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. Similar to the end of 2018, there does not appear to be significant tax legislation on the horizon. Also, there are still many unanswered questions regarding the 2017 Tax Cuts and Jobs Act (“TCJA”).
This newsletter briefly highlights certain tax issues and planning that hedge fund managers and investors should consider (or reconsider) before year-end.
1. Planning for changes to the taxation of carried interests. Substantial planning was done at the end of 2017 and 2018 regarding the changes to the taxation of carried interests. Click here to see our prior newsletter on this topic. In the absence of guidance from the IRS regarding the taxation of carried interests (Section 1061 of the Code), some of the ideas considered at the end of 2017 and 2018 should be considered again before year-end (e.g., converting through reclassification or otherwise some of your GP interest to an LP interest).
2. When to recognize gains and losses; Loss harvesting. Consider your tax situation in 2019 and your projected tax situation in 2020 to determine in which year it would be preferable to recognize gains and losses for tax purposes. Many funds compare taxable income to book income in making this determination. As with the other potential tax planning ideas discussed herein, non-tax considerations may need to be taken into account. There may be ways to essentially 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 through the wash sale rules or the constructive sales rules). Loss harvesting is also an important year-end consideration (but the wash sale rules need to be considered).
3. Charitable tax planning. Many individuals own publicly traded shares with large built-in gains. One tax planning idea is to contribute shares which have been held for more than one year to a charity (a private foundation or a public charity, including a donor advised fund). The individual is not taxed on the built-in gain and gets a charitable contribution deduction for tax purposes equal to the fair market value of the shares (subject to certain limitations).
4. Miscellaneous itemized deductions. Under the TCJA, individuals can no longer deduct miscellaneous itemized deductions for 2018 through 2025. Evaluate whether your fund is a trader or an investor and whether that may change in 2020. It might be better to defer paying expenses until 2020 or pay expenses in 2019 depending on your fund’s tax status and whether that may change. Alternatively, it might be possible to see if such expenses can be capitalized, otherwise recharacterized or paid in a different manner (for example, by taking advantage of a PFIC, as described below).
5. Investing in PFICs. Investing in the offshore fund (which is usually 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. A PFIC can deduct its expenses, including what would otherwise be miscellaneous itemized deductions, in determining its earnings and profits. A PFIC may also minimize state and local taxes.
6. 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 2019 state and local taxes to meet estimated tax safe harbors, but there does not appear to be another reason to pay such taxes before year-end.
7. 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 for New York individuals. These trusts have become even more beneficial due to the new limitation on deducting state and local taxes. Many people do not realize that these trusts can still be used (in New York and in some other states as well). You may also wish to do this as part of your overall trust and estate planning.
8. Consider state and local entity-level taxes. Connecticut, New York and other jurisdictions have enacted potential workarounds to state and local tax limitations. Connecticut enacted an entity-level tax which is in part elective. Click here to see our newsletter on the Connecticut tax. Other states have also enacted, or are considering enacting, such taxes.
9. 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 provide a path to reducing your taxes substantially. What is required to change your residence and the benefits of changing residency need to be evaluated based on the particular facts and circumstances. Alternatively, moving some or all of your place of business might also reduce taxes.
10. Whether to pay bonuses in 2019 or 2020; Excess business loss rules. Consider whether it is preferable to pay bonuses in 2019 or 2020. 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 newsletter on the excess business loss rules. As with the carried interest rules, regulations have still not been issued on the excess business loss rules.
11. Consider changing the carried interest allocation to a fee or the management fee to an allocation. These might be beneficial to a fund’s investors and not materially 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? Does your fund have significant unrealized income? Where is your fund manager located?
12. 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 newsletter on making (or revoking) a Section 475 election.
13. 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 have been issued. There have not been many opportunity zone funds to date, but you can set up your own opportunity zone fund for gain allocated to you or realized by you. We can help guide you through the rules either from the investor perspective or from the fund perspective.
14. 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.
15. Private Placement Life Insurance/Insurance Dedicated Funds. Hedge fund managers should consider offering insurance dedicated funds (“IDFs”) 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. Investing in an IDF can eliminate income and estate taxes if done properly.
16. Estate and Gift Tax Planning. In light of the recent increase in the federal unified credit, other recent changes in federal estate and gift tax rules and low interest rates, we recommend that you review your estate and gift tax planning. In addition, there have been recent changes to the state-level estate tax rules in several states (including in New York, New Jersey and Connecticut) that may impact your estate and gift tax planning.
17. Partnership audit rules. New partnership audit rules are effective for audits of partnerships for 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 from the prior audit rules. Partnerships can expect the new rules to result in more IRS audits of hedge funds and other large partnerships which may lead to 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.