Basic Tax Considerations Affecting Hedge Funds


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Basic Tax Considerations Affecting Hedge Funds

  1. 1. Basic Tax Considerations Affecting Hedge Funds Julie Canty, Tax Partner Deloitte, LLP Lynn Rodgers, Tax PrincipalJoseph Decosimo and Company, PLLC
  3. 3. PartnershipFormationSection 721(a) - Property defined:General Rule  Money  Installment obligationsOn an exchange of [Treas. Reg. §1.721-1(a)]property for an interest in a  Personal note of transferor-partnerpartnership there is no gain [Rev. Rul. 68-629]or loss to the partner or the  Contract negotiated by partnerpartnership. [See Ungar; Stafford]  Technical know-how, secret formulas, etc. [Rev. Rul. 64-56]  Accounts receivable  Goodwill [Rev. Rul. 70-45]  Letter of intent Property does not include services performed by a partner on behalf of the partnership.
  4. 4. Contributions to Partnerships Section 721(b) provides an exception to the general rule for partnerships that would be treated as “investment companies” if they were incorporated Generally, a partnership will be treated as an investment company if immediately after the exchange the transfer results, directly or indirectly, in diversification of the transferor’s interest and more than 80% of the value of the assets (excluding certain items) are held for investment and the assets consist of readily marketable stocks or securities, or interests in RICs or REITs. Diversification can result if 2 or more persons transfer nonidentical assets to the partnership. If each transferor transfers a diversified portfolio of assets, the transfer will not result in diversification.
  5. 5. Contributed Property– Section 722 (Basis of contributing partner’s interest) • Substituted basis • Referred to as “outside” basis– Section 723 (Basis of property to the partnership) • Carryover basis • Referred to as “inside” basis
  6. 6. Types of Partnership InterestCapital Interest • An interest which entitles the partner to share in distribution of partnership assets upon liquidationProfits Interest • An interest which entitles the partner to share only in the future profits of the partnership
  8. 8. Section 731(a) General RuleA Partner does not generally recognize gain or loss on receipt of propertydistribution.A partner only recognizes a loss if it receives– Cash– A/R or– Inventoryin a liquidating distribution and the basis of the property is less than thepartner’s outside basis.
  9. 9. Section 731(c) Marketable Securities• For purposes of distributions, cash includes marketable securities.• Exceptions – Security was contributed to partnership by distributee partner – Was not a marketable security when acquired – Partnership is an investment partnership and distributee is an eligible partner• Investment partnership has never been engaged in a trade or business and substantially all its assets have always been money, securities, currencies, financial contracts, etc. – Investor, traders, dealers are not considered in a trade/business• Eligible contributed only assets that an investment partnership can hold
  10. 10. Current Distributions• Defined – any distribution if, after the distribution, the partner remains a partner• Gain or loss recognition – Generally, no gain or loss recognized on current distribution – Exception: Gain recognized if amount of cash distributed exceeds partner’s basis in interest• Basis – Distributee partner generally takes distributed property with a carryover basis, but can never take partnership property with higher basis than partner’s basis in partnership – Distributee partner reduces outside basis by basis taken in property distributed
  11. 11. Liquidating Distributions• Defined – any distribution if, after distribution, partner is no longer a partner• Gain or loss recognition – Generally, no gain or loss recognized on liquidating distribution – Partner recognizes gain if amount of cash distributed exceeds partner’s basis in interest – Partner recognizes loss if • Only cash, unrealized receivables and/or inventory are distributed, and • Amount of money and inside basis of assets distributed is less than distributee partners outside basis• Basis – Basis in distributed property equals adjusted basis of distributee partner’s interest in partnership, reduced by any cash received
  13. 13. Mandatory Basis AdjustmentsThe American Jobs Creation Act of 2004 states that the basis adjustmentrules under sections 734 and 743 are mandatory when there is either:– Substantial basis reduction (734), or– Substantial built-in loss (743) • Both tests are 250k tests – substantial basis reduction is a partner level test and substantial built in loss is a partnership level test.Section 743(b) —• Transfers of partnership interestSection 734(b) —• Distribution of property/cash
  15. 15. Primary Market Participants• Market participants can be categorized as: – hedgers – dealers – traders, and/or – investors• A single taxpayer may have activities in multiple categories• The mark-to-market rules of IRC § 475 only apply to dealers and traders in securities or commodities – These rules do not apply to investors and hedgers who are not dealers or traders
  16. 16. Hedgers– Hedgers use the financial markets to protect the price at which they will acquire products they need in their businesses and/or to ensure themselves of a market in which to sell their products– Traditionally, hedgers used the futures markets to hedge their ordinary income positions in the underlying property • That is, they attempted to shift some commercial risks while generating ordinary income or loss treatment on their hedging transactions– In recent years, however, hedging techniques have expanded with the continual introduction of new products and sophisticated valuation techniques. • As a result, hedgers now establish positions in options, forwards, futures contracts, swaps, and various other types of products
  17. 17. Dealers– Dealers profit from a markup on the items sold from their inventory (or stock-in-trade) to customers in the ordinary course of their trade or business– A taxpayer who buys securities from customers and sells them to in the market to noncustomers can also be a dealer– Dealers also include “non-inventory” dealers, who regularly offer to enter into, assume, offset, assign, or terminate securities or commodities positions with customers in the ordinary course of their trade or business– A dealer may act as principal or as an agent in its transactions with customers– Certain securities (or commodities) held by dealers receive mark to market ordinary gain and loss treatment under have IRC § 475
  18. 18. Traders– Traders are professional investors– Engaged in trade or business of buying and selling financial assets to profit from favorable changes in the market prices for their positions • Courts often look to see if the taxpayer engages in the activity with the intent to earn income or profit and is so engaged with regularity and continuity • Recent case law has focused on the volume of trading– Traders deduct their trading expenses under IRC § 162. • These deductions are not itemized deductions subject to potential limitation under IRC § 67 (2% floor) and phase-out under IRC § 68– Traders may be eligible to make an IRC § 475(f) election Income and losses from trading activities generally are capital in character unless the trader makes an IRC § 475(f) election.
  19. 19. Traders (cont’d)– The term “trader” is not defined in either the Code or Treasury Regulations– The issue is whether the taxpayer is engaged in a trade or business– There is a body of case law addressing when a taxpayer’s activities result in characterization of the taxpayer as a trader– Other Considerations: • Intent as evidenced by PPM/OM, LPA, minutes of investment committee • Turnover of portfolio, number of trades • Actual results of activity (i.e., long-term vs. short-term) Key factors: frequency and continuity of trading activity and whether the taxpayer seeks short-swing profits
  20. 20. Distinction Between Dealers and TradersThe standard distinction between a dealer and a trader is that: Dealer Trader• The dealer’s income is based on the • The trader’s income is based not on services it provides to customers in any service it provides but rather on the chain of distribution of the goods fluctuations in the market value of it buys and/or sells, rather than on the items (e.g., securities, fluctuations in the market value of commodities) that it trades. those items. The dealer may perform the function of “middleman” in the chain of distribution.
  21. 21. Investors– “Investor” is a “catch all” category – if a taxpayer is not a trader, dealer, or hedger, it is an investor • Investors generally seek to profit from price appreciation and income earned on the financial assets they hold – Realize gains from intrinsic value of company with regard to short-term developments – Income from long-term capital appreciation and income (interest and dividends) • Investors typically hold capital assets for a longer term than other capital market participants and realize capital gains and losses– An investor’s investing activities do not rise to the level of a trade or business
  22. 22. Trader vs. Investor Summary of Factors to Consider• Amount of time spent on the activity• Length of time security is held• Are expected gains long-term or short-term capital gains?• Ratio of margin debt to portfolio value• Is intent to benefit from interest, dividends, capital appreciation or from short-term trading?• Refer to extensive case law for specifics
  23. 23. Trader or Investor Characterization Facts and circumstances analysis is based on common law Determination oftrader vs. investor • Typical holding periods for securities bought classification and soldis made annually • Frequency and dollar amount of trades during the year • Fund strategy • Stat Arb/Algorithmic Trading funds almost always considered trading • Long/Short funds typically considered investing • Credit funds typically considered investing • Event-driven funds typically considered trading
  24. 24. Trader or Investor CharacterizationINVESTOR TRADER• IRC § 212 expenses are deductible as • IRC § 162 expenses deducted above the itemized deductions subject to 2% of line AGI floor• For high-income taxpayers, the 2% floor • Ability to make IRC § 475 election frequently causes complete disallowance of the deductions passed through from investment partnerships• IRC § 212 expenses are an addback for AMT purposes• Not a deduction in calculating income and subject to 3.8% Medicare tax imposed on net investment income under IRC § 1411 starting in 2013• Wash sale and straddle rules apply
  25. 25. Deductibility of ExpensesINVESTOR TRADER• Reported on Schedule K as an – Page 1 of Form 1065 Investment Expense (Portfolio – Above the line deduction of expenses Deduction) – Deductible for AMT• Misc. Deductions – Subject to the 2% / – Investment Interest limitations – 3% limitations Schedule E• Not deductible for AMT – State tax advantages• Interest Expense limits – Reported on Schedule A
  26. 26. Interest Expense Limitations– “Investor” Partnership • Assets are property for investment • Subject to limitations for Section 163(d) • Individuals: Report as an Itemized Deduction– “Trader” Partnership • Partnership interest of limited partners will be considered property held for investment • Subject to limitations for Section 163(d) • Individuals: Report as an “above-the-line” deduction • General partner that materially participates is not subject to the limitations of Section 163(d) and will report the item as an “above-the- line” deduction
  27. 27. Investor vs. Trader Considerations for Fund of FundsTrader vs. Investor Determination– When preparing a tax return for Fund of Funds, the Trader vs. Investor determination will need to be made for every K-1 received. The following factors need to be considered: • Footnote disclosure of status • Location of various K-1 income/expense items (Lines 1 & 11f vs. the various separately stated lines) • Character of gain L/T vs. S/T gain • Often the information received need to be reorganized at the fund level to achieve consistent presentation • An underlying partnership investment can have both investor and trader activities
  28. 28. Investor vs. Trader Considerations for Fund of Funds Revenue Ruling 2008-39– Management and Other fees generated at fund level • Historically the status of the underlying funds were considered when determining how to treat the management and other fees paid at the fund of funds level • Revenue Ruling 2008-39 states that management fees paid at fund level should be treated as “investor” expenses– Application • All fund level expenses should be reported as investor type expenses regardless of the status of the underlying funds– Able to pass through the ordinary character of deductions taken at lower tier partnership level
  30. 30. What is the Mark-to-Market Election & Who is it For?– 475(f)(1)&(2) General rule: In the case of a person who is engaged in a trade or business as a trader in securities and commodities and who elects to apply §475(f), • the person shall recognize gain or loss on any security held in connection with trade or business at the close of the tax year as if the security was sold for its fair market value on the last business day of the year, and • any gain or loss shall be taken into account for the taxable year. • Applies separately for each trade or business without consent.– Held for investment election
  31. 31. Why Make the Mark-to-Market Election?– As a solution to the limitations on capital losses, wash-sale rules and other restrictions that apply to stock traders.– By making the election, gain or loss from trading in securities becomes ordinary. Therefore, the following limitations on capital losses do not apply. • Individual taxpayers can deduct up to $3,000 of capital losses against ordinary income. • Corporate taxpayers cannot deduct capital losses in excess of capital gains.– The wash sale and straddle rules do not apply.– Possibly eliminates complex bond calculations related to OID and Market Discount– For individuals, the ordinary gain is not subject to self-employment tax; Also, can carry back NOLs in excess of current year income to the 2 preceding years– Potential Disadvantages: • Acceleration of unrealized gains • Limited capital gain opportunities
  32. 32. Tax Implications of Making the MTM Election– The taxpayer must mark all securities at their market value at year-end. Thus, unrealized gains and losses are accelerated.– The gain or loss is treated as ordinary income or loss. Losses are deductible in full against ordinary income from sources such as wages, salary and dividends.– Proper adjustment is made in the amount of any gain or loss subsequently realized for the gain or loss taken into account previously.– Once such an election is made, however, it shall apply to the tax year for which made and all subsequent tax years, unless revoked with the consent of the Secretary.
  33. 33. Tax Implications of Making the MTM Election– The electing taxpayer loses the benefit of lower (15%) long-term capital gains tax rate. However, note that such a taxpayer is an active short- term trader and should have very few, if any, long-term capital gain transactions.– An electing taxpayer can exclude certain securities from the “mark-to- market & ordinary income” regime by timely identifying and segregating such purchases into separate “investment” accounts. If proper procedures are followed, then the gain or loss on such securities will get long-term capital gain treatment if the holding period and other requirements are met.
  34. 34. How Do You Make the Election?– Revenue Procedure 99-17 provides specific procedures to follow– Procedures for existing taxpayers • File a statement describing the election being made, the first taxable year for which the election is effective, and the trade or business for which the election is made. • The statement must be filed no later than the due date (without regard to extensions) of the original tax return for the tax year immediately preceding the election year • Must be attached either to that return or, if applicable, to a request for an extension of time to file that return.– Procedures for new taxpayers • A new taxpayer makes the election by placing in its books and records no later than 2 months and 15 days after the first day of election year a statement describing the election being made, the first taxable year for which the election is effective, and the trade or business for which the election is made. • To notify the Service that the election was made, the new taxpayer must attach a copy of the statement to its original federal income tax return for the election year