This annual newsletter briefly highlights certain tax issues and planning that hedge fund managers should consider (or reconsider) before year-end. Although tax planning at the end of each year is always important, tax planning at the end of 2012 is crucial due to potential tax rate increases. Even with the election over, there is still great uncertainty regarding tax rates and other potential tax changes.
Consider Potential Significant Increases in Income Tax Rates Effective January 1, 2013. Below is a comparison of the highest federal 2012 tax rates versus 2013 tax rates:
Long-term capital gains: 15% 25%
Ordinary income (non-compensatory): 35% 44.6%
Ordinary income (compensatory): 37.9% 44.6%
Qualified dividend income: 15% 44.6%
Unless legislation is enacted, tax rates are scheduled to drastically increase as of January 1, 2013, due to the expiration of the 2001 Bush tax cuts and the imposition of a new 3.8% tax (known as the Medicare contribution tax) on net investment income on taxpayers with income in excess of certain thresholds (e.g., $250,000 modified adjusted gross income for married filing jointly). Whether these rates actually become effective or are changed is not certain. While we would anticipate that tax rates will increase, there may be no certainty during the lame-duck session of Congress in 2012 or even well into 2013.
Some ideas for tax planning due to the potential increases in tax rates are:
Accelerate income into 2012. Realize taxable gains in 2012 that you might not have recognized until 2013 or possibly later. For non-liquid investments, it may take some time to execute a transaction by year-end so the sales process would need to begin very shortly if feasible. In contrast with losses, there is no “wash sale” type concept for gains, meaning you can sell something at a gain and then buy it back soon after.
Distribute dividends before January 1, 2013. With tax rates on qualified dividends scheduled to almost triple from 15% to 44.6%, this could produce significant tax savings.
Delay incurring expenses until 2013. Incurring tax deductible expenses in 2013 could be more valuable than incurring such expenses in 2012 when rates are lower. As a caveat, there have been proposals to limit the deductibility of itemized deductions.
Pay bonuses in 2012. Employees may prefer to be paid some or all of their bonuses in 2012, instead of early in 2013, so they may be subject to a lower tax rate on their bonuses. Note, employers may prefer to pay bonuses in 2013 instead
of 2012 (see C above). This idea (as with the other ideas) needs to take into account non-tax considerations.
Wash sales. You could realize a loss this year but then undo the recognition of the loss by entering into a wash sale within 30 days of realizing the loss; this
provides you with flexibility to take the loss in 2013 instead if rates increase.
Hedge your bets! Due to the uncertainty regarding tax rates, you may want to hedge your bets regarding whether tax rates will increase and take some actions this year which may buy time into next year to see what happens. (i) One example is that you may sell an asset for future payments (i.e., an installment sale) and elect out of the installment sale method by the extended due date of your 2012 tax return (September or October of 2013) if tax rates increase and not elect out if rates do not increase. (The installment method of accounting, however, is not available for publicly traded securities.) (ii) Another example is doing what could be a constructive sale (e.g., shorting an appreciated stock position) and (A) terminating the constructive sale (e.g., the short sale) by January 30, 2013, and leaving the appreciated position unhedged for 60 days thereafter, in which case
there would be deemed not to be a constructive sale in 2012 (you would do this if tax rates do not increase), or (B) not terminating the constructive sale by January 30, 2013, in which case there would be deemed to be a constructive sale in 2012 (you would do this if tax rates increase). (iii) There are also other potential ways to undo a dividend that is distributed in 2012 or to undo a sale, but only within the first few months of 2013.
Fund’s 2012 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 2012 to take advantage of 2012 tax rates? 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.
Impact of Potential Tax Changes on Trading. Will the potential tax rate increase impact trading? Will prices for shares in corporations sitting on large amounts of cash increase due to the potential that they will distribute the cash? Will there be more redemptions of stock? What are the consequences of purchasing shares in advance of a large dividend distribution?
3.8% Medicare Contribution Tax (“MCT”) — Manager. As mentioned above, for 2013, there is a new and novel tax on net investment income. Does the LP technique for potentially avoiding self-employment tax also potentially avoid the 3.8% MCT?
3.8% Medicare Contribution Tax — Fund. Funds need to be cognizant of this new tax when considering effective tax rates on dispositions. This new tax puts even more pressure on the trader versus investor classification because expenses of an investor would be subject to the itemized deduction limitations.
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. Some managers have delayed restructuring due to high water mark issues or because of concerns that the taxation of carried interests would change. 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 so that the restructuring is in place by the beginning of the year, such as January 1, 2013, for 2013, but it can be done later (preferably early in the year).
Review Swaps If You Are An Investor. If your fund is considered an investor for tax purposes (as opposed to a trader) and your fund has swaps which have decreased in value and you mark-to-market your swaps, consider terminating the swaps and realizing capital losses as opposed to marking-to-market the depreciation which would result in miscellaneous itemized deductions which would potentially not be useable by your investors.
Consider Making a Section 481(a) Election. If you no longer want to defer
compensation but want to leave your money in the fund, 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 2012 tax return to be effective for 2012. 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., 2012 through 2015), one-quarter each year. It may be possible to terminate deferrals but this raises a number of tax issues.
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 defer realizing the losses until 2013 and elect to mark-to-market for 2013, thus converting capital losses to ordinary losses and applying them against income subject to tax at the higher 2013 tax rates. If you have unrealized gains, you could wait until 2013 and realize the gains in 2013 and be subject to tax on the income over 4 tears but you would also be converting capital gains to ordinary income. A Section 475 election may offer other tax benefits as well.
Re-Evaluate Going Over the 25% Benefit Plan Investor (“BPI”) Threshold; Consider Hard-Wiring. With the 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 required for managers with over $150 million in assets under management) eliminates one of the biggest hurdles in evaluating whether to exceed the 25% BPI threshold and comply with ERISA. Registration has always been an expensive proposition and would subject you to SEC review. For managers that have registered, it is no longer a factor to weigh in deciding whether to exceed 25% BPI. There are still uncertainties in what happens when you exceed 25% BPI, but generally 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 and 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.
FATCA Compliance. Most funds have not done that much yet regarding
FATCA (Foreign Account Tax Compliance Act). It is anticipated, however, that final regulations will be issued shortly (400 pages of proposed regulations were issued in February 2012) and funds will need to address FATCA during 2013 since various effective dates are generally January 1, 2014.
Estate and Gift Tax Planning – Important Year-End Deadlines. Substantial
potential changes may also apply to estate and gift tax planning. The uniform exemption which is currently $5.12 million may decrease to $1 million and the estate and gift tax rate which is currently 35% may increase to 55%. Also, interest rates remain historically low and a low interest rate environment can provide substantial estate and income tax planning opportunities.