Tax Issues and Planning to Consider Before and After Year-End 2023

This newsletter briefly highlights certain tax issues and planning that fund managers and high-net-worth individuals should consider (or reconsider) before and shortly after the end of 2023.

There does not appear to be any proposed tax legislation that is expected to be enacted in the near-term, but that is always subject to change. There have been some significant tax proposals that would impact the taxation of funds and their managers. There have also been some recent court cases that may have a significant impact. Also, there are a number of provisions enacted in 2017 which are scheduled to expire at the end of 2025, if not extended or changed before then.

YEAR-END TAX PLANNING

1. Review Fund’s 2023 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 you should realize in 2023? 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 (discussed below) and straddle rules.

2. Accelerate income into 2023. Realize taxable gains in 2023 that you might not have recognized until 2024 or possibly later. In contrast with losses, there are no “wash sale” rules for gains, meaning you can sell something at a gain and then buy it back soon after without any suspension of the gain.

3. Delay incurring expenses until 2024. For example, you could delay incurring tax-deductible expenses in 2023 to increase 2023 taxable income.

4. Delay paying state and local taxes in 2024. It is possible that the $10,000 limitation on the deductibility of state and local taxes may be increased or eliminated in 2024; if that happens, delaying payment of such taxes until 2024 would be beneficial.

5. Pay bonuses in 2023. A manager that uses the cash basis method of accounting for tax purposes may reduce its 2023 taxable income by paying bonuses in 2023. A manager that uses the accrual method of accounting can pay bonuses no later than March 15, 2024, and deduct such bonuses in 2023, assuming the accrual requirements are otherwise met.

6. Wash sales. Realize a loss this year and potentially undo the recognition of the loss by entering into a wash sale within 30 days; this provides you with flexibility to take the loss in 2023 or to undo the loss by repurchasing the position. The wash sale rules offer some degree of flexibility regarding the timing of losses and possibly character, such as converting long-term capital losses into short-term capital losses. Basket swaps may be able to restore the economic exposure to the loss position without triggering suspension of the loss under the wash sale rules.

7. Constructive sales. The constructive sale rules also offer a degree of flexibility regarding the timing of income, but with respect to gains as opposed to losses. An example is entering into a position that is a constructive sale (e.g., shorting an appreciated stock position) and (A) terminating the constructive sale (e.g., the short sale) by January 30, 2024, and leaving the appreciated position unhedged for 60 days thereafter, in which case there would not be a constructive sale in 2023; or (B), if preferable, not terminating the constructive sale by January 30, 2024, or not leaving the position unhedged for 60 days thereafter, in which case there would be a constructive sale in 2023. The constructive sale rules provide retroactive optionality as to whether the gain is triggered in 2023.

8. Section 475(f) Election. A Section 475(f) election to mark-to-market securities can offer significant tax benefits for a trader in securities. For example, if you are a trader and have significant net unrealized losses, you could wait until 2024 and make an election to mark-to-market for 2024, thus converting capital losses to ordinary losses which may offset ordinary income in 2024. Alternatively, if you have unrealized gains, you could wait until 2024 and make an election to mark-to-market the gains in 2024 and be subject to tax on the income over four years. This would, however, also be converting capital gains into ordinary income. In contrast, if your fund already has a Section 475(f) election in place, you should consider whether it should be revoked, depending on your facts and circumstances.

TAX PLANNING AFTER YEAR-END

There are many tax planning ideas to potentially reduce your effective tax rate going forward.

1. State tax residency. Due to the effectiveness of remote working, some have considered changing or have changed their residency, including to low tax (or no tax) jurisdictions. But beware of traps like the “convenience of the employer” rule and the possibility that a move results in double state taxation because of the unavailability of credits. Also, beware that a person is still subject to tax in other states on income sourced to such states.

2. Puerto Rico and the USVI. Puerto Rico and the USVI offer U.S. citizens the potential ability to significantly reduce their federal tax rate without giving up their citizenship. There are a number of rules and requirements, but the tax savings can be significant.

3. State and local tax-free trusts. Trusts can offer significant tax planning opportunities. One potential benefit is avoiding the imposition of state and local taxes on trust income. However, federal income tax brackets are more compressed for trusts.

4. Private Placement Life Insurance (“PPLI”) / Insurance Dedicated Funds (“IDFs”). PPLI may offer the opportunity to reduce income and estate taxes, and IDFs may offer managers a way to increase assets under management.

5. Pass-Through Entity Taxes (“PTET”). Many states have enacted pass-through entity taxes as a workaround to the $10,000 federal limit on the deductibility of state and local taxes. For example, New York State and New York City have enacted pass-through entity taxes. NYS and NYC PTET elections must be made by March 15th of the applicable year (e.g., for 2024, by March 15, 2024). There can be a number of traps and considerations, and each state’s PTET can have its own nuances. Do you need to admit a new member to your LLC so you are treated as a partnership and not a sole proprietorship to take advantage of the PTET? Do you need to create a sleeve for partners subject to NYS tax? Do you need to create a separate partnership for certain investments? Should very highly compensated employees be made partners or indirect partners of management companies to benefit from the PTET rules? PTET taxes can offer significant benefits.

6. Opportunity Zones. Investing in opportunity zones may offer a way to defer or eliminate taxes (on subsequent appreciation). While some of the opportunity zone tax benefits no longer apply, the opportunity zone rules may still offer significant tax benefits.

7. Excess Business Loss (“EBL”) Rules. The EBL rules apply through 2028. The impact of the EBL rules to managers should be considered, particularly if funds managed are considered to be investor funds, and not trader funds, for tax purposes. For example, a fund manager of an investor fund should consider the application of the EBL rules to deductions from the investment manager and the general partner.

8. Incentive Fee Versus Allocation. In the wake of the recently decided Soroban case (to be discussed in an upcoming newsletter), managers currently taking an incentive fee instead of an incentive allocation may wish to consider their effective tax rate if those fees may be subject to self-employment tax. It may be too early to make any changes with respect to any tax planning that relies on the exclusion of a limited partner’s distributive share of partnership income from self-employment tax.

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If you have any questions regarding this client alert, please contact your primary Kleinberg Kaplan attorney or one of the members of our Tax Practice.