners, but instead were paid to a related entity also owned by its partners, to which it asserted the UBT addback did not apply. Skidmore filed a petition with the New York City Tax Appeals Tribunal to contest the department’s addback.
Decision. The administrative law judge (“ALJ”) held that the commissions were, in substance, payments to Skidmore’s partners and therefore upheld the addback.
The department argued that the DISC lacked economic substance—as it had no employees—and, somewhat incongruously, that therefore the payments to the DISC could not be deducted because they constituted payments to partners for services.
The ALJ first noted that the parties had agreed that the DISC was a “federally authorized fiction” and that the commissions were paid “for deemed services which are not actually performed.” The ALJ’s decision was based on neither a lack of economic substance for the commissions themselves—federal taxable income is the starting point in computing UBT taxable income and the commissions were fully deductible for federal income tax purposes—nor on a holding that the DISC was a “sham.” Instead, the ALJ held that the economic substance of the Skidmore-DISC arrangement was that the payments were made “to [Skidmore’s] partners or for their benefit,” and, therefore, were subject to the addback. Since the payments in question clearly were not made directly to Skidmore’s partners, the decision’s reference to payments made “for [the] benefit” of Skidmore’s partners could, if the decision is upheld on appeal, extend the addback to payments made to legal entities which are neither direct nor indirect partners of the unincorporated business, but that merely share some of the same owners.