Year-end has always been a time for tax planning and we send our clients and friends our year-end tax planning newsletter on an annual basis. Unlike the end of 2017, there does not appear to be significant tax legislation on the horizon, although there still could be some changes enacted in 2019, including some potential technical corrections. The 2017 Tax Cuts and Jobs Act (“TCJA”), however, was extremely complex, made many changes that affected hedge funds and hedge fund managers, still has many unanswered questions, and will impact 2018 year-end tax planning as well.
This newsletter briefly highlights certain tax issues and planning that hedge fund managers should consider (or reconsider) before year-end. Some planning may need to wait until 2019 and some planning may be able to be changed retroactively. Lastly, there are still a number of glitches and mistakes in the 2017 law which may provide tax opportunities as well as the potential for tax pitfalls.
1. Planning for the changes to the taxation of carried interests.
There was substantial planning done at the end of 2017 regarding the changes to the taxation of carried interests which were enacted at the end of 2017. Click here
to see our prior newsletter on this topic. In the absence of guidance from the IRS regarding the new provision (Section 1061) relating to the taxation of carried interests, some of the ideas considered at the end of 2017 should be considered again before year-end.
2. When to recognize gains and losses; Loss harvesting. Consider your tax situation in 2018 and your projected tax situation in 2019 to determine in which year it would be preferable to recognize gains and losses. Obviously, as with all the other potential tax planning ideas discussed herein, there are non-tax considerations that need to be taken into account. There may be ways to basically lock in gains or losses or to recognize such gains and losses with some ability to undo such recognition within a period of time (such as violating the wash sale rules or undoing constructive sales). Loss harvesting is also an important year-end consideration (but the wash sale rules need to be considered).
3. Miscellaneous itemized deductions. Under the TCJA, individuals can no longer deduct miscellaneous itemized deductions for 2018 through 2025. It might be better to defer paying such expenses until 2019 in the hope that the law changes. Alternatively, it might be possible to see if such expenses can be capitalized or otherwise recharacterized or paid in a different manner (for example, by taking advantage of a PFIC, as described below).
4. Investing in PFICs. Investing in a PFIC (i.e., a passive foreign investment company) may be a way to address the loss of miscellaneous itemized deductions for investors in a fund treated as an “investor” fund and, in addition, may be a way to minimize state and local taxes.
5. State and local income taxes. Under the TCJA, non-business state and local taxes (in excess of $10,000 for each year) are no longer deductible for taxes paid for 2018 through 2025. Individuals should generally pay 2018 state and local taxes to meet estimated tax safe harbors, but there generally does not appear to be another reason to pay such taxes before year-end. Instead, paying such taxes in 2019 may be more beneficial if Congress acts to restore some or all of the deduction for state and local taxes (now that there has been a change in the House).
6. State and local tax-free trusts. Consider the use of state and local tax-free trusts. New York tax rules were changed in 2014 but there are still potential significant tax benefits. These trusts have become even more beneficial due to the new limitations on deducting state and local taxes. Many people do not realize that these trusts can still be used. You may also wish to do this as part of your overall trust and estate planning.
7. Consider state and local entity-level taxes.
Connecticut and New York and other jurisdictions have enacted potential workarounds to state and local tax limitations. New York enacted a tax on amounts paid to employees but that required an election to opt in on or before December 1, 2018, and very few opted in. Connecticut enacted an entity-level tax which is in part elective. Click here
to see our recent newsletter on the new Connecticut tax.
8. Residence or place of business. You may, in light of high effective tax rates, consider establishing your residence in a new low (or no) tax jurisdiction. Some states such as Florida have no personal income tax. Establishing residency in Puerto Rico can also still provide a path to reduce your taxes substantially. What it means to move and the benefits of moving need to be evaluated.
9. Whether to pay bonuses in 2018 or 2019; Excess business loss rules.
Consider whether it is preferable to pay bonuses in 2018 or 2019. Remember to take into account the new excess business loss rules and determine whether an allocation from a partnership is preferable to W-2 compensation. Click here
to see our recent newsletter on the excess business loss rules.
10. Consider changing the carried interest allocation to a fee. This might be beneficial to a fund’s investors and not be that detrimental to the manager (or might even be beneficial to the manager). Is your fund an investor for tax purposes? Does your fund have significant qualified dividend income or other income taxed at preferential tax rates that still might flow through in the carry? Does your fund have significant unrealized income generally? Where is your fund manager located?
11. Consider making a Section 475(f) mark-to-market election.
A Section 475 election may offer significant tax benefits, including for built-in gains or losses. Please click here
to see our prior newsletter on making (or revoking) a Section 475 election.
12. Opportunity Zones. If you have recognized capital gains, consider whether it makes sense to reinvest some or all of your capital gains in opportunity zone funds. Opportunity zone provisions were enacted in the TCJA and offer significant tax benefits including deferral of income tax and potential elimination of income tax on future appreciation. Proposed regulations were recently issued and we have spent significant time on these provisions and can help guide you through them either from the investor perspective or from the fund perspective.
13. Consider the use of stock-settled stock appreciation rights. If a substantial portion of the carried interest will now be taxable as short-term capital gains, you might want to consider the use of stock appreciation rights (SARs). SARs allow the deferral of income but there is a built-in clawback, they are very complex and no, or very few, funds have actually implemented SARs. There are a number of issues regarding the use of SARs and it might take a significant amount of time to implement a SARs plan.
14. Private Placement Life Insurance/Insurance Dedicated Funds. Hedge fund managers should consider offering insurance dedicated funds as a way for investors to invest in their fund strategy in a more tax-efficient manner. Conversely, investors should consider whether investing in a fund via private placement life insurance or private placement variable annuities is potentially a more tax-efficient way to invest.
15. Partnership audit rules. New partnership audit rules are effective for audits of taxable years beginning on or after January 1, 2018. Your fund documents and your management company documents should be updated for the rules if they have not been updated already. These rules are significantly different than the prior audit rules. Partnerships can expect the new rules to result in more IRS audits of hedge funds and other large partnerships and more tax liabilities from audit adjustments. Fund documents need certain disclosures regarding the new rules and the ability to require partners, including former partners, to take certain actions.
16. 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 remains very important. There are still some uncertainties in what happens when you exceed 25% BPI, but exceeding 25% may be worthwhile and offer substantial opportunities to grow your fund. One trend for funds in a master-feeder structure continues to be the so-called hard-wiring of feeder funds which requires the feeder funds to invest all of their 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.