Hedge Funds – Tax Issues and Planning to Consider Before Year-End
This newsletter briefly highlights certain tax issues and planning that hedge fund managers should consider (or reconsider) before year-end. Tax rates are scheduled to remain the same in 2016.
1. Federal Income Tax Rates in 2015 and 2016.
Long-term capital gains and qualified dividend income: 25%*
Ordinary income: 44.6%*
(*includes effect of net income investment tax and 3% phase-out of itemized deductions)
2. Fund’s 2015 Tax Picture. Your fund’s tax picture should be evaluated throughout the year, but particularly at year-end. How does your fund’s taxable income compare to its book income? Any unrealized gains that are almost long-term that you should consider holding a little bit longer to realize long-term capital gains rather than selling now and realizing short-term capital gains? Any unrealized losses that you should realize? Beware of the wash sale and straddle rules. There may be ways to realize losses and avoid the wash rules while still economically maintaining exposure to the applicable positions.
3. 3.8% Medicare Contribution Tax (aka “net investment income tax” or “NII tax”). Managers need to be aware of this tax when determining their individual taxes and considering the taxation of investors in their funds.
4. Self-employment tax. Managers should consider the impact of self-employment tax and the structure of their management entities. Investment managers can be structured as limited partnerships in order to minimize self-employment tax.
5. Changing Your Incentive Fee To An Incentive Allocation. Most offshore funds have restructured their incentive fee to an incentive allocation. If you have not, you should consider doing so. Restructuring is generally still beneficial for tax purposes. Restructuring can be done as a mini-master or master-feeder structure. In general, we recommend restructuring by the beginning of the year (such as January 1, 2016, for 2016) but it can be done later (preferably early in the year). Note, if most of your income is short-term capital gains or ordinary income (including if you have made a Section 475 election), it may instead be beneficial to keep the incentive fee as a fee or restructure your incentive allocation as an incentive fee. See item 3 above regarding self-employment tax.
6. Consider the Use of Stock-Settled Stock Appreciation Rights. The IRS issued a ruling in June 2014 confirming that certain SARs will not be subject to the rules set forth in Section 409A and Section 457A. The use, if any, of SARs by fund managers has been very limited, primarily due to built-in economic clawbacks, significant complexity, and the tax benefits of incentive allocations. There are a number of issues regarding the use of SARs and it would take a significant amount of time to implement a SARs plan, so considering or implementing SARs for 2016 needs to be done very soon. Multi-year compensation continues to be a topic of discussion.
7. Review Swaps If You Are An Investor. If your fund is considered an investor for tax purposes (as opposed to a trader), has swaps which have decreased in value and marks-to-market its swaps, consider terminating the swaps and realizing capital losses. If, instead, you simply mark-to-market the swaps at year end, their decrease in value would give rise to miscellaneous itemized deductions which would potentially not be useable by your investors.
8. Consider Making a Section 481(a) Election. This is a potentially valuable and underutilized election. This election does not need to be made by year-end but must be made on or before the extended due date of your management entity’s 2015 tax return to be effective for 2015. This election essentially changes the management entity’s method of accounting for tax purposes to the accrual method, and enables the manager to include the aggregate deferred compensation in income over a four-year period (e.g., 2015 through 2018), one quarter each year. It may be possible to accelerate deferred fees but this raises a number of tax issues.
9. Consider Making a Section 475 Election. A Section 475 election to mark-to-market securities can offer significant tax benefits. For example, if you are a trader and have significant net unrealized losses, you could elect to mark-to-market for 2016, thus converting unrealized capital losses at the end of 2015 to ordinary losses in 2016. If you have unrealized gains, you could realize the gains in 2016 and be subject to tax on the income over 4 years but you would also be converting capital gains to ordinary income. A Section 475 election may offer other tax benefits as well.
10. Re-Evaluate Going Over the 25% Benefit Plan Investor (“BPI”) Threshold; Consider Hard-Wiring. With the continued influx of pension plan investments in hedge funds, the ability to exceed the 25% BPI test has become even more important. The registration of hedge fund managers (which is generally required for managers with over $150 million in gross assets under management) eliminates one of the biggest hurdles in evaluating whether to exceed the 25% BPI threshold and comply with ERISA. For managers that have registered, registration is no longer a factor to weigh in deciding whether to exceed 25% BPI. There are still some uncertainties in what happens when you exceed 25% BPI, but exceeding 25% may be worthwhile and offer you substantial opportunities to grow your fund. One trend for funds in a master-feeder structure is to hard-wire the feeder funds so that they must invest all investable assets in the master fund. This potentially causes the impact of ERISA to mostly be at the master fund level and increases the total that may be invested by BPIs without triggering many of the potentially negative implications of ERISA.
11. U.S. FATCA, UK FATCA, and Common Reporting Standards (“CRS”). Fund managers need to evaluate their compliance (registration, documentation and reporting) with U.S. FATCA, UK FATCA and CRS (which is scheduled to go into effect on January 1, 2016).
12. Estate and Gift Tax Planning. Consideration should be given to whether a gift should be made before year-end. Interest rates continue to remain low and a low interest rate environment can provide substantial estate and income tax planning opportunities (such as the use of grantor retained annuity trusts (“GRATs”)).
13. Charitable Contributions. For taxpayers sitting on large unrealized gains, it may be prudent to contribute appreciated shares to charities in lieu of donating cash. Depending on the type of charity and the holding period for the shares, you may be able to get a charitable deduction equal to fair market value and avoid tax on the gain. Many hedge fund managers with large taxable income reduce their taxes through donations to charity before year-end. If a manager wants a current charitable deduction but wants to defer selection of the public charities, setting up a private foundation or donor advised fund before year-end should be considered.
14. Deferred Fees — Tax Planning. Managers that have significant deferred fees which are subject to tax in 2017 (or 2016), should consider income and estate tax planning for such fees.