This annual 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 2014. FATCA compliance deadlines are beginning to approach (unless they are further delayed) and net investment
income tax final regulations were just issued.
Federal Income Tax Rates in 2014
Long-term capital gains and qualified dividend income: 25%
Ordinary income: 44.6%
Fund’s 2013 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 traddle rules.
3.8% Medicare Contribution Tax (aka “net investment income tax”). Final
regulations were just issued but the final form and instructions have not yet been issued. This tax will impact K-1 preparation as well as managers and investors (including regarding year-end tax estimates). We are determining whether there are any opportunities or pitfalls for funds and fund managers.
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 so that the restructuring is in place by the beginning of the year, such as January 1, 2014, for 2014, 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), 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 marked-to-market the swaps, their decrease in value would give rise to its 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 2013 tax return to be effective for 2013. 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., 2013 through 2016), 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 securites 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 2014, thus converting losses to ordinary losses. If you have unrealized gains, you could realize the gains in 2014 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.
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 offshore funds have been holding off regarding FATCA (Foreign Account Tax Compliance Act). Final regulations were issued in January 2013, and, unless FATCA is further delayed, funds will need to address FATCA between January 1, 2014, and April 25, 2014, as effective dates are fast approaching. For example, withholding agents will be required to withhold on withholdable payments made after June 30, 2014. While the web portal for FATCA registration is already accessible, information entered into the system will not be finalized until a submission on or after January 1, 2014, and registration must be done by April 25, 2014.
Estate and Gift Tax Planning – Important Year-End Deadlines. There are few changes to estate and gift tax planning, but consideration should be given to whether a gift should be made in the current year. The uniform exemption which is currently $5.25 million for 2013 is indexed to inflation, and will increase to $5.34 million in 2014. The estate and gift tax rate increased from 35% to 40% in 2013. Also, interest rates 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”)).
Don’t Forget About the AMT. Increased regular income tax rates and the 2013 AMT patch mean that fewer taxpayers will get caught by the alternative minimum tax. Because the alternative minimum tax limits or eliminates many deductions normally available—including deductions for state taxes and mortgage interest—it may be that more taxpayers are better off paying their 2013 estimated state and local taxes before year-end.
Charitable Contributions. With the stock market going up substantially in 2013 and taxpayers sitting on large unrealized gains, it may be prudent to contribute 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, thus getting a favorable charitable contribution and avoiding tax on the gain. Managers may be able to contribute appreciated securities to charities.