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The ABCs Hedge Fund Tax


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Elizabeth Powell presented The ABCs Hedge Fund Tax at the Hedge Fund Investment & Operations Boot Camp hosted by the FRA in New York July 31, 2012.

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The ABCs Hedge Fund Tax

  1. 1. A Global Reach with a Local Perspective www.decosimo.comThe ABCs Hedge Fund TaxElizabeth F. PowellTax Manager
  2. 2. CONTACT ME Elizabeth F. Powell, CPA Tax Manager 423-756-7100 The contents and opinions contained in this article are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals.
  3. 3. Hedge Fund Formation Structure  Domestic/Foreign  LP/LLC/LLP  Some states distinguish between LP and LLC. Potential for additional fees.  Master/Feeder  Master Fund with two investors – Onshore feeder fund and an Offshore feeder fund  Mini-Master  Onshore investors are directly invested in in Master fund, along with an Offshore feeder.
  4. 4. Hedge Fund Formation Capital Contributions  In Hedge Funds, generally money or securities.  General rule is that there is no gain or loss to the partner or partnership on an exchange of property for an interest in a partnership.  Exception to general rule for partnerships that would be treated as an “investment company” if they were incorporated.
  5. 5. Hedge Fund Formation Capital Interest  An interest which entitles the partner to share in distribution of partnership assets upon liquidation Profits Interest  An interest which entitles the partner to share only in the future profits of the partnership
  6. 6. Distributions Current Distributions  Cash distributions – no gain recognized unless cash distributed in excess of tax basis of interest  Securities distributions – tax basis of securities carried over to the investor Liquidating Distributions  Cash distributions – gain or loss recognized to extent cash distributed is greater or less than tax basis of partnership interest  Securities distributions – the securities distributed take the tax basis of the partnership interest
  7. 7. Basic Tax ConsiderationsTrader vs. Investor Trader  Engaged in frequent and continuous trading of financial assets to profit from favorable fluctuations in the market Investor  Generally seeks to profit from price appreciation and income earned on the financial assets they hold.
  8. 8. Basic Tax ConsiderationsTax Treatment Trader –  Trading expenses are deductible as ordinary and necessary business expenses  Above the line deduction for AGI  Deductible for AMT  Investment interest after limitations – reported on Schedule E (for individuals)
  9. 9. Basic Tax ConsiderationsTax Treatment Investor –  Trading expenses are considered investment expenses  Miscellaneous itemized deductions subject to the 2% / 3% limitations  Not deductible for AMT  Investment interest expense after limitation – deductible on Schedule A
  10. 10. Basic Tax ConsiderationsTrader vs. Investor Summary of factors to consider:  Intent as evidenced by PPM/OP or LPA  Turnover of portfolio, number of trades  Amount of time spent on activity  Actual results of activity (i.e. long-term vs. short-term)  Ratio of margin debt to portfolio value  Determination is made annually
  11. 11. Basic Tax Considerations Wash Sales  Occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:  Buy substantially identical stock or securities  Acquire substantially identical stock or securities in a fully taxable trade, or  Acquire a contract or option to buy substantially identical stock or securities.  Losses are not deductible  Deferred wash sale attaches to the basis of the repurchased stock or securities
  12. 12. Basic Tax Considerations Constructive Sales  Transactions that take an offsetting position to an already owned position  Examples:  Making short sales against similar or identical positions  Entering into futures or forward contracts that call for the delivery of an already-held asset.  Accelerates recognition of gain
  13. 13. Basic Tax Considerations Section 475 Mark-to-Market Election  Under the MTM rules traders in securities are treated as having sold all their securities on the last day of the year at their fair market value  Any gain or loss recognized is taxed as ordinary income or ordinary loss  Reported on Form 4797
  14. 14. Basic Tax Considerations Advantages to Sec 475 Election  Losses are ordinary trade or business losses rather than capital losses  Losses are not subject to $3,000 limitation  Net operating losses can be carried back or forward  Eliminates problems of straddles, wash sales, constructive sale limitations, along with complex bond calculations relating to OID and market discount
  15. 15. Basic Tax Considerations Disadvantages to Sec 475 Election  Capital gains converted to ordinary income  Eliminates offsetting against Short-term capital losses  Limited ability to carry forward prior capital losses How is the election made?  New taxpayers must place election statement in their books or records no later than two and fifteen days of the beginning of the tax year for which it is effective  Existing taxpayers must attach statement to their U.S. federal income tax return or extension for the tax year immediately preceding the election year
  16. 16. Basic Tax Considerations Section 1256 Contracts  Only available for regulated futures contracts  A regulated futures contract is a contract based on a system of marking to market and traded on a qualified exchange  Gain/Loss is 60% long-term and 40% short-term Swap contracts  Cross-border swaps will no longer escape withholding  Tax as Notional Principal Contracts  Specifically excluded from Section 1256 treatment
  17. 17. Basic Tax Considerations UBTI – Unrelated Business Taxable Income  Big concern for tax-exempt investors  Taxable Income from business activities unrelated to the tax-exempt purpose of the organization  Generally not an issue for trading partnerships due to exemptions for interest, dividends, rents, capital gains, etc.  Debt-financed income – income from property acquired or carried with debt  Real estate, some securities portfolios, fund of fund with line of credit
  18. 18. Hedge Fund Tax AllocationsEconomic Allocations Fair Value Break period accounting Operating results  Investment Income  Interest and dividend income  Operating expenses  Trading results  Realized gains  Change in unrealized
  19. 19. Hedge Fund Tax AllocationsCapital Gain Allocations Allocating Capital Gains and Losses  Layering method  Aggregate method Fill up/down  Allocate realized gain to withdrawing partners in order to remove the unrealized gains associated with their interest
  20. 20. Hedge Fund Tax AllocationsReallocations Performance Fee  Comes into play when return exceeds a specified benchmark Carried Interest  Most commonly seen in Private Equity or Real Estate funds
  21. 21. State and Local Tax Considerations Nexus Apportionment Departure from Pass-through Treatment Entity-level Income Taxes Withholding and Estimated Tax Payments Composite Filings
  22. 22. Foreign InvestorsNon-resident Withholding ECI  Income effectively connected with a trade or business in the U.S.  Subject to 35% withholding FDAP  Fixed, Determinable, Annual or Periodic  Interest, Dividends, Royalties  Maximum withholding at 30%  Some treaty rates may be lower
  23. 23. Foreign InvestorsFIRPTA Foreign Investment in Real Property Tax Act All direct and indirect rights to appreciation in real property interest Gross proceeds are subject to 10% withholding FATCA  Foreign Accounts Tax Compliance Act  FFIs and NFFEs required to report to IRS information about accounts held by U.S. taxpayers  Must enter into a special agreement with the IRS or be subject to 30% withholding on payments of U.S. source income
  24. 24. Foreign InvestmentsReporting of foreign investments Foreign Partnerships  Form 8865 Foreign Corporations  Form 5471 Disclosures  Form 926
  25. 25. Foreign InvestmentsPFICs (Passive Foreign Investment Company) A non-U.S. corporation is a PFIC if either  75% or more of its gross income is from passive sources  50% or more of its average gross assets generate passive income or are held to generate passive income Consequences  No long-term capital gain treatment when sold  Gain is allocated over holding period of stock, with gain allocated to current year taxed at ordinary rates and  Gain allocated to prior year:  Taxed at highest ordinary income rates  Interest charge imposed
  26. 26. Foreign InvestmentsAvoiding PFIC punishment QEF election (Qualified Electing Fund)  Taxed currently on share of net capital gain and ordinary earnings  No flow-through of losses  PFIC must provide PFIC Annual Information Statement  Must make QEF election on timely filed return
  27. 27. Foreign InvestmentsAvoiding PFIC punishment MTM election (Mark to Market)  Stock must be marketable  Unrealized appreciation is taxed as ordinary income annually  Losses are allowed only to extend of prior year inclusions