Tax Issues and Planning to Consider Before and After Year-End 2024

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 2024.

With Republicans winning control of the Presidency, House and Senate and lower expectations that taxes will be increased in 2025, there is less urgency to plan for year-end other than standard year-end tax planning. No one knows what changes, if any, may be enacted in 2025 and when such changes will be effective. However, most expect the enactment of a large tax act sometime in 2025 due to both the change in administration and the expiration on December 31, 2025, of a number of changes enacted in the 2017 Tax Cuts and Jobs Act. Many expect that tax rates will remain the same or be lowered and that there will be a push to extend expiring tax provisions, albeit in the face of a growing budget deficit. Therefore, this year-end may not require any specific tax changes before December 31, 2024, due to expectations of unfavorable tax changes. Rather, this year-end will involve more typical year-end tax planning.

YEAR-END TAX PLANNING

1. Review Fund’s 2024 Tax Picture. If you are a fund manager, 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? Some prefer to try to have taxable income be similar to or match book income while some prefer to have taxable income be less than book income if possible. Do you have any unrealized gains that you should realize in 2024? Do you have 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? Do you have any unrealized losses that you should realize, including before they become long-term? Beware of the wash sale rules (discussed below) and straddle rules.
2. Accelerate income or losses into 2024. Realize taxable gains in 2024 that you might not have recognized until 2025 or possibly later if you want to increase your 2024 taxable income. 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. With the expectation that tax rates may be lower in the future (although there can be no assurance thereof), there may be less of a need to accelerate income into 2024 and more of a need to accelerate losses into 2024.  Harvesting losses in 2024 may thus be beneficial. (See “Wash sales” below.)
3. Incur expenses in 2024. You could incur tax-deductible expenses in 2024 to decrease 2024 taxable income if you anticipate that tax rates will be decreased in 2025.
4. Pay state and local taxes in 2025. It is possible that the $10,000 limitation on the deductibility of state and local taxes may be increased or eliminated in 2025; if that happens delaying payment of such taxes until 2025 would be beneficial. Also, it may be possible to delay income until 2025 so that state and local taxes may be paid by an entity, as opposed to personally, or by an entity for which a timely pass-through entity tax election has not been made in 2024 but will be made for 2025, so that the taxes are effectively deductible in 2025 in contrast to being non-deductible in 2024. (See “Pass-Through Entity Taxes” below.)
5. Pay bonuses in 2024. A manager that uses the cash basis method of accounting for tax purposes may reduce its 2024 taxable income by paying bonuses in 2024. A manager that uses the accrual method of accounting must pay bonuses no later than March 15, 2025, in order to deduct such bonuses in 2024, assuming the other accrual requirements are met.
6. Wash sales. Realize a loss in 2024 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 2024 or undo the loss by repurchasing the position. The wash sale rules offer some degree of flexibility regarding the timing of losses and possibly the character of losses, such as converting from long-term capital losses to short-term capital losses. One may be able to use basket swaps to restore economic exposure to the loss position without triggering suspension of the loss under the wash sale rules. A basket swap that reflects at least 20 stocks and does not have 70% or more overlap with the position that was sold at a loss will generally not trigger a suspension of the loss.
7. Constructive sales. The constructive sale rules also offer a degree of flexibility regarding 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, 2025, and leaving the appreciated position unhedged for 60 days thereafter, in which case there would not be a constructive sale in 2024; or (B) not terminating the constructive sale by January 30, 2025, or not leaving the position unhedged for 60 days thereafter, in which case there would be a constructive sale in 2024 (effectively providing flexibility until March 30, 2025, to make a decision regarding 2024 taxable income). Thus, the constructive sale rules provide retroactive optionality as to whether the gain is triggered in 2024.
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 2025 to realize the losses and make an election to mark-to-market for 2025, thus converting capital losses to ordinary losses (which may be applied against ordinary income in 2025 without limitation). Alternatively, if you have unrealized gains, you could wait until 2025 to realize the gains and make an election to mark-to-market in 2025 and be subject to tax on the income spread over four years. This would, however, also be converting capital gains to 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 limitations on or 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 U.S. citizenship. There are a number of rules and requirements, but the tax savings can be considerable.
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 2025, by March 15, 2025). There can be a number of traps and considerations and each state’s PTET can have its own nuances. Do you need 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 provide material tax benefits.
6. Opportunity Zones. Investing in opportunity zones offer a way to defer taxes or eliminate taxes (on subsequent appreciation). While some of the opportunity zone tax benefits no longer apply, the opportunity zone rules may still offer considerable tax benefits.
7. Excess Business Loss (“EBL”) Rules.The EBL rules currently apply through 2028. The impact of the EBL rules on 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 income from the investment manager and the general partner.
8. Incentive Fee Versus Allocation.In the wake of the Soroban case and other similar cases regarding whether a limited partner’s distributive share of fee income earned by a management company that was formed as a limited partnership is subject to self-employment tax, managers currently taking an incentive fee instead of an incentive allocation may wish to consider their effective tax rate if those fees become subject to self-employment tax. Most are still not changing structures until and unless case law becomes more definitive or legislation or other guidance is enacted or promulgated.

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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.