On July 30, 2021, the Administrative Law Judge (ALJ) Division of the New York City Tax Appeals Tribunal (Tribunal) disallowed a federal deduction for commission payments made by an architectural firm to a domestic international sales corporation (DISC) whose only shareholders were all active partners in the firm.1 The ALJ determined that an addback was required because the payments were in effect payments to the firm’s partners, which are not deductible for purposes of the New York City Unincorporated Business Tax (UBT).
The petitioner, Skidmore, Owings & Merrill, LLP (Skidmore), is an architectural, urban planning and engineering firm organized as a New York limited liability partnership. In 2004, Skidmore formed Skidmore, Owings & Merrill DISC, Inc., a Delaware corporation. Skidmore formed the DISC in order to defer federal income tax as permitted under IRC Sec. 992.2 That same year, Skidmore and the DISC entered into a commission agreement, under which Skidmore made commission payments to the DISC for agency services that the DISC was deemed to perform for federal income tax purposes. During the 2011-2012 tax years, Skidmore paid approximately $50 million in commissions to the DISC, of which approximately $17 million was apportioned to New York City. During these years, the 14 active equity partners in Skidmore were also the only the shareholders in the DISC, which had no employees and did not file City tax returns.
Following an audit covering the tax years at issue, the New York City Department of Finance issued a notice for a proposed deficiency totaling approximately $1.19 million, consisting of $720,000 in UBT plus $220,000 in interest and $250,000 in penalty. Citing a provision in the New York City Administrative Code, the Department determined that the federal deduction for commission payments made to the DISC was required to be added back “for amounts paid or incurred to a proprietor or partner for services or for use of capital.”3 Skidmore requested a conciliation conference, after which the Department issued a partial decision in August 2017, abating the penalty. In November 2017, Skidmore filed a petition to contest the decision, resulting in the instant case.
In its petition, Skidmore argued that the deductions at issue should be allowed because the DISC received the commission payments, not the firm’s partners. In response, the Department alleged that Skidmore was making payments to the partners for services, because the DISC lacked economic substance and was being used as a mechanism to defer taxes that Skidmore’s partners would otherwise be required to pay.
Acknowledging that there were no direct payments made to partners, the ALJ considered the sole question of whether the federal deduction for deemed commission payments to a DISC whose shareholders are all partners in Skidmore should be allowed for UBT purposes. In its analysis, the ALJ discussed several decisions from the Tribunal’s appeals division. In Matter of Tocqueville Asset Management LP, the Tribunal disallowed a deduction for compensation paid by a partnership to the employees of a corporate partner that provided services to the partnership, but who were also partners in the partnership.4 The basis for this decision was Matter of Miller Tabak Hirsch & Co., which held that payments made to employees who were also partners in the taxpayer were not deductible, and that payments to a partner for services “in whatever capacity” are not deductible.5
Following guidance from applicable Tribunal decisions to look at the economic substance of the transaction, the ALJ first viewed the case through the federal fiction that the DISC rendered services for Skidmore. Noting that the DISC had no employees, the ALJ determined that the only way the DISC could render services was through its shareholders, the active partners of Skidmore. Under this analysis, the ALJ reasoned, “the payments are to partners, and therefore the deduction for these payments must be denied.”
Under an alternative view of the case, the ALJ disregarded the legal fiction of the DISC and acknowledged a federal income tax benefit conferred by a deduction providing a tax benefit to the partners. Guided by previous Tribunal decisions disallowing federal deductions for payments to a retirement plan and a pension plan, the ALJ concluded that such deductions should still be denied.6
Next, the ALJ considered a Department Finance Letter Ruling advanced by Skidmore, which allowed the deduction of payments to a corporation that provided management services by a limited partnership, even though the corporation was partially owned by two shareholders who each owned a 15% interest in the partnership.7 However, the ALJ found that the ruling was easily distinguishable from the present case because Skidmore’s payments were made to a non-partner corporation in which all the active partners of the firm were shareholders.
Finally, the ALJ considered Skidmore’s argument that federal conformity rules required the allowance of the deduction for commissions paid to the DISC, relying on the Tribunal’s decision in Matter of Ark Restaurants Corp.8 However, the ALJ found that this decision was not controlling because the issue in this case concerned whether an applicable provision required commissions to be added back in computing UBT. In analyzing the economic substance of the transactions, the ALJ determined that such a provision existed.
For these reasons, the ALJ concluded that Skidmore’s commission payments to the DISC could not be deducted because they were payments in effect to the firm’s partners. Accordingly, the ALJ denied Skidmore’s petition and sustained the deficiency notice.
The ALJ decision in Skidmore represents an instance in which a deduction for payments made to a federally recognized DISC were disallowed under New York City UBT rules regardless of whether they were explicitly permitted for federal income tax purposes. Looking specifically at the economic substance of the commission payments at issue, the ALJ determined that the payments were in fact being made to the partners of the firm because they were all shareholders in the DISC, even though the payments were not directly made to such partners. In effect, the decision indicates that New York City does not respect the DISC structure in this instance for UBT purposes, although it is a permissible structure for federal tax purposes.
In interpreting the New York City Administrative Code provisions, the Department has regularly disallowed deductions for amounts paid for services rendered by: (i) a partner in an unincorporated business; (ii) an officer of a corporate partner in an unincorporated business; or (iii) a partner in a partnership that is a partner in the unincorporated business. The Department’s position has been sustained by Tribunal decisions and promulgated in the city’s UBT rules.9 However, the Skidmore case presents the unique fact pattern of a payment made to a non-partner DISC having shareholders who are also partners in the firm. The ALJ was not persuaded by the formation of the DISC specifically to obtain a federal tax benefit, and not primarily for UBT tax avoidance purposes. Should the decision be appealed, one potential question would be whether the City is required to respect the federal DISC structure when the payments are permitted to be deducted for federal tax purposes, and whether the Department has the authority to make an independent determination of a DISC’s economic substance. The decision also raises the important question of whether the City would respect the DISC structure in other cases or whether they are disregarding the deduction outright.
1 Matter of the Petition of Skidmore, Owings & Merrill, LLP, No. TAT(H)17-21(UB), New York City Tax Appeals Tribunal, Administration Law Judge Division, July 30, 2021.
2 In order to qualify as a federal DISC, a corporation must satisfy certain requirements, including that 95% or more of its gross receipts consist of “qualified export receipts.” IRC § 992. DISCs are often formed for the purpose of transferring export revenue to an export company’s shareholders as a dividend without first taxing it as corporate income. Benenson v. Commissioner, 887 F.3d 514 (2nd Cir. 2018).
3 N.Y.C. ADMIN. CODE § 11-507(3).
4 No. TAT(E)10-37(UB), New York City Tax Appeals Tribunal, Appeals Division, 2015.
5 No. TAT(E)94-173(UB), New York City Tax Appeals Tribunal, Appeals Division, 1999.
6 Matter of Proskauer Rose LLP, No. TAT(E)01-19(UB), New York City Tax Appeals Tribunal, Appeals Division, 2007; Matter of Murphy & O’Connell, No. TAT(E)06-18(UB), New York City Tax Appeals Tribunal, Appeals Division, 2011.
7 Finance Letter Ruling No. 28-UB-4/86, New York City Department of Finance, Apr. 7, 1986.
8 No. TAT(E)16-18(GC), New York City Tax Appeals Tribunal, 2019.
9 See 19 R.C.N.Y. §§ 28-06(d)(ii)(A)-(C).
Matthew DiDonato is a State and Local Tax (SALT) practice partner in the New York office and leads the Metro New York SALT practice. He has more than 18 years of public accounting, private industry and legal state and local tax experience.
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Arthur C.E. Burkard
Art Burkard is a managing director with Grant Thornton’s Metro New York/New England market territory State and Local Tax practice. Burkard was a law clerk with the New York State Tax Appeals Tribunal and has more than 21 years of public accounting experience at Grant Thornton, KPMG and Deloitte & Touche.
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Jamie C. Yesnowitz
Jamie Yesnowitz, principal serving as the State and Local Tax (SALT) leader within Grant Thornton's Washington National Tax Office, is a national technical resource for Grant Thornton's SALT practice. He has 22 years of broad-based SALT consulting experience at the national and practice office levels in large public accounting firms.
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